It's been a rough year for investors. But you wouldn't have known it if you had followed Benjamin Graham's advice. Instead of bemoaning losses, you would be counting profits.
Graham knew all about making money in hard times. He honed his investing techniques during the Depression, when he managed money on Wall Street and invented value investing. He later taught Warren Buffett how to invest. Before Graham died in 1976, he boiled his experience down to what he called The Simplest Way to Select Bargain Stocks.
If you're a long-time reader of MoneySense, you already know about Graham's Simple Way. Every year for the past four years, we've compiled a list of Simple Way stocks. Each year our list has outperformed the S&P 500. Assuming you had purchased equal dollar amounts of each Simple Way stock for your RRSP and rolled the profits into new Simple Way stocks every year, you would be up 93% in 56 months, not including dividends. Over the same period, the S&P 500 advanced only 17%. We're particularly pleased with the Graham picks over the past year. They gained 22% while the S&P 500 lost 8%.
In 1976 Graham calculated that a Simple Way investor would have achieved fairly consistent 15% average annual returns during the prior 50 years. Our performance since 2004 has been close, with annualized returns of 15.4%.
Picking stocks using the Simple Way is like doing the two-step. In the first step, you seek stocks that are cheap and in the second you keep those that are relatively safe. Graham defined a cheap stock as one with an earnings yield that was at least twice as large as the average yield on long-term AAA corporate bonds. The yield on 20-year AAA U.S. corporate bonds was 6.1% when we selected this year's batch of Graham stocks, so we looked for stocks with earnings yields of 12.2% or more which is equivalent to a priceearnings ratio of 8.2 or less.
We now come to the safety step. Graham detested excessive debt and insisted his picks be well capitalized to protect against bad times. He stuck to stocks with leverage ratios (the ratio of total assets to shareholders' equity) of two or less.
Graham suggested selling his picks when you had achieved a 50% profit or no later than the end of the second calendar year after purchase. To make things even easier, we sell a crop of Graham stocks when we pick a new bunch.
With Graham's criteria in hand, we used the MSN.com stock screener to find a short list of this year's candidates. We narrowed it down by focusing on U.S.-listed stocks with market capitalizations of more than $2 billion. (All figures are in U.S. dollars.)
I have high hopes that Graham's method will continue to do well, but all the usual warnings apply. Use Graham's list as a starting point for your research not the final destination. If you don't understand a company, pass it by. After all, there are lots of Graham-style bargains out there and you don't have to buy every one.
From the October 2008 issue of MoneySense magazine
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