10 Rules to select good Shares/Stocks for Value Investing

Having opened a Demat account after listening to countless stories of making huge profits in the stock markets, you feel ready to make inroads into the world of stock markets, scrips and profits. Bulls, bears, pig and chickens are terms that you hear every time you log onto a business channel. Wondering if you want to go long or short or use options to hedge your positions? Welcome to the murky waters that are known to drown most persons ready to brave the labyrinth of the stock markets called DalalStreet.

The rags to riches or riches to rags story that holds us captivated and longing for a share of the pie is just a myth. The truth, behind making profits in stocks and investing wisely, was unraveled a long time ago by a gentleman called Benjamin Graham. Most of us are familiar with the name Warren Buffet, who is considered a Wall Street genius. He refers to Benjamin Graham, the father of value-based investing, as his mentor and role model.

Interestingly enough, Benjamin Graham’s rules for investing laid down towards the last part of his life holds relevance even today. Let us now take a look at the rules popularly referred to, as his last will. Benjamin was known to manually fill out the values for each stock being considered. This painstaking work used to result in only a very limited number of stocks that fulfilled the criteria set out by him.

Benjamin Graham’s Last Will & 10 Rules for Value Investing

Graham referred to few fundamental ratios and made them the basis of his computations. Let me start off by listing out the rules below:

1)  Earnings Per Share : The First rule states that earnings per share (EPS) of a particular stock must be twice that of the triple-A rated bond.  For ease of calculations, the yield of  10 year SBI bond is taken as the rate of the AAA bond which is around 8, Graham says the stock should have EPS should be 16 or above.  For ease of calculations, the yield of  10 year SBI bond is taken as the rate of the AAA bond which is around 8%.

For example, The EPS of Amrutanjan Healthcare for the year ended March 2015 is 21.13 while the 10-year  yield is in the range of percent and therefore meets the above criterion.

2) PE Ratio : The second rule refers to the Price to earnings ratio.

Which is also popularly known as the PE ratio. Let’s understand the PE ratio first,

As the name says its calculated by dividing market price of the share with the earnings per share i.e.,. If the market price of a particular company is 100 and the per share earnings is 10 then the PE ratio would be 100/10=10. (The earnings yield i.e., EPS is the reciprocal of the price earnings ratio.)

It, however, takes the historical data of the previous years into consideration. The rule states that the present price to earning ratio must be at least 4/10th (40 percent) of the highest average P/E ratio attained by the stock during the immediately preceding five years.

Amruthanjan health care which has a present average PE of 28.73 fulfills the above condition.

3) A dividend yield of 2/3 times that of the triple-A bond yield is a positive indicator for investing in a stock. However, Amruthanjan does not fit this criterion. Also most companies do not declare a dividend in purely monetary terms now-a-days.

4) If the stock prices (market value) are down to 2/3 times the book value, the stock is a good candidate for further investigation prior to making the investment decision. This particular point is often considered as a yardstick on which to identify and shortlist potential scrips for investment. (What is Book Value ? – Book value refers to the total amount a company would be worth if it liquidated its assets and paid back all its liabilities. It is the value of a security or asset as entered in a firm’s accounting books.)

5)  When stock prices plummet to 2/3’s of the “net current asset value“, then it is a good idea to include them in the stocks to be considered for investment. Net current asset value, also called the net quick liquidation value is calculated by reducing total debts from current assets. Fixed assets are not a part of this computation.

6)  Any stock with total debt, lower than the book value of the scrip is a candidate that can be included in the shortlist. In the case of Amruanjan Healthcare, the total debt to equity ratio (D/E)  stands at zero and book value of the scrip is 71.74, thereby satisfying the criteria.

7)  A current ratio greater than or equal to 2 is considered important for profit making while investing. The current ratio for Amrutanjan Healthcare is at a robust 7.95 making it pass this criterion.

8)  A continuation of point no 5 above, this rule too is based on the net quick liquidation value. The criteria state that total debt must be equal to lesser than two times the net quick liquidation value.

9)  Stock that has doubled itself over the last ten year period is a good bet.  Amruthanjan fits this criterion as well. So, the earnings growth of prior 10 years should have been atleast at a 7% annual compound rate.

10) The final commandment refers to the growth in earnings of the stock. Intelligent investors look out for stability in growth. In other words, a maximum of two declines that is greater than 5 percent in the immediately preceding ten-year period.

Making Profits the Benjamin Graham Way

A careful look at the listed criteria clearly shows us that the first five rules measure the rewards while the next five measures the risk associated with a scrip. From the rules listed out by Graham, it is easy to conclude that price to the value of the scrip is of great significance while identifying potential scrips that would make sound investment options. The valuation of the company is also equally important.

However, while testing these rules on Indian Scrips, they failed to meet the mark by not being able to satisfy all the 10 criteria simultaneously.  So considering our present market trends, Its important that you develop your own value investment philosophy based on the above principles.

Tips and surefire ‘bets’ in the stock market are all just words. Why would someone who is so sure of the profits want you to invest? Why is he not putting in his money and reaping the dividends? Bad news may lead to temporary fluctuations, but stay calm and focused. If the stocks have passed Benjamin Graham’s test’s and unless your calculations are off the mark, you will reap good return on your investments.

Risk Vs Investment Goals

The risk appetite of each individual differs based on his age, income, social status and financial health. Do not wildly follow trends just because your neighbor/ colleague/ cousin or friend is doing so. Keep your investment goals in mind while making decisions with regards to investment, portfolio size and value. Emotions are the bane of intelligent investors. The more emotionally involved you are in an investment decision the greater are the chances of going overboard. Never let emotions cloud your judgment. Instead, stay focused and make decisions based on facts and logic.

Always remember, trading is a misconception that has caught the imagination of countless people wanting to reap huge profits on the stock markets. While it may or may not yield results, the general trend is that people tend to lose money while trading without understanding the fundamentals. The risk is comparatively high as is the probability of making huge losses. Margin trading and leveraging might seem lucrative, but carry huge risks and are best avoided. Why not leave that to the professionals? (You may like reading : ‘10 reasons to avoid Short Term Trading in Stock Markets.’)

It is important, an intelligent investor must have patience and faith. Patience, since stock prices will not go up in a flash under ordinary circumstances. More importantly, as an investor, you must have faith in yourself. Having applied Benjamin Graham’s rules to your investment decision, you can now sit back and relax before reaping the fruits of your efforts!

This article is a guest post by Kishorkumar.

About the Author / Company

KishorKumar Balpalli – Kishor is the founder of mymoneysage.in. He believes that financial literacy and discipline is the key to one’s financial freedom. Mymoneysage.in is an award winning personal finance platform, which helps you aggregate all your personal finance accounts like FD, Equity, Mutual Funds, PPF EPF, Credit Cards, Loans etc. Its one place where you can track, plan and invest seamlessly. Mymoneysage.in empowers you to invest in zero commission direct plans of mutual funds thereby helping you generate higher return on investments when compared to Regular Plans.

Continue reading other interesting articles written by dear Kishor :

• The 7 most important Personal Finance Ratios you need to know.
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(Kindly note that Relakhs.com is not associated with mymoneysage.in. This post is for information purposes only. This is a guest post and NOT a sponsored one.  We have not received any monetary benefit for publishing this article.) 

(Image courtesy of Stuart Miles at FreeDigitalPhotos.net) (Post Published on : 11-May-2016)