As a career long analyst of stocks, markets, economies and just about everything else that contained data, I spent years digging through microfiche and old newspapers seeking any tidbit of information that would provide an edge to my investment selection. No detail was too small, no place in the world too remote. Unfortunately, I kept running into a whole lot of other data freaks doing the same thing. We all had the notion that information, by itself, was as sacred as Sergeant Pepper.
Hail To The Chief
Benjamin Graham was interviewed in the September 20, 1976 edition of Medical Economics. It was a revelation. In the interview he pointed out how conventional tools such as market share or projected earnings were of little practical use in deciding what price to pay for stocks or when to sell them.
In the 1970’s growth stocks were the rage and 5-10 year earning projections were common. Institutional investors focused on 50 of America’s fastest growing corporations. It was not unusual for these stocks to sport price earnings ratios of 50. Thus, Grahams 1976 observations amounted to heresy. But, results of institutional investors proved him right. In this 10-year period many of the most well informed institutional investors seriously underperformed leaving corporate pensions materially underfunded. Obviously, very few people understood what price to pay for a stock or when to sell it.
The Ground Rules
The mantra of Graham & Dodd was “Security analysis is the discipline of comparative selection”. But without at least an earnings projection or a PE based on profits 5 years away, where does one start? Graham’s answer was simple. Start with a definite rule for purchasing that shows that you’re are buying stocks for less than they are worth. Next there needs to be a large enough number of stocks to make for a valid sample size. Finally, there must be a definite rule for selling. Well, none of this is exactly proprietary wisdom. It sounds a lot like always “buy low and sell high”. So, how does it all work
The Buck Starts Here
Valuation begins with interest rates. All investments involve some degree of risk. Bonds backed by the full faith and credit of the US government carry the lowest followed by America’s strongest corporations. Interest rates and stock values have an inverted relationship. Rising interest rates translate into lower stock valuations while the reverse is true when interest rates are falling.
For sake of illustration, imagine the highest ranked AAA Corporation is willing to pay you 8% interest to buy their bonds. Stockholders face higher risks and need to be compensated with a higher return. That makes sense. Here is where Graham’s magic begins. His approach is to search out those stocks who’s earnings to price ratio is more than twice the interest rate paid on AAA corporate bonds. We’re talking about earnings to price ratios, not the conventional PE so lets take a hypothetical example.
Intergalactic Enterprises has EPS of $3.00 and a stock price of $10. Earnings equal 30% of the stocks price so the ratio of earnings to price is 30. For the moment let’s assume AAA bonds are yielding 8%. Given the two options, Graham buys the stock since the EP ratio of 30 on Intergalactic stock is more than twice the 8% yield on AAA bonds.
For those who are tradition bound and love math, Mr. Graham offers an alternative way to come to the solution. First take the 8% AAA bond yield in our example, double it and divide by 100. Using this method gives you and answer of 6.25. This is this is a benchmark PE ratio so any stock selling for less than 6.25 is good value.
If AAA bond yields fell to only 5% the PE benchmark for stocks rises to 10. Conversely if AAA yields rise to 10%, the PE benchmark falls to just 5.
Graham maintains for most investors, these criteria alone should supply plenty of candidates for a diverse portfolio of at least 30 stocks.
According to Mr. G, simply look at balance sheets. When you find companies where shareholder equity that is at least 50% of total assets, you have located a financially sound company at an attractive value. An accounting degree is not necessary. Just read the major balance sheet headings Shareholder Equity and divide by Total Assets.
For those truly uncomfortable with financial statements but feel comfy with your laptop here are two other options. Find a low cost (free) App that offers
a screening function allowing you to sort companies by pre selected balance sheet characteristics.
OK what’s next? The goal is to take our list of candidates and develop a portfolio of at least 30 companies. This creates just enough diversification to be effective without becoming a burden. Now, it’s time for the best part. Be prepared to commit to this list for 2-3 years and set a price object. Your goal should be a 50% return. Wow, who wouldn’t be satisfied with 50% return over 24-36 months? Well there are no guarantees so what should be done after 24 months if a stock hasn’t made major progress toward that 50% return? According to the Simple Way Investment Strategy, sell it and reinvest the money in a different stock that meets the value criteria.
That is the essence of Grahams Simple Way approach. It is not purely mechanical however. Some human interpretation helps so long emotions like fear and greed can be kept in check. Not every stock is going to produce a 50% return and having the objectivity to sell is important.
Practiced with dedication over a long enough period provided Graham with returns averaging 15%. Compared with the general market at 10% that is big time stuff to feather your investment nest.
The beauty of Ben Grahams Simple Way strategy is taking the guesswork out of investing. No more forecasting the future, predicting interest and cap rates, trying to nail down EPS, none of that.
Warren Buffett has long been a value-investing disciple, carrying the banner after Grahams death in 1976 adding a few of his own tricks along the way. Most importantly, Bentham Graham’s Simple Way Investment Strategy opens the door to a level playing field we can all share.
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