Seven Criteria for Defensive Stock Selection
A quantitative checklist to screen for financially sound, fairly priced stocks
Graham provided the defensive investor with seven specific, quantitative criteria for selecting common stocks. These criteria are designed to be applied mechanically, requiring no subjective judgment about a company's future prospects. They filter for adequate size, strong financial condition, earnings stability, dividend record, earnings growth, moderate valuation, and moderate price-to-asset ratio.
The genius of these criteria is that they screen out the vast majority of stocks, leaving only those that combine financial strength with reasonable price. Graham argued that a portfolio of 10 to 30 stocks meeting all seven criteria would produce satisfactory results with minimal research effort. The criteria serve as a first-pass filter; the defensive investor need not analyze the remaining candidates further.
These criteria have been backtested extensively and shown to outperform the market over long periods. They work because they systematically avoid the two main sources of investment loss: financially weak companies that go bankrupt and overpriced companies whose valuations contract.
- Adequate size provides a buffer against business risk and ensures sufficient financial data
- Strong financial condition (current ratio of at least 2:1) protects against liquidity crises
- Earnings stability over ten years demonstrates resilience through business cycles
- A continuous dividend record proves the company can generate and return cash
- Moderate P/E ratios protect against overpaying for expected growth
- Price-to-book limits ensure you are not paying excessive premiums over tangible assets
- Screen for adequate enterprise sizeFilter for companies above a minimum revenue threshold (Graham suggested $100 million in sales, adjusted for inflation). This eliminates small and micro-cap stocks that are more volatile and less well-covered by analysts.
- Apply financial strength filtersRequire a current ratio of at least 2:1 (current assets at least double current liabilities) for industrial companies. Long-term debt should not exceed net current assets. These tests ensure the company can survive economic downturns.
- Check earnings stability and growthRequire positive earnings in each of the past ten years (earnings stability) and at least one-third growth in per-share earnings over the past ten years using three-year averages at beginning and end (earnings growth). This demonstrates resilience and forward progress.
- Verify dividend recordRequire uninterrupted dividend payments for at least twenty years. A long dividend record indicates financial health, management discipline, and a commitment to returning capital to shareholders.
- Apply valuation limitsRequire that the current price is no more than 15 times average earnings of the past three years, and no more than 1.5 times the last reported book value. Graham also suggested that the product of the P/E ratio and the price-to-book ratio should not exceed 22.5.
- Build a diversified portfolio from qualifying stocksSelect 10 to 30 stocks from those meeting all criteria. Diversify across industries. This diversification provides additional safety beyond the individual security criteria. Review the portfolio once or twice per year and replace any stocks that no longer meet the criteria.
Graham applied quantitative criteria similar to these at his investment firm, Graham-Newman Corporation, from the 1930s through the 1950s. He purchased diversified portfolios of stocks meeting strict value and financial quality criteria, holding them until they reached fair value or were replaced by better candidates.
Graham refined these criteria over decades of investment practice and teaching at Columbia Business School. They represent the distillation of his experience into the simplest possible set of rules that still produce satisfactory results. He presented them in Chapter 14 of The Intelligent Investor as the complete stock selection method for the defensive investor, requiring no additional research beyond checking these filters.