Most value investors will be aware of the value investing checklists Benjamin Graham published toward the end of his life in an attempt to streamline his investing process. These lists have become a sort of set of guidelines for value investors over the years and remain an essential part of the value discipline today.
As well as these later checklists, Graham also published a more rudimentary checklist much earlier in his life. In an article in the Analysts Journal for the first quarter of 1946, Graham penned an article titled "On Being Right In Security Analysis," which considers the process of trying to evaluate how successful an analyst is at picking stocks.
Graham asked, “If a security analyst should recommend the purchase of US Steel (X, Financial) at 80, as a 'good buy,' what criteria of corresponding definiteness can we apply to test his wisdom?” The answer to this question is not going to be as simple as asking "Will it go up 10% in a year?" or "Will it beat the benchmark by 10% over the next 12 months?" Instead, the answer to this question has to be based on the company’s future earnings potential, a more long-term assessment of the analysts' skill as no analyst can consistently predict the movement of markets in the short term with any degree of accuracy.
For an analyst’s recommendation to be trusted Graham wrote “not only must it work out well in the market, but it must be based on sound reasoning. For without such reasoning, we may have a good market tip, but we cannot have a good security analysis.” Without solid fundamental analysis, the analyst is only issuing a speculative price target.
To assess whether the investor has conducted “good security analysis,” Graham suggested investors follow a simple four-point checklist to determine the analysis, using US Steel as an example:
1. Steel should be bought because its future earnings power is likely to average about $13 per share. [Long-term, sustainable earnings growth]
2. Steel should be bought because it is fundamentally cheaper at $80 than is the Dow Jones Industrial Average at 190.
3. Steel should be bought at $80 because next year’s earnings will show a substantial increase.
4. Steel should be bought at $80 because that price is far below the top figure reached in the last two bull markets.
Even though this checklist is simple, it’s still fairly rigorous in trying to hunt out undervalued stocks with bright futures. The first criteria is probably the most important because, without earnings growth, it’s unlikely the share price will rise much further. Graham wrote:
“Reason one implies that Steel will prove a satisfactory long pull investment. That does not necessarily mean that it will average earnings of $13 over the next 25 years but certainly over the next five years. If this analysis is correct, the purchaser will have both satisfactory earnings and dividends and an undoubted opportunity to sell out at a good advance. The correctness of the analysis and the consequent recommendation can be proved only over a five-year period or longer.”
The second point may sound strange at first, but Graham designed this checkpoint to be a fail-safe against a lack of earnings growth. He wrote:
“The analyst properly may recommend Steel, and on a comparative basis only, without claiming that it is intrinsically cheap. In that case, he will be proved right if Steel performs better than the average, even though it may not do well by itself.”
On the last point, Graham acknowledged that this view might divide opinions, but he believed it was one final check for investors seeking market-beating returns:
“Is this a valid type of reasoning for security analysis? Opinions may differ on this point, but in any case, we can readily tell if such a recommendation proves right. The stock must advance substantially –Â say at least 20% – in the current bull market.”
Disclosure: The author owns no stock mentioned.
