A stock portfolio based on Ben Graham’s Stock Selection Criteria for the Defensive Investor is a robust and straightforward method to beat the market. We present here a custom screener, with detailed instructions, allowing investors of any expertise level to build a low-volatility tax-efficient market-beating portfolio. The strategy selects 15 stocks listed in the S&P 500 and holds them for one year or more. Once a year, investors examine the portfolio and are instructed on replacing between two and three stocks. Over a recent period of 18 years, such strategy had amassed 11.5% a year (incl. dividends), vs. 5.13% for the S&P 500. It has done so with lower volatility and a lower maximum drawdown.
Benjamin Graham, known as the father of value investing and as the first quantitative investor in the new era, published his mechanical stock selection
criteria in his 1949 seminal book “The Intelligent Investor.”
Graham makes a distinction between a risk-averse Defensive Investor whose primary goal is the preservation of principal and an Enterprising Investor whose primary goal is the maximization of investment returns.
Graham’s stock selection criteria for the Defensive Investor are based on the following principles (Graham, p. 114):
- There should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty.
- Each company selected should be large, prominent, and conservatively financed. Indefinite as these adjectives must be, their general sense is clear.
- Each company should have a long record of continuous dividend payments. (All the issues in the Dow Jones Industrial Average met this dividend requirement in 1971.) To be specific on this point we would suggest the requirement of continuous dividend payments beginning at least in 1950.
- The investor should impose some limit on the price he will pay for an issue in relation to its average earnings over, say, the past seven years. We suggest that this limit be set at 25 times such average earnings, and not more than 20 times those of the last twelve-month period. But such a restriction would eliminate nearly all the strongest and most popular companies from the portfolio. In particular, it would ban virtually the entire category of “growth stocks,” which have for some years past been the favorites of both speculators and institutional investors. We must give our reasons for proposing so drastic an exclusion.
In chapter 14 Graham provides his lists of rules. Following are the rules and how we applied them:
1. Adequate size of the enterprise
we defined our stock universe to be the S&P 500. All constituents are large and prominent companies.
2. A sufficiently strong financial position
Graham suggested to filter out companies whose current ratio (current asset divided by current liabilities) is less than 2, or whose long-term debt exceeds net current assets (current assets – current liabilities). We assume that the constituents of our universe, the S&P 500, possess a sufficiently strong financial position. Applying further rules are not necessary. Such rules would be too restrictive and will result in losing good opportunities rather than avoiding bad companies. Our testing confirms this choice.
3. Earnings Stability
Graham suggested a positive net earnings figure in any of the last ten years. We are less stringent and require only five years with some net earnings in every year.
Graham was suggesting uninterrupted payments for at least 20 years. Over the years, paying a dividend has become less popular and were substituted in part by repurchasing shares or re-investing in the firm. We require uninterrupted payments for only five years.
5. Earnings growth
Graham suggested a minimum increase of at least 33% during the last ten years, using three-year averages at the beginning and the end. We adopted the rule as stated.
6. Moderate Price/Earning Ratio
Graham required that the current stock price should not be more than 15 times the average earnings of the past three years. Given the much lower interest rates these days than in Graham’s day, we relaxed the rule to P/E <= 20.
7. Moderate Ratio of Price/Assets
Graham required that the multiple of P/E (using average earnings for the past three years) and P/B would be less than 22.5. This rule is interchangeable with the previous rule (OR function between them). We have relaxed it to P/E * P/B<= 30.
Applying these rules on the S&P 500 universe results in over 40-150 stocks at any given time. Graham allows the defensive investor to apply his own discretionary judgment as to which stocks to select out of this group. We have performed backtesting with numerous criteria, and we have found that choosing the least volatile stocks (as measured by 3-y Beta) provides the best risk-adjusted returns. Selecting stocks on the merit of either momentum or value results in excellent performance, yet the higher volatility may be uneasy to handle, especially for defensive investors.
Following is a performance summary of a portfolio holding only 15 stocks selected for their lowest 3y Beta, and re-balanced every one year:
We are amazed that such a simple strategy beats the market by a wide margin for almost 70 years, and with less volatility and drawdown. Moreover, the asset turnover of this strategy is less than 20%, meaning that on average, every year only a fifth of the holding (or 3 stocks) are being replaced. The strategy is thus suitable for investors operating in either taxed or taxed-deferred accounts. The strategy provides an easy-to-maintain low-adrenaline low-volatility method to consistently beat the market over a holding period of several years.
Read our backtesting report where we discuss our extensive testing results and portfolio construction considerations.
List of Defensive Investor stocks:
Portfolio Constructions Instructions:
- Sort the list based on 3y beta
- Buy the first 15 stocks with the lowest beta (highest “3Y Beta Rank”)
- Hold for one year and a day (to avoid short-term tax implications)
- On the rebalance date, sell the stocks which either 1) had negative net earnings during the last 12 months, OR 2) did not pay a dividend during the previous year OR 3) have appreciated more than 100% OR 4) have been held for three years yet have appreciated less than the S&P 500.
- Replace with the stocks in the list with the highest 3y-beta rank (which correspond to the lowest beta stocks).