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7 Graham Stocks for 2011

Graham's time-tested strategy for defensive investors gained ground this year but, in a rare turn of events, it failed to beat the market. As a result, it has only bested the market in eight out of the last ten years which, as they say, ain't bad.

The full record can be seen in Table 1 which reveals the yearly performance of the Graham stocks, the S&P500 (as tracked by the SPY exchange-traded fund), and the percentage point difference between the two. If you had bought equal dollar amounts of each year's Graham stocks in your RRSP and then replaced them with the new crop of stocks each year, you would have gained 493% (or 20% annually) over the full period. On the other hand, the unfortunate index investor who bought and held the S&P500 ETF (NYSE:SPY) would have lost 3% over the same time period. That even includes quarterly dividends reinvested annually. As you might imagine, I'm very pleased with the performance of my version of Graham's defensive strategy.

TABLE 1: Performance of Past Graham Stocks
YearGraham S&P500 +/-
2000 - 2001 20.4% -22.2% 42.6
2001 - 2002 28.2% -15.1% 43.3
2002 - 2003 56.8% 16.5% 40.3
2003 - 2004 32.2% 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
2008 - 2009 2.2% -6.2% 8.4
2009 - 2010 2.3% 9.1% -6.8
Total Gain 492.8% -2.7%495.5
Annualized 19.9% -0.3%20.2

Graham first described his method for defensive investors in The Intelligent Investor. While he passed away in 1976, an updated edition of The Intelligent Investor (ISBN 0060555661) with new commentary from veteran columnist Jason Zweig was published in 2003. (Serious Graham buffs should also get a copy of the sixth edition of Security Analysis (ISBN 0071592539) which includes commentary from some of today's famous value investors.)

Because Graham's rules for defensive investors are extraordinarily strict, I use a more moderate 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 focus on five years worth of earnings growth instead of ten largely because it is easier to find the five-year figures.

TABLE 2: Graham-inspired rules
1. P/E Ratio less than 15
2. P/Book Ratio less than 1.5
3. Positive Book Value
4. Current Ratio more than 2
5. Annual EPS Growth (5-Yr Avg) more than 3%
6. Positive 5 Year Dividend Growth
7. Positive Annual Earnings for 5 Years
8. 1-Year Revenue more than $400 Million

Even using my less-stringent version of Graham's rules, very few U.S. stocks usually pass the test. The annual list peaked at 10 stocks in 2002 and bottomed out at 2 stocks in 2003. (As an aside, there were over 40 stocks that passed the test back near the recent market lows in the spring of 2009.) This year, we're back up to 7 stocks. Nonetheless, that's a tiny number compared to the thousands of stocks that trade each day. As a result, my version of the defensive approach remains quite strict.

The current list of Graham stocks is shown in Table 3. Before diving in, you should always examine any stock in great detail and remember that a well-diversified portfolio contains more than only a few stocks. You should also be on the look out for problems that might not be reflected in a company's latest numbers. Study news stories, press releases, and regulatory filings.

If you'd like more information on the Graham stocks, I publish the Graham Value Stocks letter which tracks several Graham-inspired strategies and highlights value stocks in both the U.S. and Canada. You can get a free sample copy at stingyinvestor.com.

While Graham's Defensive method has avoided serious long-term trouble, it can't be expected to outperform all of the time. Last year was a prime example. So, don't dive in based on past performance alone. Take your time and get comfortable with the method and value investing more generally.

TABLE 3: U.S. stocks that pass our Graham-inspired rules
CompanyPriceP/EP/BEPS GrowthCurrent RatioD/ERevenue ($M)Dividend Growth
ADM(ADM)31.9210.61.4013.4%2.10.5261,68212.3%
AVX(AVX)13.8613.91.2913.7%6.70.001,3052.5%
Cash Am(CSH)35.5910.11.4420.6%4.00.551,1208.9%
Ensco(ESV)44.8410.61.1123.6%4.10.051,9468.6%
Noble(NE)33.506.01.1846.5%3.90.103,64144.3%
Smucker(SJM)60.2713.31.3312.0%3.70.244,6056.5%
Tidewater(TDW)43.9710.40.9218.1%2.40.121,16916.4%
Source: msn.com, zacks.com, October 1, 2010


Additional Resources:


First published in the November/December 2010 edition of the Canadian MoneySaver magazine.

 
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