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Graham's Simple Way 2010

I like to use stock screens to find interesting value stocks and Benjamin Graham's Simple Way is one of my favourites. Regrettably, the Simple Way has experienced a few rocky years recently. But I've high hopes that it will stage a strong 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) and its returns, over the long term, have been very good.

Last year the Simple Way gained 5.6% but fell behind the S&P500 (as represented by the SPY exchange-traded fund) which advanced 17.3%. (In both cases dividends were included but not reinvested.) The big difference was largely due to the inclusion of several oil & gas drillers in last year's list including Transocean (RIG) which got caught up in B.P.'s oil-spill disaster in the Gulf of Mexico. (Transocean was up nicely before the spill.) As it stands, the Simple Way is down 2.0% annually since 2005 and trails the S&P500 ETF which is up 0.2% 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 avoid stocks with earnings yields below 10% which, as we'll see, is 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 fell below 5% as of May 31, 2010. As a result, Benjamin Graham's minimum 10% 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 stocks that pass Graham's test. Last year's large stocks didn't fare nearly as well as a deep-value version of the Simple Way that I use in my Graham Value Stocks letter which gained 27% (not including dividends) over the last year. But I expect the large stock version of the method to return to its market-beating pattern and to be less volatile over time.

When looking at the current stock list, you should keep in mind that some firms will inevitably fair poorly. Even worse, as the last few 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.

Table 1: Graham's Simple Way Stocks for 2010
CompanyIndustryM.Cap ($M)Price ($)P/ELeverageYield (%)
Merck (MRK)Drugs$105,113$33.697.31.94.5%
Bristol-Myers (BMY)Drugs$39,921$23.214.22.05.5%
Corning (GLW)Comm.Equip.$27,191$17.439.71.31.2%
Gamestop (GME)Electronics$3,483$22.799.81.70.0%
Cameco (CCJ)Metals$9,604$24.448.71.50.0%
Diamond (DO)O&G Drilling$8,773$63.106.71.80.8%
Western Digital (WDC)Data Storage$7,977$34.816.11.60.0%
Noble (NE)O&G Svcs$7,437$29.074.61.21.3%
Garmin (GRMN)Instruments$6,688$33.589.81.44.5%
Leucadia (LUK)Conglomerate$5,333$21.926.21.50.0%
Ensco (ESV)O&G Drilling$5,331$37.407.11.23.7%
Validus (VR)P&C Ins.$3,037$24.563.92.03.6%
Source: Yahoo.com, MSN.com, May 31, 2010


First published in the July/August 2010 edition of the Canadian MoneySaver.

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