7 Value Investing Principles by Benjamin Graham for Indian Stocks

Benjamin Graham Principles of Value Investing

Benjamin Graham is credited with the creation of value investing as a branch of knowledge in the world of finance and stock markets. 

Benjamin Graham not only excelled at making money in the stock markets but did that without taking big risks.

A large reason for this was, him losing a sizeable portion of his wealth in the market crash of 1929 & the Great Depression. That experience taught him the importance of minimising risks and he practiced that by investing in companies which traded at far below their actual intrinsic value.

These principles and ideals led Benjamin Graham to write the book Security Analysis in 1934 which is a sort of the bible of value investing.

Between Security Analysis and The Intelligent Investor, Benjamin Graham laid out the 8 investment rules for low-risk investing. 

📚I recently did a book review on The Intelligent Investor. Have a read and let me know what you think of it.

The 7 value investing principles (rules) of Benjamin Graham are –

  1. Portfolio diversification of between 10 to 30 stocks
  2. Large sales numbers of atleast $1 billion
  3. Current ratio of 2
  4. Paid dividends for at least 20 years with no misses
  5. No single year of decreasing earnings over the past 10 years & earning growth of atleast 3% annually during those 10 years
  6. Price earnings ratio should be 15 or lower
  7. Difference between assets and liabilities atleast 1.5 times of market capitalization

If we feel that these principles are strict. Yes! They are.

But Benjamin Graham lived in a very different time and age to where we are. Remember, he & the United States of America had gone through and come out of a very difficult recessionary period with massive unemployment and plummeting value of businesses in the stock markets.

As shown in the graph below, the country was on a standstill for a decade in terms of gross domestic product (GDP)

A difficult 1930s in the United States transformed Benjamin Graham into a risk-adjusted return seeking investor and led to the birth of value investing

This period taught Graham the value of preservation of capital and how to use numbers & statistics to achieve this goal.

Benjamin Graham Principle #1 : Portfolio Diversification 

Benjamin Graham recommends that the average investor should have 10 to 30 stocks in their portfolio.

In other words, he advocates a manageable risk structure where there is not too much concentration on a few stocks (high risk) and not too much diversification (average returns).

There are others who don’t agree with this. Even big investors like Warren Buffett have said at times that he does not mind putting in upto 40% of available assets into one bet if it is a high conviction bet. And on the other hand, there are mutual fund managers who invest in dozens and dozens of stocks on the garb of diversification and risk minimization. 

In my view, Warren Buffett is merely suggesting that you should be sure and he himself takes bets on multiple stocks but does not spread himself too thin.

I totally disagree with the mutual fund manager’s view that more stocks mean more risk diversification. The reason why I see this concept as flawed because many studies have proven that diversification beyond 25 to 30 stocks does not yield commensurate returns and does not significantly reduce unsystematic risk. 

If you’d like to geek it out, do read the 1973 paper by Franco Modigliani and Geral A. Pogue titled An Introduction To Risk And Return Concepts And Evidence 

Higher number of stocks in a portfolio does not mean lowering of risk. However it does lead to lowering of returns in most cases
Higher number of stocks in a portfolio does not mean lowering of risk. However it does lead to lowering of returns in most cases

In this context, Graham is correct in recommending investors look at a 10 to 30 stock portfolio.

Benjamin Graham Principle #2 : Sales of $1 billion or more

Large companies have large advantages. They can – 

  • Bear shocks more easily
  • Attract better talent and management
  • Higher cash flows 
  • Negotiate better terms with supplier

The flipside is that these companies might move at a much slower pace as compared to smaller companies.

Unlike beginner investors, Benjamin Graham here is not looking at the pace of growth only. Graham is trying to help us with a model which can offer us better risk-adjusted returns and he feels the large cap companies are better suited for that.

I am personally not in total agreement with this.

