http://articles.businessinsider.

com/2012-02-14/markets/31057539_1_criteria-aaa-bond-
ncav

We've discussed in the past some of the more familiar value/bargain screening criteria
that can be derived from Benjamin Graham's earlier work, e.g the NCAV and
Enterprising Investor Screens.
What may be less known to you, though, is some quantitative work that Graham did
towards just before his death (known as his "Last Will") with the help of a aeronautical
engineer James Rea, where he first identified the 10 best-performing stock selection
criteria and then apparently distilled them into the 3 most important criteria.

Background
It seems that, upon reading an article that Graham had written for Barrons
Renaissance of Value Rea forwarded some of his quantitative/screening research
to Graham. This led to a three-year working relationship before Graham died, which
culminated in two articles, one by Rea and one by Blustein (for Forbes) where they set
out the findings of the research based on 50 years of back-testing as to the most
effective value screening criteria for the US market.
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Benjamin Graham's 10 Rules for Stock Selection

Here's the list that Graham came up with. The idea behind the rules is that the first five
measure "reward" (by pinpointing a low price in relation to key operating results like
earnings) and the second five "risk" (by measuring financial soundness and stability of
earnings).
1. An earnings-to-price yield at least twice the AAA bond rate
2. P/E ratio less than 40% of the highest P/E ratio the stock had over the past 5 years
3. Dividend yield of at least 2/3 the AAA bond yield
4. Stock price below 2/3 of tangible book value per share
5. Stock price below 2/3 of Net Current Asset Value
6. Total debt less than book value
7. Current ratio great than 2
8. Total debt less than 2 times Net Current Asset Value
9. Earnings growth of prior 10 years at least at a 7% annual compound rate
10. Stability of growth of earnings in that no more than 2 declines of 5% or more in
year end earnings in the prior ten years are permissible.

Unfortunately, the issue with these criteria is that, if all 10 are used, the criteria are just
too onerous and are unlikely to result in a meaningful number of picks, especially with
changing market conditions and business practices over time. The question which
Graham and Rea explored is whether certain criteria can be preferred over others?

The Magic 3
http://articles.businessinsider.com/2012-02-14/markets/31057539_1_criteria-aaa-bond-
ncav
The caveat here is that we've unfortunately not yet managed to get hold of the Graham-
Blustein article, so this is based on secondary material. However, this source indicates
that Graham found that the earning yield and the dividend yield criteria (i.e. the criteria
numbered 1 and 3) to be by far the most important performance criteria, while also
finding that criteria 1 in combination with criteria 6 would perform almost as well as all
10. Blustein (who wrote up the work for the Forbes article) apparently suggested that
criteria 1, 3 and 6 were the most profitable (similar results have been found on the
Johannesburg stock exchange). This ties to another source which indicates that
"Graham stated in a lecture at UCLA that if an investor just used earnings yield,
dividend yield, and debt to tangible equity, they would get results double the DJIA".