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Graham's Simple Way

Warren Buffett's insurance company GEICO is currently running a series of humorous ads featuring the line, 'So easy even a caveman can do it'. In a curious twist of fate, Buffett's mentor Benjamin Graham developed a way to pick stocks that even cavemen would appreciate. Graham described his Simple Way in a 1976 article called The Simplest Way to Select Bargain Stocks that can be found in Janet Lowe's book The Rediscovered Benjamin Graham (ISBN 0471244724). Given its recent success, these days stock-picking cavemen are dining out on mammoth steak.

Indeed, stocks selected by Graham's Simple Way gained an average of 26.6% over the last year which bests a 20.8% advance for the S&P500 as represented by the SPY exchange-traded fund. (In both cases dividends are included but not reinvested.) That's an outperformance of 5.8 percentage points for the Simple Way. Since 2005 Graham's method did even better with a 54.0% gain that outpaced the SPY fund by 19.8 percentage points. Not bad for a technique that has been around for more than 40 years.

Graham's Simple Way is based on two main criteria. First, stocks must have an earnings yield that is at least twice as large as the average yield on long-term AAA corporate bonds. Furthermore, Graham thought investors should not buy stocks with earnings yields 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, earnings yield is found by dividing earnings by price and the result shown as a percentage. So, if a stock earned $1 per share last year and is trading at $20 per share then its earnings yield would be 5% (i.e. $1 / $20 * 100%).

The average yield on AAA 20-year U.S. corporate bonds was 6.01% on June 1, 2007. So, according to the Simplest Way a stock is cheap if it has an earnings yield of more than 12.02% (or a positive P/E ratio of less than 8.32).

Graham's second requirement focused on 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 low-debt firms 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.

This year Graham's criteria narrowed the large universe of stocks down to 179. But I decided to focus on U.S. stocks with market capitalizations of more than $500 million (down from a billion dollars last year), which are shown in Table 1. Even after including a few smaller stocks, the list is down to 11 stocks this year from 22 last year.

When looking at the list, you should keep in mind that some stocks will inevitably fair poorly. For instance, the biggest dog from last year was Louisiana-Pacific Corp (LPX) which lost 16.9%. Indeed, 7 of the 22 stocks from last year lost money. While losses were more than made up for by big gains elsewhere, owning a portfolio of value stocks can be stressful for some investors.

I have high hopes that Graham's method will continue to do well in the long run. But demonstrate that you're smarter than a caveman and 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.

Table 1: Graham's Simple Stocks
CompanyIndustryMarket Cap ($M)Price ($)P/ELeverage RatioDiv. Yield (%)
Valero Energy(VLO)Oil & Gas41,657$75.888.32.00.6%
American Capital(ACAS)Diversified Investments7,822$48.428.01.97.5%
Patterson-UTI Energy (PTEN)Oil & Gas4,129$26.356.91.31.8%
IPC (IPCR)Life Insurance1,997$31.375.51.42.6%
Kaiser Aluminum (KALU)Metals & Minerals1,541$74.881.81.60.0%
Calumet Specialty Products (CLMT)Oil & Gas1,517$51.536.81.64.7%
Grey Wolf (GW)Oil & Gas1,475$7.987.92.00.0%
BP Prudhoe Bay RT (BPT)Diversified Investments1,431$66.867.91.111.0%
Flagstone Reinsurance (FSR)P&C Insurance1,125$
Encore Wire (WIRE)Electrical Equipment696$29.826.71.50.3%
Avatar (AVTR)Residential Construction680$
Source:, June 1, 2007

First published in the July/August 2007 magazine.

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