The Graham Strategy: An Oldie, But A Very, Very Goodie

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Benjamin Graham-inspired strategy, which has averaged annual returns of 15.6% since its July 2003 inception vs. 5.9% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Graham-based investment strategy.  Continue reading

The Gurus Accessorize with Coach

In his latest Seeking Alpha column, Validea CEO John Reese takes a look at a luxury goods stock that’s getting strong scores from his guru-inspired models: Coach Inc.

Reese notes that Coach shares have stumbled over the past year and a half, with the latest negative catalyst being a downward revision to its forward guidance. “Some weakness in North America, in part due to increased competition, is a driving factor behind the guidance change. Investors also may be nervous that Coach is in the process of changing up its business model, shifting from a handbag/accessory specialist to more of a ‘lifestyle brand,’ a la Louis Vuitton,” Reese explains. “But it looks like the declines are an overreaction. That’s what my Joel Greenblatt- and Benjamin Graham-based approaches … are telling me. Both of these models look for companies with strong balance sheets that are trading at attractive prices, and that’s just what they see in Coach.”

Reese says the Graham- and Greenblatt-inspired models recently triggered a “Trade Alert” for Coach. Historically, stocks that have triggered this alert have gone on to gain an average of about 19% over the next six months, beating the S&P 500 about 70% of the time. Reese looks at the specific reasons why these two models are high on Coach, and why the firm has the sort of “durable competitive advantage” that Warren Buffett likes to see.

What’s Your Advantage?

If you don’t want to put all your faith in luck, you need to have an advantage to beat the market over the long haul. But The Motley Fool’s Morgan Housel says that many investors don’t really think about what their advantage is — or whether they even have one.

Housel notes that, late in his life, value guru Benjamin Graham actually talked about how he thought stock-picking wasn’t for most investors. So many investors had adopted the in-depth, analytical techniques Graham pioneered that it had become tougher to make money with them. Housel thus asked The Wall Street Journal’s Jason Zweig, who wrote the commentary and footnotes in the latest updated version of Graham’s classic The Intelligent Investor, if he thought that meant Graham would have simply had all his money in index funds today. “No, I don’t think so,” Zweig said. “He would advise knowing your advantages and your disadvantages, and not playing a game you have no advantages in.”

That led Housel to think about what his own advantages might be when it comes to stock picking. He offers a couple that pertain to individual investors, including “time”. “I’m patient to the point of obsessive when it comes to delayed gratification,” he says. “I bought stocks all the way down in 2008 and 2009, dreaming about what they’d be worth in 2038 and 2039. That’s a big advantage over Wall Street, whose definition of ‘long term’ is the time between Lightning Round segments on CNBC. If Wall Street is thinking about the next ten months, and you’re thinking about the next ten years, case closed — that’s your advantage.”

Two other advantages individual investors can have, Housel says: the ability to think about stocks as businesses, not stocks, and a steadfast belief in reversion to the mean. “It’s simple stuff, but it’s one of the most powerful forces in finance because, by definition, only a small portion of investors can be contrarians,” he says of mean reversion. “It’s much easier to say ‘I’ll be greedy when others are fearful’ than to actually do it. But those who can truly train themselves to be skeptical of outperformance and attracted to underperformance will likely do better than most. They have an advantage.”

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The Graham-Based Strategy: 300%+ Returns Since ’03

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Benjamin Graham-inspired strategy, which has averaged annual returns of 15.4% since its July 2003 inception vs. 5.3% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Graham-based investment strategy.

Taken from the May 24, 2013 issue of The Validea Hot List

Guru Spotlight: Benjamin Graham

Today, many investors look to Warren Buffett for advice about the stock market and the economy. But before he became one of the world’s richest men and greatest investors, there was someone whose investment advice Buffett himself cherished: Benjamin Graham. And Buffett was far from alone. Known as “The Father of Value Investing”, Graham inspired a number of famous “sons” — Mario Gabelli, John Neff, John Templeton, and, most famously, Buffett, are all Graham disciples who went on to their own stock market greatness.

So, just who was Graham? Born in England in 1894 as Benjamin Grossbaum (his family later changed its surname to Graham during World War I, when German names were viewed with suspicion), 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, and two factors from his early years may show why. The first was Graham’s own family’s fall from financial comfort to poverty not long after his father died when he was nine. The second involved his first major business venture, an investment firm he founded with Jerome Newman. Just three years after opening, the stock market crash of 1929 and the Great Depression arrived. Graham’s clients, like just about everyone else, were hit hard, according to Graham biographer Janet Lowe, and Graham worked without compensation for five years until his clients’ fortunes were fully restored.