While I understand the importance of having enough bottom line, the top line (revenue or sales) is a completely different matter. There are two reasons why I don’t put a lot of credence on this because –

  1. Graham lived in a time when most businesses were industrials or utilities. The typical company worked on net margins of 5-7%. This is unlike today when services or technology companies deliver big billion dollar sales at 25-30% margins. In other words, the companies in the 1930s delivered $1 profit from $20 of sales while major 2020 companies deliver $1 profit from just $4 of sales. See the tables below for an idea of how the S&P 500 index has changed over the years.
  2. I won’t want to look at merely sales in isolation but give a lot of importance to the generation of operating cash flow and free cash flow. So, while a company can give a billion plus in sales, it’s possible that it is operating at negative cash flows which is a sign of peril in the long run for companies.

Here is an interesting interactive chart I found on the internet that shows the changing type of companies on the S&P 500 over the years. Enjoy!

It is interesting to see how the companies have changed since the year 2000 when there were two technology companies in the top 12 i.e. Microsoft and Intel. The #1 company then (and a previous employer of mine) was General Electric.

By 2018, GE had moved out of the top 12 and so had Intel. Completely new tech-driven companies had moved into the top spots with Apple, Google, Microsoft, Amazon, Tencent and Facebook occupying the top 6 spots.

If you are curious, at the time of writing this article, there are 210 listed companies in India which had declared sales of over $1 billion (₹7,000 crores)

List of largest companies in India by revenue

#Name of CompanyMarket Cap (in ₹ crs) Total Revenue (in ₹ crs)Total Revenue (in $ bn)
1Indian Oil Corporation Ltd80,9626,17,24388.2
2Reliance Industries Ltd7,75,9305,82,84583.3
3Oil and Natural Gas Corporation Ltd95,9884,53,46164.8
4Bharat Petroleum Corporation Ltd78,1153,40,87948.7
5State Bank of India1,72,4683,30,68747.2
6Tata Motors Ltd25,5743,01,93843.1
7Hindustan Petroleum Corp Ltd33,1742,97,20542.5
8Rajesh Exports Ltd16,1581,75,76325.1
9Tata Steel Ltd33,3031,57,66922.5
10Tata Consultancy Services Ltd6,77,7561,46,46320.9

Do notice that there are five Oil & Gas industry companies in the top 10 list. The one big surprise in this list is Rajesh Exports which is ranked just 133 by market capitalization but is ranked 8th in revenue.

Benjamin Graham Principle #3 : Current Ratio of 2 or more

Current Ratio is the ratio between a business’s current assets and current liabilities. 

A current asset is that asset or holding that is expected to be converted to cash within a year. This includes cash, short term credit given to distributors, loans advances to suppliers, stock/inventory etc. Most of these get converted from their current state into cash within 365 days.

A current liability is a short-term financial obligation that is due within a year. This includes any loans advanced to us, any credit offered by the purchaser, working capital loans, loans maturing within an year, taxes payable etc. These need to be paid within 365 days and hence the company should have enough cash in their coffers to make good their obligations

For example, here are the current assets and current liabilities of Relaxo Footwears Limited over the last five years

Current Assets and Current Liabilities of Relaxo Footwears Limited
Current Assets and Current Liabilities of Relaxo Footwears Limited

The current ratio of these five years were 1.20, 1.14, 1.24, 1.35 and 1.58

Hence, in none of the years, the company qualified per Benjamin Graham’s current ratio greater than 2 rule.

Now let’s look at two of Relaxo Footwears competitors and see how the current ratio stacks there.

FY2015FY2016FY2017FY2018FY2019
Relaxo Footwear1.201.141.241.351.58
Bata India2.192.832.762.782.93
Liberty Shoes1.191.221.261.341.45

Benjamin Graham would have certainly found more comfort with Bata India who has consistently shown a Current Ratio of over 2 in all of the last five years.

As far as I am concerned, I am not a fan of a high current ratios.

Infact, large current ratios are not always good for investors as it shows that the company is not efficiently using its current assets or its short-term financing facilities. Having said this, I agree it is better to have a current ratio of over 1 as it lends support to short-term working capital cycles.

