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Selling Graham Stocks

I had the great pleasure of talking with many of you at the recent Canadian MoneySaver conference in Toronto. While discussing Graham's method for defensive investors, many people asked me how Graham went about selling such stocks. Regrettably, Graham didn't provide a clear selling strategy, but there are a few simple approaches that investors can use.

Before exploring a few ways to sell, it is useful to recall how Graham went about buying stocks. In brief, Graham wanted defensive investors to look for stocks with adequate size, sufficiently strong financial conditions, earnings stability, a long dividend record, moderate earnings growth, moderate price-to-earnings ratios and moderate price-tobook value ratios. The details can be found in chapter fourteen of Graham's book The Intelligent Investor (ISBN: 0060555661). In addition, my previous article called 'High Performance Graham Stocks', which appeared in the November/ December edition of the Canadian MoneySaver, contains more information about my slightly modified take on Graham's basic approach.

Back in October, my more lenient version of Graham's method yielded a list of only five U.S. stocks: Kellwood (KWD), Seaboard (SEB), SkyWest (SKYW), Steel Tech (STTX) and Thomas Industries (TII). When I ran the screen on March 11, 2005 the list was little changed, but Seaboard had been removed because its stock had climbed 77.2% higher.

If you follow my columns, you'll have noticed that I track the performance of all previous Graham stocks. Undoubtedly this decision has caused some confusion as to when one might want to sell.

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 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 annual advantage of low price-to-earnings ratio stocks dropped 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 can continue to provide a performance advantage for many years. In addition, holding for longer periods tends to reduce transaction costs and defers capital gains taxes. Because I like to keep costs to a minimum, I decided to track Graham stocks for many years to see if long holding periods continue to be profitable in practice.

Dreman's findings also suggest a few possible selling methods. For instance, you could sell each year and repurchase new stocks. With an annual turnover you might get a slight advantage but incur higher transaction costs. Alternately, you could wait longer to sell and rebalance. However, the simple approach of selling after a fixed number of years and buying new stocks runs into a problem. In some years Graham's method provides a very small list of stocks to choose from (only two in 2003). If you automatically sell every few years, you might not be able to buy a diversified selection of Graham stocks and you could wind up with an under-diversified and higher-risk portfolio.

Instead of a fixed time limit, Graham's moderate price-to-earnings and moderate price-to-book value criteria can be used to determine a high target. In his book, Graham suggested that defensive investors could be a little less strict and buy stocks with a price-to-earnings ratio times priceto- book value ratio of less than 22.5. This formula can be used to find the highest price at which defensive investors should buy a stock. You can turn the logic around and if a stock is no longer a buy then it might be sell.

The highest price at which Graham thought defensive investors should consider buying, or his high target, is found by taking the square root of the product of 22.5 times earnings- per-share times book-value per share. Formularically, the high target = the square root of (22.5 * EPS *BPS). For instance, Seaboard earns $133.93 per share and it has a book value of $551.92 per share. So, its high target would be the square root of (22.5 * $133.93 * $551.92) which is equal to $1,289.64. Similarly, Kellwood, SkyWest, Steel Tech and Thomas Industries would have high targets of $38.21, $20.71, $38.42 and $65.30 respectively. An advantage of the high limit approach is that the limit is dynamic and will change as earnings and book values change. A disadvantage of the approach is that you might be cutting profits short by selling at relatively low prices when the stock is on the cusp of being a buy. One could avoid this problem by raising the high target arbitrarily, say, by 20% or more.

To make matters even more complicated, Graham also suggested a simple selling method when discussing a lowdebt, low price-to-earnings approach in The Simplest Way to Select Bargain Stocks, which was republished in the book The Rediscovered Benjamin Graham (ISBN 0471244724). Here, he suggested selling after a price increase of 50% or after two calendar years, whichever came first. I expect to discuss this alternate method in more detail in a future article.

I've presented several possible selling methods for your consideration. Each method has its own advantages and disadvantages. You can decide for yourself which best suits your circumstances.

Date: Apr 2005

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