Having lived through both his own family’s financial troubles and the 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. Here are the current holdings of the 10-stock Graham portfolio:

HollyFrontier Corp. (HFC)

Cheung Kong Holdings Limited (CHEUY)

Alliant TechSystems (ATK)

National-Oilwell Varco (NOV)

NTT DoCoMo, Inc. (DCM)

Bridgepoint Education (BPI)

Chevron Corporation (CVX)

Inter Parfums (IPAR)

Western Digital Corp. (WDC)

Apollo Group (APOL)

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 nearly 10 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 May 20, the 10-stock Graham-based portfolio was up 311.8% since its July 2003 inception, making it my best 10-stock performer. That’s a 15.4% annualized return in a period in which the S&P 500 has gained just 5.3% 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. In 2011, it had its worst year, however, falling 19.0% while the broader market was flat. It rebounded nicely, though, gaining 33.8% in 2012 and 22.0% so far this year.

It’s also worth noting that the 20-stock Graham-based portfolio I track has been even better. In fact, it’s the best performer of any of my 10- or 20-stock portfolios, having returned 389.4% since its July 2003 inception — that’s 17.5% per year.

The Graham portfolios’ long-term results 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. Do that, and you should produce some strong results of your own.

Investor vs. Speculator: Which Are You?

In today’s financial world, the line between investing and speculation are often blurred. What is the real distinction between the two? Jason Zweig endeavors to answer that on The Wall Street Journal’s Total Return blog.

“As Josh Brown at the Reformed Broker pointed out earlier this week, nearly all commentary about the financial markets is tailored to speculators, not investors,” Zweig writes. “That can contaminate the mind of even the most intelligent investor with speculative thinking. How can you keep your head clear?”

Zweig notes that up until the 20th century (and for a good chunk of that century), all stocks were considered speculative. Bonds were considered investments, because they guaranteed a return of capital. The late, great Benjamin Graham helped change that. “He wanted people to see things differently,” Zweig writes. “Graham insisted that stocks could be investments and bonds could be speculations – all dependent on the price. If a stock’s price is cheap relative to its underlying value as a cash-generating business, that stock is an investment. If a bond is trading above the sum of its maturity value and all its future interest payments, that bond is a speculation.”

So how can one define investment and speculation? Zweig offers this: “An investor never buys purely because an asset’s price has been going up and never sells merely because its price has been going down. An investor uses internal sources of return — dividends, rising future profits or asset values — to estimate what an investment is worth.” And a speculator? “A speculator buys and sells on the basis of recent fluctuations in price,” Zweig says. “A speculator uses external sources of return — primarily what he thinks someone else might pay — to estimate what a speculation is worth.”

Zweig’s piece was the second of a two-part examination of the investment/speculation question. You can read the first article here.

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How Ben Graham Is Still Beating the Market Today

While Benjamin Graham’s classic The Intelligent Investor was written over six decades ago, the Defensive Investor strategy he laid out in it remains a winner, Validea CEO John Reese writes in his latest Forbes.com column.

“The investment world is no stranger to apparent greatness that doesn’t last,” Reese writes. “Every year, a number of fund managers will post stellar returns, catching the eye of the media and the public. Then many, if not most, of their funds disappoint the following year — and over the long term. That’s why I try to focus on investors with truly long-term track records, those whose greatness is, in fact, lasting.”

In terms of lasting greatness, “no investor fits the description better than the late Benjamin Graham,” says Reese. That’s because Graham didn’t just post exceptional returns during his own career in the middle of the 20th century — Graham also provided a blueprint for beating the market that Reese has used for the past decade. Reese has been tracking a portfolio of stocks picked using his Graham-based “Guru Strategy” since mid-2003, and since then it has returned more than 13% annualized, while the S&P 500 has returned less than 4% per year. It’s had a particularly good 2012, more than doubling the S&P despite the many concerns hovering over stocks.

Reese looks at how the Graham-based model works, and offers a handful of picks that have recently caught the strategy’s eye. Among them: Japanese telecom giant NTT Docomo.

Double-Digit Returns from a 60-Year-Old Strategy

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Benjamin Graham-inspired strategy, which has averaged annual returns of 12.1% since its July 2003 inception vs. 3.5% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Graham-based investment strategy.

