The Simple Way
Benjamin Graham is often called the father of value investing and during his lifetime provided the world a variety of useful stock-selection techniques. Remarkably, some of his simplest methods have continued to outperform long after his passing. Although many of Graham's methods are easily described, their continued success relies on the fact that they can be psychologically hard to put into practice.
Very few people truly have the temperament to be value investors and while it's relatively easy to find value stocks holding them is the real test. Value stocks usually become inexpensive for a variety of unappealing reasons. As a result, even when value stocks are identified, relatively few investors want to buy them. Even worse, a few value stocks inevitable do badly and decline as their business weakens which tends to scare off investors.
Graham described a good value screen in a 1976 article called The Simplest Way to Select Bargain Stocks which was more recently republished in Janet Lowe's book The Rediscovered Benjamin Graham (ISBN 0471244724). As always, Graham sought stocks with a margin of safety which means that he wanted a stock to be cheap and relatively safe.
Graham's Simplest Way demands that a stock have an earnings yield that is at least twice as big as the average yield on long-term AAA corporate bonds. Furthermore, Graham thought that at no time should investors buy a stock with an earnings yield of less than 10%.
Earnings yield is the reciprocal of the more common price-to-earnings ratio. Instead of dividing price by earnings, as you do for P/E ratios, the earnings yield is found by dividing earnings by price and the result shown as a percentage. So, if a stock earned $1 per share last year and it is trading at $20 per share then its earnings yield would be 5% (i.e. $1 / $20 * 100%).
The average yield on AAA 20-yr U.S corporate bonds was 5.49% on June 2. So, according to the Simplest Way a stock is cheap if it has an earnings yield of more than 10.98% (or a positive P/E ratio of less than 9.11).
Graham looked for safety by demanding that companies have little debt. He stuck to stocks with leverage ratios (the ratio of total assets to shareholder's equity) of two or less. Although low-debt firms are relatively safe, it is important to remember that returns of such stocks are by no means guaranteed.
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. On this point I tend to differ from Graham in that I'm willing to let my winners run. However, Graham's admonition to trim one's losers is good to keep in mind.
When Graham back-tested his method in 1976, he found that it provided fairly consistent 15% average annual returns during the prior fifty years. More recent studies continue to show that buying low price-to-earnings ratio stocks has been a winning strategy over the long term.
Indeed, I'm pleased to report that the method has performed admirably since I wrote about it in the May 2005 edition of the Canadian MoneySaver. In about 14 months, 2005's Graham stocks gained an average of 21.6% versus gains of 11.2% for the S&P500 as represented by the SPY exchange-traded fund. (In both cases dividends are included in the gains but not reinvested.) That's an outperformance of 10.4 percentage points for the Graham stocks. However, if you had followed Graham's instruction to sell after a 50% profit then you'd have gained 18.6% which is 'only' 7.4 percentage points better than the index. Annualizing the gains results in an 18.6% gain for the Graham stocks, 16.0% if you sold as per Graham's 50% criteria, and 9.7% for the S&P500. Coincidentally, the results are quite close to Graham's original study which pointed to 15% average annual returns.
This year, Graham's two criteria narrowed the large universe of U.S. stocks down to only 111. However, many of the companies are quite small and I decided to focus on U.S. stocks with market capitalizations of more than a billion dollars, which are shown in Table 1. Even with these limitations, the list remains quite long at twenty-two stocks. As a result, Graham's screen is a good place to start and there is room for additional discretion.
I must admit to being a little concerned about the large number of oil and gas stocks in this year's list. I'm generally not a big fan of stocks whose fortunes are linked to commodity prices which tend to be unpredictable. Even worse, commodity prices generally fall as the technology used to extract them improves. Here's what Charlie Munger, Warren Buffett's sidekick, had to say in a 1994 speech,
"The great lesson in microeconomics is to discriminate between when technology is going to help you and when it's going to kill you. And most people do not get this straight in their heads. But a fellow like Buffett does.
For example, when we were in the textile business, which is a terrible commodity business, we were making low-end textiles - which are a real commodity product. And one day, the people came to Warren and said, 'They've invented a new loom that we think will do twice as much work as our old ones.'
And Warren said, 'Gee, I hope this doesn't work because if it does, I'm going to close the mill.' And he meant it.
What was he thinking? He was thinking, 'It's a lousy business. We're earning substandard returns and keeping it open just to be nice to the elderly workers. But we're not going to put huge amounts of new capital into a lousy business.'
And he knew that the huge productivity increases that would come from a better machine introduced into the production of a commodity product would all go to the benefit of the buyers of the textiles. Nothing was going to stick to our ribs as owners.
That's such an obvious concept - that there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that's still going to be lousy. The money still won't come to you. All of the advantages from great improvements are going to flow through to the customers."
You can read the full text of Munger's enlightening speech at www.ycombinator.com/munger.html.
In a similar vein, Bill Miller's recent commentary on commodities is worth reading. Miller is the manager of the Legg Mason Value Trust which has had the remarkable habit of beating the S&P500 for 15 years in a row. Here's a bit of what he had to say,
"The time to own commodities is (or at least has been) when they are down, when everybody has lost money in them, and when they trade below the cost of production. That time is not now. The data showing the returns of commodities will look very different if you start measuring just after prices have tripled.
Every commodity we can get data on trades significantly above both the average and the marginal cost of production. Copper, for example, has an average cost of production of around 90 cents per pound, and a marginal cost of about $1.30 per pound. The marginal cost should approximate the equilibrium price over time. The current price is around $3.25 per pound. It is not a question of if copper prices are going down, it is a question of when."
You can read the full text of Miller's commentary at www.newswire.ca/en/releases/archive/April2006/25/c0481.html
You should also keep in mind that some of Graham's Simple Stocks will inevitably do poorly. For instance, the biggest dog from last year's list was NL Industries (NL) which lost 38.3% and 8 out of 26 picks from last year lost money. While losses in these stocks were more than made up for by big gains elsewhere, investors are highly attuned to losses. Market psychologists say that the emotional impact of a loss is twice that from a gain. (Naturally, losses are painful whereas gains are joyful). A portfolio of stocks with a few big losers, which are more than made up for by gainers, may actually be emotionally intolerable for many investors.
Perhaps the discomfort of eating an occasional loss may be part of the reason why the Simplest Way has continued to do well after all of these years. Alternately, periods when the method underperforms, and these will happen from time to time, may also dissuade investors
First published in July 2006.
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