List of companies with high current ratios

Currently, 407 companies in India have a current ratio of more than 2. 

The below table shows large cap companies (with over ₹20,000 crores in market capitalization) with the highest current ratios. Notice the dominance of pharmaceutical and information technology companies in this list. The reason for this is the high amount of cash generated by these industries. Cash is counted under current assets.

NameSub-SectorMarket Cap (in ₹ crs)Current Ratio
Divi’s Laboratories LtdLabs & Life Sciences Services61,9135.5
Tata Consultancy Services LtdIT Services & Consulting6,77,7564.2
Cipla LtdPharmaceuticals48,2133.3
Abbott India LtdPharmaceuticals35,9513.2
ITC LtdFMCG – Tobacco2,31,2173.2
Larsen & Toubro Infotech LtdIT Services & Consulting25,1563.1
Tata Consumer Products LtdTea & Coffee29,9043.1
Info Edge (India) LtdOnline Services30,3953.0
Infosys LtdIT Services & Consulting2,66,6372.8
Hindustan Zinc LtdMining – Diversified73,7322.8

Benjamin Graham Principle #4 : Dividends for 20+ years without a miss

Dividend discipline is again, a metric of the times.

The biggest companies in the 1930s and 1940s were industrials, railroads and utilities. These companies had been in existence for years and it was a popular notion that the companies that pay dividends are often the better stocks to hold.

In his book, Security Analysis, Benjamin Graham used many examples of companies to understand if the company will be able to pay the same or better dividend in the current or coming year.

The concept of offering dividend has now been replaced by offering better return on equity. In other words, instead of giving dividend to shareholders, companies have the option of retaining that part of the profit if it can provide better returns to the shareholder. This can be done by spending that portion in more R&D, better products, more distribution etc. which can lead to higher profits and consequently better share price appreciation.

Over the last two decades we have seen a lot more technology companies entering and staying in the S&P 500. Technology companies are not big dividend payers.

Further these companies are very young. Three of the top 5 companies in the S&P 500 are Amazon, Alphabet and Facebook. These three companies are less than 25 years of age. As a result, getting a wide spread of companies for this Graham rule becomes more and more difficult. 

The image above shows that the returns from dividend were the least in the period 1990 to 2020 (over 30 years) as against anytime in the history of the S&P 500.

Some excellent screeners for companies paying dividend for over 25 years are available for United States stocks. While I tried, I could not collate a 20 year dividend table for Indian companies.

Benjamin Graham Principle #5 : Earnings growth in all of last 10 years & at least 3% growth

😕 I am not sure if Graham meant earnings or earnings per share growth. There is quite a difference in this because a company could have simply brought in more capital through a rights issue and used the proceeds to increase the earning capacity of the company. This would have given the business more earnings but at the expense of the shareholder whose share in the profits would have been diluted

Let’s assume Benjamin Graham means earnings growth (and not EPS)

Graham has clearly put in a flag here that one should go for only those companies which show consistency in growth.

This is OK for regular companies in business which are more staple but will rule out most cyclical companies which are in only one line of business and go through periods of peaks and troughs. The reason for these ups and downs are largely a demand-supply play or a high price-low price moment.

While it is not uncommon to find companies which have shown a consistent earnings growth trajectory, my cursory view of some household Indian stocks like Maruti Udyog, Hindustan Unilever, Pidilite, Hero Motorcorp, Bajaj Auto, ICICI Bank, HDFC Bank, Procter & Gamble etc. shows that maintaining an upward movement every year is a bit difficult.

Of these companies, only two companies show a growth in earnings in each of the last five years.

Benjamin Graham Principle #6 : Price Earning Ratio of 15 or lower

Benjamin Graham created the PE Ratio rule for investors so that they don’t overpay for the business they are buying a stake (shares) into. Since the type of companies were not too many during the 1930s and 1940s, a PE Ratio rule of 15 or lower would have made sense.