Taken from the July 20, 2012 issue of The Validea Hot List

Guru Spotlight: Benjamin Graham
Today, many investors look to Warren Buffett for advice about the stock market and the economy. But before he became one of the world’s richest men and greatest investors, there was someone whose investment advice Buffett himself cherished: Benjamin Graham. And Buffett was far from alone. Known as “The Father of Value Investing”, Graham inspired a number of famous “sons” — Mario Gabelli, John Neff, John Templeton, and, most famously, Buffett, are all Graham disciples who went on to their own stock market greatness.

So, just who was Graham? Born in England in 1894 as Benjamin Grossbaum (his family later changed its surname to Graham during World War I, when German names were viewed with suspicion), 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, and two factors from his early years may show why. The first was Graham’s own family’s fall from financial comfort to poverty not long after his father died when he was nine. The second involved his first major business venture, an investment firm he founded with Jerome Newman. Just three years after opening, the stock market crash of 1929 and the Great Depression arrived. Graham’s clients, like just about everyone else, were hit hard, according to Graham biographer Janet Lowe, and Graham worked without compensation for five years until his clients’ fortunes were fully restored.

Having lived through both his own family’s financial troubles and the 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. Here are the current holdings of the 10-stock Graham portfolio:

Forest Laboratories, Inc. (FRX)

Curtiss-Wright Corp. (CW)

Helmerich & Payne, Inc. (HP)

NTT DoCoMo, Inc. (DCM)

United Stationers Inc. (USTR)

GameStop Corp. (GME)

General Dynamics Corporation (GD)

USANA Health Sciences, Inc. (USNA)

DeVry, Inc. (DV)

Walgreen Company (WAG)

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 nine 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 July17, the 10-stock Graham-based portfolio was up 179.2% since its July 2003 inception, making it my second-best performer. That’s a 12.1% annualized return in a period in which the S&P 500 has gained just 3.5% 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. In 2011, it had its worst year, however, falling 19.0% while the broader market was flat. It’s rebounded nicely in 2012, though, having risen 10.7% vs. 8.4% for the S&P, indicating that last year was an aberration.

It’s also worth noting that the 20-stock Graham-based portfolio I track has been even better. In fact, it’s the best performer of any of my 10- or 20-stock portfolios, having returned 259.7% since its July 2003 inception — that’s 15.3% per year.

The Graham portfolios’ long-term results 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. Do that, and you should produce some strong results of your own.

Fisher Likes Pharma, Tech, and Toys — and Books

In his latest column for Forbes, Kenneth Fisher recommends a number of classic investing books, and advises readers to learn all they can from them. 

Among the books Fisher touts are Benjamin Graham and David Dodd’s Security Analysis, and Roger Babson’s Business Barometers for Anticipating Conditions — which he thinks could increase 100-fold in value over the next 20 years. But potential collectible gains aren’t the only reason to read these classics, he adds: “There is another benefit to collecting investment classics. Learning from them may lead you to make wiser decisions and ultimately help you build your wealth. So read a few classics this summer.”

Fisher also offers a handful of stocks that he’s high on right now, with two from the pharmaceutical industry and two others that involve toys or games. Among them: Mattel and Forest Laboratories. To read the full article and see all the picks, click here.

Advice from the Best — In 10 Words or Less

Could you distill your investment philosophy into 10 words or less? In his latest post for The Wall Street Journal’s Total Return blog, Jason Zweig poses that question to some of the world’s most successful investors.

Zweig says that when someone recently asked him the question, he “laughed and said, ‘Of course not!’ But right afterward, I realized to my surprise that I could. I banged this out almost instantly: Anything is possible, and the unexpected is inevitable. Proceed accordingly.”

Here’s what some top investors told Zweig when asked the same question:

David Herro, Morningstar Fund Manager of the Decade:

Determine value.  Then buy low, sell high.  ;-)

Robert Rodriguez, managing partner, First Pacific Advisors:

Plan for the worst. Hope for the best.

Christopher C. Davis, chairman, Davis Advisors and co-manager, Davis New York Venture Fund:

Fallible, emotional people determine price; cold, hard cash determines value.

Zweig also notes that Benjamin Graham, the man known as “The Father of Value Investing”, distilled his philosophy into just three words in his classic book The Intelligent Investor, saying, “In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, ‘This too will pass.’ Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.”