Return of the master:
Benjamin Graham is still pointing the way to great buys
Benjamin Graham, the father of value investing, developed some of the earliest and most successful techniques for selecting stocks. Despite all the changes in the financial world since Graham's heyday on Wall Street in the 1930s, '40s and '50s, some of his simplest methods have continued to perform unusually well.
The reason? Few people have the temperament to be value investors. The problem isn't finding value stocks — that's relatively easy. But buying and holding them can test anyone's psychological mettle. Value stocks usually become inexpensive because they're genuinely unappealing. For instance, a company's business might have declined or it may have encountered an accounting scandal or any number of other calamities. As a result, even when you find value stocks, few investors want to buy them.
One of my favorite screens for finding value stocks was first described in Graham's 1976 article "The Simplest Way to Select Bargain Stocks," which was recently republished in Janet Lowe's book The Rediscovered Benjamin Graham. The stock screen is built on two fundamental rules that Graham laid down.
First, Graham insisted that any stock he invested in must have an earnings yield that was at least twice as big as the average yield on long-term high-quality AAA corporate bonds. At the start of 2004, the yield on AAA U.S. corporate bonds was about 5.5%. So today Graham would have sought stocks with earnings yields of 11% or more.
How do you calculate the earnings yield on a stock? It's the inverse of the more popular price-to-earnings ratio. An easy way to convert an earnings yield to a P/E ratio is to divide 100 by the earnings yield. Put another way, looking for stocks with an earnings yield of 11% or more is roughly equivalent to searching for stocks that possess a P/E ratio of 9.1 or less.
Second, Graham insisted his chosen companies carry little debt. He stuck to stocks with leverage ratios (the ratio of total assets to shareholder's equity) of two or less. When it came to selling, Graham suggested waiting for either a 50% profit or no later than the end of the second calendar year after purchase.
In 1976, Graham back-tested his method and found that it provided a fairly consistent 15% average annual return during the prior fifty years. Recent studies continue to show that buying low P/E stocks has been a winning strategy over the long term.
With Graham's criteria in hand, I turned to msn.com's deluxe stock screener, which contains information on over 6,600 stocks listed on U.S. stock exchanges. Graham's two criteria narrowed this large universe of stocks down to only 74. However, many of the companies were quite small and I decided to focus on stocks with market capitalizations of more than $500 million (all figures are in U.S. dollars), which are shown in the chart The bargain bin. In addition, I excluded non-U.S. stocks (known as ADRs) and Price Communications (or PRs) because they are not typical common stocks.
Although Graham's stock screen is a good place to start, it is important to look at each stock in much more detail before investing. Every investment should be scrutinized to make sure that potential problems are bearable. For instance, the track record of new stocks tends to be poor because many of them are brought to market at favorable times during their business cycles. Jay R. Ritter of the University of Florida studied the performance of newly listed U.S. stocks from 1970 to 2002. He determined that new stocks underperformed stocks of similar size (as measured by market capitalization) by an average of 4.2% a year during the five years following their first day of trading. That's a substantial cumulative underperformance of 22.8%.
As a result, two of the stocks found by Graham's screen — Montpelier Re and Journal Communications — are too youthful for my blood. On the other hand, CompuCredit is almost five years old and its stock price has followed a classic new-stock pattern with an early rise, a significant fall and then a gradual recovery.
Another potential problem, particularly for this value approach, is earnings stability. Often, low-P/E screens pick out stocks that have recently experienced a nonrecurring earnings boost. Usually the earnings boost is due to an asset sale, but InVision Technologies illustrates a slightly different problem. InVision makes explosives detection systems for airports. As the U.S. builds safeguards against terrorist strikes, these systems have been in high demand.
Before 2001, InVision would normally sell about $65 million worth of equipment annually. Last year, sales jumped to about $440 million and in the first threequarters of this year they were $367 million. Not surprisingly, earnings were also very strong. However, it is reasonable to expect that airports will slow orders for new machines as they complete their modernization programs. Even the usually optimistic analyst community expects InVision to earn between $1.34 and $2.45 a share next year, much less than the $5.22 a share it earned this year. Buying InVision based on strong earnings may lead to disappointment.
Will Graham's technique continue to outperform? Over the long run, I believe that it will but investors looking for a quick buck may be disappointed. After all, occasional short-term weakness tends to scare off most investors — and that has the perverse effect of prolonging Graham's long-term success.
From the February/March 2004 issue.
THE BARGAIN BIN
Benjamin Graham, one of the greatest investing minds of all time, believed you could achieve outstanding returns by sticking to value stocks that possess a few key characteristics. Applying his methods to the current U.S. stock market reveals these tantalizing prospects.
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