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The defensive investor's screen

Graham's seven tests for a defensive investor's stocks, from financial strength to the 22.5 rule, with a calculator.

FinanceGraham ch. 14About 4 min: 2 reading, 2 practiceUpdated

General education, not financial advice.

After this lesson you can
  • List Graham's seven tests for a defensive investor's stocks
  • Apply the price tests, including the 22.5 rule
  • Explain why the tests exclude both weak companies and popular expensive ones

Builds toward: Judge a company. Read a company's accounts, apply Graham's tests, and make a rough valuation.

The Intelligent Investor: Benjamin Graham's ideas: lesson 16 of 25
  1. Graham ch. 1
  2. Investment versus speculation 4 min
  3. Graham ch. 2
  4. Inflation and the investor 4 min
  5. Graham ch. 3
  6. A century of market history 5 min
  7. Graham ch. 4
  8. The defensive investor's portfolio 4 min
  9. Graham ch. 8
  10. Mr. Market 5 min
  11. Living with fluctuations 5 min
  12. Graham ch. 9
  13. Investing in funds 5 min
  14. Costs and the market
  15. Is advice worth paying for? 7 min
  16. Reading the accounts
  17. The balance sheet always balances 5 min
  18. Graham ch. 5
  19. Defensive investors and stocks 4 min
  20. Graham ch. 6
  21. What the enterprising investor avoids 4 min
  22. Graham ch. 11
  23. Security analysis for the lay investor 4 min
  24. Graham ch. 12
  25. Per-share earnings and their traps 4 min
  26. Graham ch. 7
  27. What the enterprising investor does 5 min
  28. Graham ch. 13
  29. Comparing four companies 4 min
  30. Graham ch. 14
  31. The defensive investor's screen 4 min
  32. Graham ch. 15
  33. The enterprising investor's screen 7 min
  34. Graham ch. 16
  35. Convertibles and warrants 6 min
  36. Graham ch. 17
  37. Four extreme case histories 7 min
  38. Graham ch. 18
  39. Eight pairs of companies 7 min
  40. Graham ch. 19
  41. Shareholders, managements and dividends 5 min
  42. Graham ch. 20
  43. Margin of safety (1): the idea 5 min
  44. Margin of safety (2): in practice 7 min
  45. Graham appendix 1
  46. The superinvestors of Graham-and-Doddsville 6 min
  47. Graham postscript
  48. Graham today 7 min

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Pairs with Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 14, "Stock Selection for the Defensive Investor"

What it is

Graham's seven tests for a defensive investor who picks individual stocks (in 1972 terms):

  1. Adequate size: at least 100 million dollars of yearly sales for an industrial company (50 million of total assets for a utility). Graham calls the figures arbitrary; they were set in 1972 dollars.
  2. Strong financial condition (industrial companies): current assets at least twice current liabilities, and long-term debt no more than net current assets (working capital).
  3. Earnings stability: some earnings in each of the past ten years.
  4. Dividend record: unbroken dividends for at least 20 years.
  5. Earnings growth: at least one-third growth in earnings per share over ten years, using three-year averages at each end.
  6. Moderate P/E: price no more than 15 times average earnings of the past three years.
  7. Moderate price to assets: price no more than 1.5 times book value, or P/E × price-to-book no more than 22.5 (so a share at 9 times earnings could sell at up to 2.5 times book).

Quick check

Tap an answer to check it.

  1. A share trades at 12 times earnings and 2 times book value. Does it pass test 7?

    Show answer

    No: 2 is above 1.5, and 12 × 2 = 24 is above 22.5. It fails both versions of the test.

Why it matters

The tests cut from both sides. Tests 1–5 remove companies that are small, financially weak, unprofitable in some year, without a long dividend record, or without growth. Tests 6–7 remove the popular, expensive companies, because too much of their price depends on growth continuing. Graham expected them to eliminate the great majority of stocks.

Zweig's commentary adds that a defensive investor today can get much of the same result from a low-cost index fund; the screen is for those who choose to pick their own stocks.

Worked example

A company's figures (made up):

  • Current assets 400, current liabilities 150: current ratio 2.67, passes. Working capital 250; long-term debt 200 is less, passes.
  • Profitable all ten years; dividends for 25 years: passes tests 3 and 4.
  • Average EPS 3.00 now, 2.00 a decade earlier: growth 50%, passes test 5.
  • Price 40: P/E = 40 ÷ 3 ≈ 13.3, passes test 6.
  • Book value 30: price ÷ book ≈ 1.33, passes test 7 (and 13.3 × 1.33 ≈ 17.8 < 22.5).

Try your own figures:

Graham's defensive screen (tests 2–7)

Drag a slider and watch the result change.

For learning only. Real accounts have fees, taxes and changing rates.

Common mistake

Treating the screen as a list of things to buy. Graham's tests are minimums to exclude risky or expensive shares; a company that passes still needs diversification around it, and the 1972 size figure needs updating for inflation.

Key terms

current ratio
current assets ÷ current liabilities
net current assets
current assets minus current liabilities (working capital)
book value
net assets per share, from the balance sheet
22.5 rule
P/E × price-to-book should not exceed 22.5 (15 × 1.5)
screen
a set of tests used to rule shares in or out

Practise the key terms

Tap a card to turn it over. 5 cards.

FrontBack
current ratiocurrent assets ÷ current liabilities
net current assetscurrent assets minus current liabilities (working capital)
book valuenet assets per share, from the balance sheet
22.5 ruleP/E × price-to-book should not exceed 22.5 (15 × 1.5)
screena set of tests used to rule shares in or out

Practice

Work it through

Price 36; average EPS of the last three years 4; book value per share 20.

Quick quiz

Tap an answer to check it.

  1. In the last exercise, does the share pass test 7?

    Show answer

    Yes: price is above 1.5 × book, but 16.2 is within 22.5. Graham's alternative: P/E × P/B ≤ 22.5.

  2. Which two tests exclude popular, expensive companies?

    Show answer

    The P/E test and the price-to-assets test. Tests 6 and 7 demand more earnings and assets per unit of price.

In short

  • Seven tests: size, financial strength, ten years of earnings, 20 years of dividends, one-third EPS growth, P/E ≤ 15, price ≤ 1.5 × book or P/E × P/B ≤ 22.5.
  • They exclude weak companies and expensive popular ones.
  • They are minimums, not a buy list; the 1972 size figure needs updating.
  • Zweig: an index fund now does much of the defensive job.

Mastery check

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Check yourself

Answer in your head first, then open the answer. Nothing is saved.

  1. What is Graham's financial-strength test for an industrial company?

    Show answer

    Current assets at least twice current liabilities, and long-term debt no more than net current assets.

  2. How long an unbroken dividend record does Graham require?

    Show answer

    At least 20 years.

  3. A share's P/E is 10. Under the 22.5 rule, what is the highest price-to-book it can have?

    Show answer

    2.25.

Further reading

  • Benjamin Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 14.
  • On this site: Defensive investors and stocks.