Graham's Simplest 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.
Graham described a basic value screen in a 1976 article called The Simplest Way to Select Bargain Stocks which was 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 demanded that a stock have an earnings yield that was 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 takes earnings divided by price 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%).
On April 8th the average yield on AAA 20-yr U.S corporate bonds was 5.37%. So according to the Simplest Way a stock is cheap if it has an earnings yield of more than 10.7% (or a P/E ratio of less than 9.31).
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 the stock of low-debt firms is 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.
When Graham back-tested his method in 1976, he found that it provided a 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.
With Graham's criteria in hand, I turned to msn.com's deluxe stock screener, which contains information on over 6,700 U.S. stocks. Graham's two criteria narrowed this large universe of stocks down to only 113 stocks. However, many of the companies were small and I decided to focus on U.S. stocks with market capitalizations of more than $500 million, which are shown in Table 1. Even with these limitations, the list remains quite long at twenty-seven stocks. As a result, Graham's screen is a good place to start and there is even some room for additional discretion.
It is a little surprising that the Simplest Way has continued to do well. However, investors looking to make fast profits may be disappointed. After all, occasional short-term weakness tends to frighten many investors which has the side effect of prolonging Graham's long-term success. In addition, investors should not expect uniform success and some Simple Stocks will inevitably do poorly.
First published in May 2005.
October 20, 2005 Update
The stocks that currently pass the same screen are:
Chevron Corporation (CVX),
Occidental Petroleum Corporation (OXY),
Phelps Dodge Corporation (PD),
Nucor Corporation (NUE),
Computer Sciences Corporation (CSC),
MGIC Investment Corp. (MTG),
Leucadia National Corp. (LUK),
Radian Group Inc. (RDN),
Ashland Inc. (ASH),
Allied Capital Corp (ALD),
M.D.C. Holdings, Inc. (MDC),
IPSCO INC (IPS),
Novell, Inc. (NOVL),
Louisiana-Pacific Corporation (LPX),
DreamWorks Animation SKG, Inc. (DWA),
Laidlaw International, Inc. (USA) (LI),
Stolt-Nielsen S.A. (SNSA),
Leap Wireless International, Inc. (LEAP),
Seaboard Corporation (SEB),
Westlake Chemical Corporation (WLK),
Assured Guaranty Ltd. (AGO),
Reliance Steel & Aluminum (RS),
Gerdau Ameristeel Corp. (GNASF),
Gerdau Ameristeel Corp. (GNA),
Lone Star Technologies (LSS),
General Maritime Corporation (GMR),
Maverick Tube Corporation (MVK),
Foxhollow Technologies, Inc. (FOXH),
Schnitzer Steel Industries, Inc. (SCHN),
United Online, Inc. (UNTD),
InfoSpace, Inc. (INSP),
MicroStrategy Incorporated (MSTR),
NS Group, Inc. (NSS),
Tsakos Energy Navigation Ltd. (TNP),
The Marcus Corporation (MCS),
Orbital Sciences Corp. (ORB),
Metal Management, Inc. (MTLM),
Premium Standard Farms, Inc. (PORK),
Heidrick & Struggles International, Inc. (HSII),
Helen of Troy Limited (HELE),
Sigmatel, Inc. (SGTL), and
Premiere Global Services Inc (PGI).
Source: MSN.com, October 20, 2005
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