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Benjamin Graham Basic Investment Criteria
You're ready to build a stock portfolio that's right for you. Now, we'll take a look at howgreat investors of the past and present have picked stocks and built their own portfolios.Benjamin Graham is probably the most famous value investor in history, but not for anyperformance record set while managing a mutual fund. Graham is credited for the successof one of his well-known disciples, Warren Buffett, the creator and longtime chairman of Berkshire HathawayBRK.B. By following Graham's teachings (and adapting somestock-picking principles of his own), Buffett has made Berkshire one of the mostsuccessful investment vehicles of all time.We'll talk more about Buffett later. Here, in a nutshell, is Graham's approach.
Seek a Margin of Safety
Even after you think you have a good handle on what a stock should be worth, it isimportant to buy at a discount to this estimated fair value to give an adequate margin of safety. After all, no projection about the future is foolproof, and protecting yourself fromunforeseen events is entirely prudent. For instance, if a company's new product falls flatand profit growth doesn't materialize, you want to be protected.It's also important to realize that some companies are riskier and harder to predict thanothers. In general, the riskier a company is, the larger the margin of safety should be.The bottom line is that if you don't use a lot of discipline and conservatism in figuring outthe prices you are willing to pay for stocks, you will regret it eventually. You might beable to sell some of your overvalued shares to some sucker who is willing to pay an evenmore inflated price, but in the end, this kind of speculating is the investing equivalent of musical chairs, with the last one holding the stock the loser. Don't let it be you. Buy at aprice below fair value with an adequate margin of safety and sleep well at night.-------------A lecturer at the Columbia School of Business during the 1930s, Graham detailed hisinvestment philosophy in two classic books:
Security Analysis
(co-authored with DavidDodd in 1934) and
The Intelligent Investor 
(first published in 1949). These books expandon Graham's definition of a cheap company, which is based on a principle he calls marginof safety. Margin of safety simply means buying companies that are cheap relative totheir intrinsic worth, or what the company would be worth if the entire business weresold. The thinking is that if the company doesn't rebound, you can cut your losses withminimal harm.Graham bought businesses that were so cheap, so battered, and so neglected, that theysold for less than the value of their working capital, which is current assets minus currentliabilities. Graham's argument was that even with the best research, investors can never
 
know all there is to know about a company. More importantly, investors can't alwayspredict the negative surprises that can zap a stock price. So Graham championed this ideaof margin of safety.
Favor Big Companies with Strong Sales
An investor during the Great Depression, Graham saw once-thriving, smaller firms fallby the wayside as their sales grew smaller and smaller. Based on his observations, hediscerned that if a company had at least $100 million in revenues it had a better chance of surviving. (That would translate into about $1 billion in sales today. Remember thatGraham's books were written in the 1930s and 1940s, so think in terms of what $100million meant back then.) His rationale was that tiny companies have a harder timecushioning the blows of an economic downturn, so it's best to invest in larger companies.
Seek Dividends
Graham was adamant about seeking dividends. In fact, he believed that conservativeinvestors (like himself) need only consider companies that have paid a dividend everyyear for at least 20 years. Not only are dividends a sign that a company is profitable (theyare paid from profits, after all), but they also offer investors a return even if thecompany's stock is performing poorly.
Choose Companies That Are in Good Financial Shape
Graham looked for what people today refer to as "net-nets," or companies whose currentassets exceed the sum of current and long-term debt. Graham was always mindful of liquidity. His thinking was that companies with ample liquidity (access to cash) were lessrisky because their assets could always be sold to raise cash.
Look for Companies with Sustainable Earnings Growth
Graham always sought companies with an upward earnings trend, but profits didn'tnecessarily have to rise every year. They just couldn't be regressing. Graham felt thatsteadily improving earnings would lead to improving stock performance.
Pay Attention to Price Multiples
Graham searched for companies with price/earnings ratios below their historical average.Moreover, he wouldn't buy a stock unless it was trading for less than 1.2 times its book value per share. (A simple equation for book value is assets minus liabilities.) So, forexample, a company with $2 billion in assets and $1.6 billion in debt has a book value of $400 million. If the company has 20 million outstanding shares of stock, then the book value of each share is $20 ($400 million divided by 20 million). Using Graham's ownformula, he wouldn't pay more than $24 per share for that company's stock (1.2 times thebook value per share).
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