Graham's Simple Way 2008
I often find interesting value stocks by using simple stock screens. Benjamin Graham's Simple Way is one of my favourite methods and it has a good long-term performance record. Indeed, since I started highlighting the Simple Way in the Canadian MoneySaver, it has outperformed by 3.8 percentage points a year and yielded 14.1% annualized returns.
Benjamin Graham first described his Simple Way in a 1976 article called The Simplest Way to Select Bargain Stocks. All of the details can be found in Janet Lowe's book The Rediscovered Benjamin Graham (ISBN 0471244724). Although the method's long-term returns have been quite good, it hit a rough patch last year.
Last year the Simple Way stocks lost 13.8% on average and fared worse than the S&P500 (as represented by the SPY exchange-traded fund) which fell 8.0%. (In both cases dividends were included but not reinvested.) Since 2005, Graham's Simple Way has gained 32.8% and outpaced the SPY fund by 9.4 percentage points.
The Simple Way is based on two main criteria. First, a stock must have an earnings yield that is at least double the average yield on long-term AAA corporate bonds. Furthermore, Graham also insisted that investors should avoid stocks with earnings yields below 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, earnings yield is found by dividing earnings by price and the result shown as a percentage. If a stock earned $1 per share last year and it is trading at $5 per share then its earnings yield would be 20% (i.e. $1 / $5 * 100%).
The average yield on 20-year AAA U.S. corporate bonds was 6.2% as of June 2, 2008. As a result, Benjamin Graham would have considered a stock cheap if it had an earnings yield of more than 12.4% (which is equivalent to a positive P/E ratio of less than 8.06).
Graham's second requirement focused on safety. He was only interested in firms with little debt. To avoid debt-laden companies, Graham sought stocks with leverage ratios (the ratio of total assets to shareholder's equity) of two or less. Although such stocks are relatively safe, it is important to remember that there is no such thing as a totally safe stock.
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 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. Nonetheless, to make performance calculations less onerous, I assume that stocks are held between articles (which appear about once a year) and are then replaced by new stocks.
Each year I highlight the largest stocks that pass Graham's test. In the past, I've presented stocks with market capitalizations of more than $1 billion or of more than $500 million. But this year I've decided to simply stick with the 12 largest stocks that make the grade.
When looking at the list, you should keep in mind that some stocks will inevitably fair poorly. Even worse, overall results may lag from time to time.
I have high hopes that Graham's method will continue to do well over the long run. But be sure to use Graham's list as a starting point for further research and not the final destination. As always, dig deeper and do your own homework before investing.
First published in the July/August 2008 edition of the Canadian MoneySaver.
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