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4 Graham Stocks for 2009

Over the past eight years I've used my take on Benjamin Graham's time-tested strategy for defensive investors to uncover undervalued U.S. stocks. I'm pleased to say that the overall results have been superb. Over the last year we handily beat the index. But even our 16.8 percentage point outperformance wasn't enough to turn a profit in what is shaping up to be a whopper of a bear market.

The performance of each year's Graham stocks, the performance of the S&P500 (as tracked by the SPY exchange-traded fund), and the percentage point difference between the two is shown in Table 1. You can see that the Graham stocks have beaten the S&P500 in seven of the last eight years and often by a substantial margin. An investor who bought each year's Graham stocks, sold, and then bought the next crop of stocks would have gained 467% (or 26% annually1) whereas a buy-and-hold investment in SPY units would have lost 5%. Yes, that's right, the S&P500 is now down since we started. That even includes quarterly dividends reinvested annually.

TABLE 1: PERFORMANCE OF PAST GRAHAM STOCKS
Year*Graham S&P500 +/-
2000 - 200120.4%-22.2%42.6
2001 - 200228.2%-15.1%43.3
2002 - 200356.8%16.5%40.3
2003 - 200432.2%9.4% 22.8
2004 - 2005 46.6% 12.8% 33.8
2005 - 2006 -3.8% 10.7% -14.5
2006 - 2007 34.4% 16.1% 18.3
2007 - 2008 -6.5% -22.1% 15.6
Overall 467.2% -4.9%
* Indicates the time between articles and not calendar years.


Graham described his method for defensive investors in The Intelligent Investor, which has been in bookstores for more than fifty years. While Graham passed away in 1976, an updated edition of The Intelligent Investor (ISBN 0060555661) with new commentary from veteran Money Magazine columnist Jason Zweig was published in 2003. The original text is thankfully presented in its entirety. Zweig's commentary is thoughtfully separated from Graham's work and is placed in copious footnotes at the end of each chapter. If you don't already have a copy of The Intelligent Investor then this is the version to get.

If you're a real Graham buff, you'll want to check out the new sixth edition of Security Analysis (ISBN 0071592539). The new edition reprints Graham's 1940s text and adds commentary from some of today's famous value investors. It also include a foreword by Warren Buffett who apprenticed with Ben Graham. As it happens, a new Buffett biography called The Snowball (ISBN 0553805096) also hit bookshelves recently.

Because Graham's original rules for defensive investors are very strict, I use a slightly looser version. My Graham-inspired rules are shown in Table 2. For example, I require some dividend growth over the last five years whereas Graham demanded a twenty-year record of uninterrupted dividend payments. Similarly, I decided to focus on five-year earnings growth instead of ten-year earnings growth largely because five-year growth is easily found in many free internet stock screeners.

TABLE 2: GRAHAM-INSPIRED RULES
1. P/E Ratio less than 15
2. P/Book Ratio less than 1.5
3. Book Value more than 0.01
4. Current Ratio more than 2
5. Annual EPS Growth (5-Yr Avg) more than 3%
6. 5-Year Dividend Growth more than 0%
7. 5-Year P/E Low more than 0.01
8. 1-Year Revenue more than $400 Million


Even with my less-stringent version of Graham's rules, very few U.S. stocks usually pass the test. Indeed, the list peaked at 10 stocks in 2002 and then bottomed out at 2 stocks in 2003. This year there are 4 stocks to choose from down from 5 stocks last year. That's out of thousands of potential candidates. We were a little surprised at this result given the pounding the market has taken recently. We had expected to see more bargains. But relatively few firms have been increasing their dividends in recent months.

The current crop of Graham stocks is shown in Table 3. It is a good idea to look for some indication that the situation has remained largely unchanged before investing because of the time lag between my analysis and the article's publication. Similarly, be on the look out for problems that might not be reflected in a company's latest numbers by studying news stories, press releases, and regulatory filings.

Table 3: U.S. stocks that pass Graham-inspired rules
CompanyPrice ($)P/EP/E 5-Yr LowP/BAnnual EPS Growth (%)Current RatioD/E1-Yr Revenue ($M)5-Yr Dividend Growth (%)
Ameron International (AMN)$66.8010.58.01.2716.93.20.156697.1
Methanex (MEOH)$20.016.64.51.4570.12.80.522,45840.4
Reliance Steel & Aluminum (RS)$36.786.36.71.1968.42.60.517,52821.7
Rowan Companies (RDC)$29.146.76.81.2744.22.70.182,1989.9
Source: msn.com, October 1, 2008


You should examine any stock in great detail before investing and remember that four stocks can not be said to form a well-diversified portfolio. Always be cautious before jumping into any investment. Do your own due diligence and talk over potential purchases with your investment advisor.

Remember that value stocks can be psychologically difficult to hold and some stocks will fail entirely. Graham's method has avoided running into any serious trouble so far but it can't be expected to outperform all of the time. Indeed, significant periods of underperformance are likely. I'm particularly concerned that some readers might dive right in based on past performance alone. Don't. Be sure that you understand what you're investing in and focus at least as much on what can go wrong as on what might go right.

Additional Resources:


First published in the November 2008 edition of the Canadian MoneySaver.

Added:

For those who like to check performance calculations, here's a quick table of the returns for the 2008 - 2009 period. In this calculation dividends are included but not reinvested. Also the start and stop dates (October 1, 2008 and October 10, 2009 respectively) are based on when the list was generated.

Graham Stocks
SymbolPrice (1/10/08)Price (8/10/09)DividendsGain
AMN66.8072.691.2010.6%
MEOH20.0118.610.62-3.9%
RS36.7841.970.4015.2%
RDC29.1425.210.10-13.1%
Average:2.2%
S&P500 Benchmark (SPY ETF)
SymbolPrice (1/10/08)Price (8/10/09)DividendsGain
SPY116.06106.612.306-6.2%
Gain = 100%*((2009 Price + Dividends)/(2008 Price) - 1)


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