benjamin graham photo

-Introduction

In 1976 Benjamin Graham gave three interviews worth reading, one of them being The Simplest Way to Select Bargain Stocks. The interview was published in Medical Economics and all of the interviews can be downloaded here:

An Hour with Mr. Graham, FAJ (1976)

A Conversation with Benjamin Graham, FAJ (1976)

The Simplest Way to Select Bargain Stocks, Medical Economics (1976)

-The Simplest Way

In the interview with Medical Economics Benjamin Graham describes a simple quantitative method consisting of the following three steps:

Step 1: By making as large a list as possible of common stocks currently selling at no more than seven times their latest – not projected – 12-month earnings. Just look up the price-earnings ratios listed in the stock quotation columns of The Wall Street Journal or other major daily newspapers.

Step 2: You should select a portfolio of stocks that not only meet the P-E requirement but also are in companies with a satisfactory financial position. … An easy way to check on that is to look at the ratio of stockholders’ equity to total assets; if the ratio is at least 50 percent, the company’s financial condition can be considered sound.

This advice already could be found in The Intelligent Investor (1949):

An industrial company’s finances are not conservative unless the common stocks (at book value) represents at least half of the total capitalization, including all bank debt. For a railroad or public utility the figure should be 30 per cent.

Diversification is of course required.

Step 3: A portfolio of 30 would probably be an ideal minimum.

The results of this method were tested by Benjamin Graham over the period 1925-1975 with the following results:

My research shows that a portfolio put together using such an approach would have gained twice as much as the Dow Jones Industrial Average over the long run.

Otherwise said from a business economic point of view the method is based on combining a low valuation with a strong financial position, margin-of-safety plain and simple. Concerning the determinants of financial strength we refer to our April contribution.

-The Evidence

The study Analyzing Valuation Measures: A Performance Horse-Race over the past 40 Years was published a few months ago. In this study Wesley Gray and Jack Vogel test the performance of various valuation multiples over the period 1971-2010. One of the valuation multiples concerns the traditional price-to-earnings ratio. At the end of June companies are sorted based on the price-to-earnings ratio and divided in quintiles. Quintile 1 contains the growth stocks; quintile 5 contains the value stocks. Each portfolio is held for one year. Value stocks earn an average annual return of 15.99 percent for equally-weighted portfolios and 13.62 percent for value-weighted portfolios over the 1971-2010 period (TABLE I).

TABLE I

Average annual returns 1971-2010

Equally-weighted

Value-weighted

Q1 – Growth

10.44%

9.26%

Q2

12.40%

10.81%

Q3

13.74%

10.42%

Q4

14.60%

11.98%

Q5 – Value

15.99%

13.62%

It should be noted that the use of deciles or more concentrated portfolios undoubtedly results in higher average annual returns for value stocks. Nevertheless the findings are convincing and confirm those findings documented by Benjamin Graham over the period 1925-1975.

At the bottom of this article we provide the reader at the end of May with a list of fifty US companies having both a price-to-earnings ratio smaller than 10 and a common equity of at least 50 percent. A similar selection can be built using widely available professional stock screeners (e.g. screener.co).

-An Ode to Quant

Given the strong track-record of this quantitative method based on cheapness and financial strength (and other simplified quantitative value methods) over a period of more than 85 years the question should be raised why so much professional investors have not at all adopted a purely quantitative approach.

In the chapter Painting by Numbers: An Ode to Quant from the book Behavioural Investing James Montier formulates a number of answers. The principal reason happens to be overconfidence, the confidence or otherwise said the illusion that in the role of investors we can easily defeat simple quantitative models by making use of additional detailed information. Investors “adding their own two cents” should however have very strong a priori reasons why they will succeed in generating significantly higher returns.

A second reason is the loss of employment for analysts. Arranging a list according to the aforementioned three steps requires at the most one day of labour per year.

Montier considers the third reason in the sphere of marketing. It is much easier to persuade investors to invest based on attractive (growth) stories by focusing on “the intangible factors of value such as good-will, management and expected earning power” than based on a rational quantitative model. In lesser years many investors expect to receive an alleged (!) rational explanation for the negative returns and/or the underperformance. It is understood that based on this method it is hardly possible to give a significant explanation; poor years alternate with strong years. In this connection Benjamin Graham refers to the horrible stock market years 1973-1974. According to the study Value and Growth Investing: Review and Update by Chan and Lakonishok (2004) large-cap and small-cap value stocks realised returns of -40 percent and -35 percent respectively over this two-year period. A portfolio return of -40 percent implies that lots of stocks score a decrease of -50 percent, which is quite a disappointing experience for many investors.

In a well-defined bear market many sound common stocks sell temporarily at extraordinarily low prices. It is possible that the investor may then have a paper loss of fully 50 per cent on some of his holdings, without any convincing indication that the underlying values have been permanently affected. – Graham, 1949

In the light of such results investors in no time lose their confidence in a rational quantitative method; the loss years start to be such an influential factor for them that they completely lose sight of the track-record of value investing over the past decades. Instead of taking advantage of the opportunities offered by the market, investors resort to irrational panic reactions.

The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgment. – Graham, 1949

Over the period 1975-1976 large-cap and small-cap value stocks generated returns of 149 percent and 142 percent respectively, which is amply sufficient to outweigh the losses in the two previous years. Benjamin Graham correctly concludes with the following insight:

The investor needs the patience to apply these simple criteria consistently over a long enough stretch so that the statistical probabilities will operate in his favor. (Emphasis added)

-The Simpliest Stock List

The list will be published on May 31, 2012.

-References

Chan, L.K.C., and J. Lakonishok. (2004). “Value and Growth Investing: Review and Update.” Financial Analyst Journal, 71-86.

Graham, B. (1949). The Intelligent Investor. HarperCollins Publishers.

Graham, B. and D.L. Dodd. (1934). Security Analysis. The McGraw-Hill Companies.

Gray, W.R. and J. Vogel. (2012). “Analyzing Valuation Measures: A Performance Horse-Race over the past 40 Years.”

1, 2  - View Full Page