Wednesday October 26, 2011
by John Reese, editor Validea
Benjamin Graham, known as "the father of value investing", inspired a number of famous "sons" -- Mario Gabelli, John Neff, John Templeton, and, most famously, Warren Buffett.
Born in England in 1894, Graham built his reputation -- and fortune -- by using an extremely conservative, low-risk approach to investing. To him, preserving one's original capital was every bit as important as netting big gains.
Having lived through both his own family's financial troubles and the 1929 market crash, it's no surprise that the strategy Graham laid out in his classic book The Intelligent Investor was a conservative, loss-averse approach.
To Graham, an investment wasn't something that could be turned into quick, easy profits; anything that offers such "easy" rewards also comes with substantial risk, and Graham abhorred risk.
True "investment", he wrote, deals with the future "more as a hazard to be guarded against than as a source of profit through prophecy."
In terms of specifics, Graham's "Defensive Investor" approach limited risk in a number of ways, and my Graham-based model lays out several of those methods.
For example, one key criterion is that a firm's current ratio -- that is, the ratio of its current assets to its current liabilities -- is at least two, showing that the firm is in good financial shape.
The approach also targets financially sound firms by requiring that long-term debt not exceed net current assets.
Two other criteria the Graham method uses to find low-risk plays: the price/earnings ratio and the price/book ratio.
Graham wanted P/E ratios to be no greater than 15 (and, as another signal of his conservative style, he looked not only at trailing 12-month earnings but also at three-year average earnings, to ensure that one-year anomalies didn't skew the P/E ratio).
For the price/book ratio, he used a more unusual standard: He believed that the P/E ratio multiplied by the P/B ratio should be no greater than 22.
My Graham-inspired strategy tends to find bargains across a variety of areas of the market.
Two types of stocks that you won't find in the Graham portfolio are technology and financial firms. Graham excluded tech stocks from his holdings because they were too risky, and, while they're not as risky today, I do the same.
Financial stocks, meanwhile, aren't explicitly excluded from my Graham model. But because of the low-debt requirements in this strategy, it's nearly impossible for a financial firm to garner approval.
Since I started tracking my Guru Strategies more than eight years ago, the performance of my Graham-based model has been rather remarkable.
Even though the strategy Graham outlined is now more than 60 years old, it just keeps on working. Through Oct. 12, the 10-stock Graham-based portfolio was up 203.7% since its July 2003 inception, making it my second-best performer.
That's a 14.4% annualized return in a period in which the S&P 500 has gained just 2.3% per year.
The model's strict balance sheet criteria helped it avoid big losers in 2008, as the portfolio lost less than half of what the broader market lost, and it rebounded big in 2009 and 2010, gaining 31.4% in '09 and 22.6% in '10.
This year it's had some big swings amid the volatile market, but through Oct. 12 it was minimizing losses, down 2.5% for the year vs. -4.0% for the S&P.
Those figures are a great demonstration of how successful stock investing doesn't need to be incredibly complex or cutting-edge.
You don't need fancy theories or gimmicks; you just need to focus on good companies whose stocks are selling at good values. Meanwhile, here are the current holdings of the 10-stock Benjamin Graham portfolio:
Forest Laboratories (FRX)
LHC Group (LHCG)
L.B. Foster Company (FSTR)
UniFirst Corporation (UNF)
National Oilwell-Varco (NOV)
Curtiss-Wright Corp. (CW)
Regal-Beloit Corporation (RBC)
NTT DoCoMo (DCM)
Reliance Steel & Aluminum (RS)
United Stationers (USTR)
Learn more about this financial newsletter at John Reese's Validea.