STABLEBOY SELECTIONS

In 1996, an obscure money manager named James O’Shaughnessy published What Works on Wall Street. He claimed that from 1954 to 1994 an investor could have turned $10,000 into $8 million—beating the S&P 500′s return ten times over—by purchasing stocks with (1) the highest one-year returns, (2) five straight years of rising earnings and (3) share prices less than 1.5 times their corporate revenues. O’Shaughnessy obtained a patent for his automated strategy and launched four mutual funds. By early 2000, all of them had underperformed the S&P 500 and O’Shaughnessy retired.

Ben Graham also achieved poor returns when he used mechanical methods of stock selection in lieu of security analysis. What is strange is that Graham actual wrote about the weaknesses of such an approach before he went about applying them. In the Intelligent Investor he writes:

“I believe that the change in [Magic Formula Investing] results is not accidental. It demonstrates an inherent characteristic of trading formulas in the fields of business and finance. Those formulas that gain followers do so because they have been adapted to the statistical record of the past. But as their acceptance increases, their reliability tends to diminish. The moral seems to be that any approach to moneymaking in the stock market which can be easily described and followed by a lot of people is too simple to last.”

Excerpts from Benjamin Graham on Value Investing by Janet Lowe:

In a March 6, 1976 interview with Hartman L. Butler Jr., C.F.A., for a monograph the Financial Analysts Society was planning, Ben explained how his thinking had evolved.

“I have lost most of the interest I had in the details of security analysis which I devoted myself to so strenuously for so many years,” Ben said. “I feel that they are relatively unimportant, which, in a sense, has put me opposed to developments in the whole profession. I think we can do it successfully with a few techniques and simple principles.”

Putting Ideas to the Test

The research involved a 50-year study of all the corporations in the Moody’s Industrial Stock Group. Ben’s study, which was assisted by Robert Fargo, a financial consultant and researcher in San Rafael, showed that the stocks that met his standards performed twice as well as the DJIA. Ben looked for, among other factors, an earnings yield twice that of the bond interest rate in most years. He also found that certain dividend and asset value criteria worked well.

“It was tremendously gratifying to be doing research on a period you knew very little about—say, 1938,” said Fargo, “and discover the stocks that would turn out to be the real winners.

Apparently, the idea that even an ordinary investor could buy a group of stocks that meet some relatively simple criteria and succeed in the market fanned the fire of Ben’s rekindled interest in investing. On leisurely drives to Ben’s favorite restaurant in Ensenada, Mexico—El Rey Sol—he and Jim Rea debated the criteria and wrangled out the details on how the concept could best be put to use.

They started with the ten stock-picking yardsticks that seemed most likely to ensure sound portfolio performance. Then, they tried to narrow those down to the few criteria that seemed to be the decisive ones.

“Imagine,” Ben said, “there seems to be practically a foolproof way of getting good results out of common stocks investments with a minimum of work. It seems too good to be true. But all I can tell you after 60 years of experience, it seems to stand up under any of the tests that I would make up.”

Graham Search for a Simple Way to Select Stocks: Ten Attributes of an Undervalued Stock
(Few companies can meet all ten criteria.)

1. An earnings-to-price yield (reverse of the P/E ratio) that is double the triple-A bond yield. If the triple-A bond yield is 8 percent, the required earnings yield then will be 16 percent.
2. A price-to-earnings ratio that is four-tenths of the highest average P/E ratio achieved by the stock in the most recent five years. (To get the average P/E ratio, an average stock price for a given year is divided by the earnings for that year.)
3. A dividend yield of two-thirds the triple-A bond yield. Stocks paying no dividends or those that have no current profits from which to pay dividends are excluded.
4. A stock price of two-thirds the tangible book value per share. This is calculated by adding up all the assets, excluding intangibles such as goodwill, patents, etc., subtracting all liabilities and dividing by the total number of shares.
5. A stock price that is two-thirds of the “net current asset value” or the net quick liquidation value.” The net quick liquidation value is current assets (those assets that are immediately convertible into cash, fixed assets omitted) less total debt. This, of course, was the foundation of Ben’s original theory.
6. Total debt that is less than tangible book value.
7. A current ratio of two or more. The current ratio is current assets divided by current liabilities. This is an indication of the company’s liquidity, or its ability to pay its debt from its income.
8. Total debt at or less than the net quick liquidation value. (Net quick is defined in Number 5.)
9. Earnings that have doubled in the most recent ten years.
10. No more than two declines in earnings of 5 percent or more in the past ten years.

Criteria one through five measure risk; six and seven define financial soundness; eight through ten show a history of stable earnings.

The New Guidelines

Graham insisted that the fund be called the Rea-Graham Fund—with Rea’s name first—because he doubted that at age 82 and in precarious health, he would be around long to help with the management. Rea would manage the account using a condensed version of Ben’s ten criteria for choosing undervalued shares. They would buy shares with:

An earnings yield of not less than twice the average AAA bond rate for industrials;
A dividend yield of not less than two-thirds the average AAA bond rate for industrials; and
A price not greater than two-thirds the tangible book value.

Additionally, the company must meet a test for financial soundness. Only companies that met two out of the three of the following points would qualify for purchase:

A current ratio of at least two;
A total debt less than a company’s tangible net worth, or stated otherwise, a company that does not owe more money than it is worth; and
A total debt less than twice the company’s net current asset value.

The Old Values

The fund would also follow other notions that Ben had adhered to for so long:

It would be a balanced fund, with at least 25 percent of the assets in U.S. government securities and a higher level of government issues when few stocks could be found to meet the criteria.

Like his other funds, the Rea-Graham fund would be highly diversified. It started with 170 different stocks.

A stock would be sold when it had achieved a profit of 50 to 100 percent of the cost, or in two years. If in two years the stock has not appreciated 50 percent, it would be sold, even if it was necessary to take a loss. By following the same principles, Ben felt that even an individual investor could achieve a consistent 15 percent return with a minimum level of risk.

Rea-Graham Goes On

As for the Rea-Graham Plan Fund, it has not dazzled. For the five years ended in 1993, it delivered a total return of only 4.7 percent and was ranked in the bottom 20 percent of all mutual funds. The full reasons for the fund’s lackluster performance are not clear, except perhaps that in the 1990s the market has been on a rise and returns by the value-investing approach invariably cool at the top of a market. Some of Graham’s former students claim that the fund failed to follow Graham’s criteria closely.

In 1982, Rea converted the $28 million fund to a public mutual fund. In time, Rea says he liberalized the fund’s guidelines to allow the sale of a stock after 100 percent appreciation or three years, whichever came first.

“I wasn’t too taken with Rea,” said Marjorie Graham Janis. “Sincere, but not impressive. Ben was very taken.”

Many of Graham’s old friends were suspect of Rea, a Californian and a newcomer to investments with a background stronger in aviation than in finance. Rea was not of Wall Street, and they figured that he had met Ben at a time when the master investor was aging and perhaps vulnerable to persuasion.