Graham's Simple Way 2009
I like to use stock screens to find interesting value stocks and Benjamin Graham's Simple Way is one of my favourites. Regrettably, the bear market wasn't kind to the Simple Way over the last year. But I've high hopes that value stocks will stage a sterling comeback.
Benjamin Graham first described the Simple Way in a 1976 article called The Simplest Way to Select Bargain Stocks. You can find out all about it in Janet Lowe's book The Rediscovered Benjamin Graham (ISBN 0471244724). Although Graham's long-term returns have been very good, the last couple of years have been difficult.
Last year the Simple Way lost 35.9% and fell behind the S&P500 (as represented by the SPY exchange-traded fund) which tumbled 30.3%. (In both cases dividends were included but not reinvested.) The big decline managed to wipe out Graham's market-beating performance record going back to 2005. That's when I first started tracking the method for the Canadian MoneySaver. As it stands, the Simple Way is now down 3.8% annually since 2005. It trails the S&P500 ETF which lost 3.5% a year over the same period.
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. 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 $10 per share then its earnings yield would be 10% (i.e. $1 / $10 * 100%).
The average yield on 20-year AAA U.S. corporate bonds was 6.2% as of June 8, 2009. As a result, Benjamin Graham would have considered a stock cheap if it had an earnings yield of more than 12.4%. That's equivalent to a positive P/E ratio of less than 8.06.
Graham's second requirement focused on safety. He was interested in firms with little debt. To avoid debt-laden companies, Graham sought stocks with leverage ratios (the ratio of total assets to shareholders' 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 the 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 last year I decided to stick with the 12 largest stocks that made the grade. This year, the bear market pushed some very big companies down into bargain territory. Indeed, the smallest stock on this year's list has a market capitalization in excess of $3 billion.
When looking at the current stock list, you should keep in mind that some firms will inevitably fair poorly. Even worse, as the last couple of years have demonstrated, overall results may lag from time to time.
Nonetheless, I have high hopes that Graham's Simple Way will resume its winning ways. But be sure to use Graham's list as a starting point for further research and not as the final destination. Dig deeper and do your own homework before investing.
First published in the July/August 2009 edition of the Canadian MoneySaver.
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