When I applied the same rule in the Indian stock market at today’s price, I see that we will miss out on 70% of all large cap and mid cap companies. 

 Large Cap CompaniesMid Cap CompaniesSmall Cap Companies
Total number of companies tracked1101751563
PE <= 15 (and +ve)3353751
% age30%30%48%

Large cap companies are ₹20,000 crores and over of market capitalization. Mid cap companies have a market capitalization of ₹5,000 crores to ₹20,000 crores. And small cap companies have less than ₹5,000 crores in market cap.

Further, different sectors have different PE Ratio efficiencies.

I did a study on major sectors in India’s companies comprising the Nifty 500 index and found that only 41% of the companies have a PE Ratio between 0.01 to 15. Remember this evaluation has been done when the coronavirus has brought down the share prices of most stocks by an average of 28% from it’s peak levels of January 2020.

 Total number of companies trackedPE <= 15 (and +ve)% age
Consumer Discretionary792430%
Communication Services20945%
Consumer Staples36822%
Energy11655%
Financials884551%
Health Care42614%
Industrial823745%
Information Technology271763%
Materials803443%
Real Estate13538%
Utilities221255%
TOTAL50020341%

Overall, Benjamin had the right intentions for the average investor. And every investor should give credence to the PE Ratio which is an important thumb rule of how expensive (or inexpensive) is your buy.

Benjamin Graham Principle #7 : Difference between assets & liabilities atleast 1.5x of market cap

The difference between assets and liabilities equals the capital or shareholder’s equity in the company.

At 1.5 times of market capitalization, Benjamin Graham’s seventh and final rule is taking a liquidation view of the business. He is saying that the capital of the owners of the business (equity shareholders) should be atleast 50% more than the entire value of the business.

It will be difficult (impossible) to find excellent companies fitting into this rule. And when I ran this rule on the Indian stock markets over a universe of 1,800 stocks – I found 634 companies that fit this rule. 

However of these 634 companies, 313 companies had a market capitalization of less than ₹100 crores. And another 239 companies between ₹101 crores to ₹999 crores. This left me with only 82 companies (out of a possible 591 companies) to work with this firm rule.

I am presenting below the top ten constituents of this list.

Name of CompanyMarket Cap (in ₹crs)Multiple of (Asset-Liabilities)
Tata Steel BSL Ltd2,0126.1
Thomas Cook (India) Ltd1,2884.6
Jammu and Kashmir Bank Ltd1,0204.3
Vodafone Idea Ltd11,7823.4
Punjab & Sind Bank1,1323.4
South Indian Bank Ltd1,0683.3
Pilani Investment And Industries Corporation Ltd1,0953.1
Maharashtra Scooters Ltd2,4533.1
JSW Holdings Ltd1,8133.0
Bank of India Ltd11,1742.8

A glance at this list shows that all these companies are here because their market capitalization got tattered because of mismanagement, scams, poor innovation or external calamities. 

Even though this is just one of Benjamin Graham’s seven principles, this is by far the most difficult to consume as these are mostly companies with shaky foundations who are a part of this list and are awaiting a bail out of some kind.

Conclusion

Benjamin Graham’s approach to investment was a novelty in his times. He advocated the use of numbers and investing rules – which was new then. The 1920s were a time when everyone else viewed investing in stocks as a speculative activity. Benjamin Graham changed all that by building a successful branch of investing knowledge that anyone can learn without needing any sort of degree or professional certification

A number of principles and rules that we see above are for the conservative investor and at a time when the market was in a depressed state comprising industrial and old-age companies. 

A number of these rules might not be relevant in its current form but a number of these can be adopted to better use. For example, you can replace dividend for 10 years with return of equity of over 10% for 10 years. Similarly, instead of a firm PE ratio of 15, you can look at a PE ratio which is 20% below the sector average. 

Keep looking at numbers in different ways and you will get an excellent hang of what works and what doesn’t

Happy investing.

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