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Graham Stock Gainers

Over the past five years I've used Benjamin Graham's time-tested strategy for defensive investors to uncover undervalued U.S. stocks. So far, the results have been breathtaking.

The performance of each year's Graham stocks, the performance of the S&P500 (as tracked by the SPY exchange-traded fund) and the difference between the two is shown in Table 1. You can see that the Graham stocks have solidly beaten the S&P500 each year*. In fact, an investor who bought each year's Graham stocks, sold, and then bought the next crop of stocks would have gained 369% (or 38% annually**) whereas a buy and hold investment in SPY units would have actually lost 5%.

Table 1: Performance of past Graham stocks
Year* Graham S&P500 +/-
2000 - 2001 20.4% -22.2% 42.6
2001 - 2002 28.2% -15.1% 43.3
2002 - 2003 56.8% 16.5% 40.3
2003 - 2004 32.2% 9.4% 22.8
2004 - 2005 46.6% 12.8% 33.8
Overall: 369.2% -5.0%


Graham first described his method for defensive investors in his book The Intelligent Investor, which has been in bookstores for more than fifty years. An updated edition of The Intelligent Investor (ISBN 0060555661) with new commentary from veteran Money Magazine columnist Jason Zweig is now in bookstores and the original text is thankfully presented in its entirety. Zweig's commentary is thoughtfully separated and provided in footnotes and at the end of each chapter. If you donít already have a copy of The Intelligent Investor then this is the version to get.

Because Graham's original rules for defensive investors are very stringent, I've used a slightly looser version and my Graham-inspired requirements are shown in Table 2. For example, I only require some dividend growth over the last five years whereas Graham demanded a twenty-year record of uninterrupted dividend payments. Similarly I decided to focus on five-year earnings growth instead of ten-year earnings growth largely because five-year growth is easily found in many free internet stock screeners.

Table 2: Graham-inspired rules
P/E Ratio less than 15.
P/Book Ratio less than 1.5.
Book Value more than 0.01.
Current Ratio more than 2.
Annual EPS Growth (5 Yr Avg) more than 2.9186%.
5 Year Dividend Growth more than 0%.
5 Year P/E Low more than 0.01.
1 Year Revenue more than $400 Million.


Even with my less-stringent version of Graham's rules, very few stocks pass the test. For instance, I found only nine U.S. Graham stocks in 2000, five in 2001, ten in 2002, two in 2003, and five in 2004. This year the selection remains rather sparse at only three stocks out of the thousands of potential candidates.

If you've been following my Graham columns, you'll have noticed that I track the performance of all of the previous Graham stocks. Undoubtedly this decision has caused some confusion.

By way of explanation, I decided to track all of the stocks in an effort to test one of David Dreman's more interesting findings. Dreman looked at the historical performance of stocks with low price-to-earnings-ratios in his book Contrarian Investment Strategies: The Next Generation (ISBN 0684813505). He calculated the performance of buying low price-to-earnings ratio stocks, holding them for a year, selling, and then repeating the process. The average annual performance advantage of buying low price-to-earnings ratio stocks versus the market average was 3.7 percentage points from 1970 to 1996. He also calculated the results of holding stocks for 2, 3, 5 and 8 years before selling and rebalancing the portfolio. The average annual advantage of low price-to-earnings ratio stocks dropped only a bit to 3.4, 3.1, 3.1 and 2.2 percentage points when the holding period was 2, 3, 5 and 8 years respectively.

Dreman's results show that value stocks have provided a performance advantage over extended periods of time. In addition, holding for longer periods tends to reduce transaction costs and defers capital-gains taxes. Because reducing costs appeals to me, I decided to track the Graham stocks for many years to see if long holding periods were profitable in practice. It turns out that the Graham stocks have done quite well when held for a long time. The 2000, 2001, 2002, 2003 and 2004 Graham stocks provided average annualized gains of 22%, 33%, 52%, 37%, and 46% respectively.

Regrettably, this will be the last year that I expect to provide the extra performance calculations because they tend to be a little too time consuming. Nonetheless it would appear, at least anecdotally, that holding Graham stocks for long periods has provided good results.

This year's crop of Graham stocks is shown in Table 3. Because it takes a while before my articles get published, it is a good idea to look for some indication that a company's situation has remained largely unchanged before buying. For instance, reviewing news stories on the company often helps to identify recent problems that might not be reflected in the latest quarterly numbers.

Table 3: U.S. listed stocks that pass Graham-inspired rules
CompanyPrice ($)P/EP/E: 5-Yr LowP/BAnnual EPS Growth (%)Current RatioD/E1Yr Revenue ($M)5Yr Div Growth (%)
Steel Tech (STTX) 25.93 6.5 4.0 1.32 52.75 4.7 0.46 1,037 15.71
Sensient Tech (SXT) 18.95 12.8 10.1 1.38 2.92 2.4 0.76 1,044 0.62
Gibraltar Ind. (ROCK) 22.87 13.0 6.0 1.42 8.06 3.0 0.54 1,107 14.63
Source: msn.com, September 30, 2005


Naturally, you should examine any stock in detail before investing and holding only three stocks is not recommended. Be cautious before jumping into any investment and talk over potential purchases with your investment advisor. If you need assistance in this regard don't hesitate to give Dan and myself a call.

Remember that value stocks can be psychologically difficult for many investors to hold and a few beaten-up stocks inevitably fail. Thus far, Graham's method has avoided running into serious trouble but it is only a matter of time before we see a bad year. I'm particularly concerned that some people might be inclined to dive right in based on past performance alone and may not fully realize what they are getting into. Be sure to understand what you're investing in and proceed with caution.

Additional Resources:

Notes:
* I wrote each Graham article at slightly different times each year. As a result, each year's picks were not strictly separated by 365 days.
** Annualized based on the total number of days since the first article was written.

First published in the November 2005 edition of the Canadian MoneySaver magazine.

Update: Feb 15 2006

Table 3: U.S. listed stocks that pass Graham-inspired rules
CompanyPrice ($)P/EP/E: 5-Yr LowP/BAnnual EPS Growth (%)Current RatioD/E1Yr Revenue ($M)5Yr Div Growth (%)
Standard Pacific (SPF) 34.705.72.61.4729.838.11.013,9150.43
Bandag (BDG) 42.2912.27.51.486.703.00.068922.11
Steel Tech (STTX) 26.0613.64.01.3162.183.40.3196017.13
Source: msn.com, February 15, 2006


Please review the previous Graham articles before investing. Note that my previous warnings and cautions continue to apply. A portfolio of only three stocks is simply not appropriate for the vast majority of investors. Think carefully and discuss any potential purchases with your investment advisor.

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