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Graham's Simple Way: Summer 2011
I like to find interesting value stocks using stock screens. One of the best screens to follow is Benjamin Graham's Simple Way, and its variants, which I've tracked for many years in both the U.S. and Canada. I'm pleased to say that the U.S. large stock version of the Simple Way saw solid gains this year with an advance of 21.6%. In comparison, the S&P500 (as represented by the SPY exchange-traded fund) advanced 20.1%. However, the prior few years haven't been stellar for large-cap value stocks which lagged their small-cap brethren. As it stands, the U.S. large stock version of the Simple Way has climbed 1.5% annually since 2005 but trails the S&P500 ETF which was up 3.2% a year over the same period. (The aforementioned returns include non-reinvested dividends.) Benjamin Graham, the dean of value investing, first described the Simple Way in a 1976 article called The Simplest Way to Select Bargain Stocks. You can read about it in Janet Lowe's book The Rediscovered Benjamin Graham (ISBN 0471244724) and the method's returns, over the long term, have been very good. 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 avoid stocks with earnings yields below 10% which, as we'll see, was an important requirement this year. 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 $20 per share then its earnings yield would be 5% (i.e. $1 / $20 * 100%). The average yield on 20-year AAA U.S. corporate bonds was below 5% as of June 7, 2011. As a result, Benjamin Graham's 10% minimum earnings yield requirement comes into play. An earnings yield of 10% or more is equivalent to a positive P/E ratio of less than 10. 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 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 the performance calculations simpler, 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 12 largest value stocks that pass Graham's test for the Canadian MoneySaver which puts a large stock spin on the Simple Way. As it turns out, last year's large stocks didn't fare as well as a deep-value version of the Simple Way that I track in my Graham Value Stocks letter which gained 29% (not including dividends) over the same period. But I expect the large value stock version to pick up over time. When looking at the current stock list shown in the accompanying table, you should keep in mind that some firms will inevitably fair poorly. Even worse, overall results may lag from time to time. Nonetheless, I have high hopes for Graham's Simple Way, which has fared well over the long term. But be sure to use Graham's list as a starting point for further research and not the final destination. Dig deeper and do your own homework before investing.
First published in the July/August 2011 edition of the Canadian MoneySaver. |
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