THE GLOBE AND MAIL: Graham's strategy still stands tall



From Wednesday's Globe and Mail Last updated on Wednesday, Oct. 07, 2009 03:10AM EDT 

Validea.com

In the sports world, some of the most intriguing debates involve comparisons that cross generations. How many goals could Bobby Hull score in today's NHL? How about Maurice Richard? Could Babe Ruth hit 60 home runs?

In investing, you can ask similar questions - and get much more definitive answers.

Take Benjamin Graham. Born in 1894, Mr. Graham is considered the father of both value investing and the field of security analysis. He's also known as Warren Buffett's mentor. He earned his reputation by producing annual returns of about 20 per cent from the mid-1930s through the mid-1950s, far exceeding the 12.2-per-cent annual returns of the broader market.

We'll never know for sure how well Mr. Graham would have performed in today's market - but we can get a pretty good idea. That's because in his classic book The Intelligent Investor, Mr. Graham laid out a step-by-step, quantitative stock-picking method for the "defensive investor" - a method I've replicated in my Graham-inspired "Guru Strategy" computer model.

Based on the performance of that strategy, has Mr. Graham's approach been passed by? Hardly. In fact, the 10-stock Graham-inspired portfolio I track has been my best long-term performer, more than doubling in value since its July, 2003, inception.

Even amid the huge market shakeup of the past two years, the Graham portfolio has continued its strong performance. It lost less than the broader market last year, and quickly made up all of its 2008 losses.

Mind the Business 

How can a 60-year-old strategy fare so well today? It's because Mr. Graham's strategy wasn't gimmicky, or designed to capitalize on specific market conditions.

Mr. Graham knew that over the long term, stocks tend to move up or down based on how their underlying businesses perform. So, he scoured balance sheets and income statements to find strong, steady companies that were likely to thrive over the long haul.

The same criteria he used to find solid businesses 60 years ago are thus still finding solid businesses for my Graham-based portfolio today. Among those criteria:

Current Ratio: This compares current assets (a company's most liquid assets) to current liabilities (those closest to maturity) to gauge liquidity. The Graham approach wants this to be at least 2.0.

Long-Term Debt v. Net Current Assets: Net current assets (current assets minus current liabilities) should be equal to or greater than long-term debt.

Earnings-Per-Share Growth: He wanted steady growth, at least 30 per cent total over the past decade, with no negative annual EPS over the past five years.

The Margin of Safety 

Having lived through his own family's financial woes and the Great Depression, Mr. Graham thought minimizing losses was every bit as important as realizing gains. Because of that, he looked for stocks with a "margin of safety," whose prices were already so low relative to real values of their businesses that even if they struggled, the stock didn't have far to fall.

There were two ways Mr. Graham targeted such stocks: the price/earnings and price/book ratios. He measured the P/E two ways - using the past year's earnings and using the average of the past three years. He wanted both figures to be below 15.

As for the price/book ratio, Mr. Graham's defensive approach used a slightly unusual criterion: The product of the P/E ratio and the P/B ratio should be no greater than about 22.

Last year, in one of the worst market environments ever, my Graham-based model did indeed provide a margin of safety. Its tough debt requirements excluded nearly all financial firms, which were hit hard.

This year, my Graham portfolio is well ahead of the S&P 500. What is it high on right now? Here are three U.S. firms with a presence in Canada:

Smith International Inc.: Based in Houston, this oil field services firm has about 1,000 rigs in the U.S. and almost 200 in Canada. My Graham-based model likes the $2.9-billion in net current assets versus $2.1-billion in long-term debt, and 11.88 P/E ratio.

Snap-On Inc.: This Kenosha, Wis.-based company makes tools and diagnostic equipment. Two of its manufacturing and distribution centres are in Canada. My Graham-based approach likes the firm's solid 2.33 current ratio, manageable long-term debt and 11.6 P/E ratio.

Cabela's Inc.: Cabela's is the world's largest direct marketer, and a leading retailer of outdoor merchandise. The Sidney, Neb.-based firm has about 30 retail locations, most in the northern U.S. and one in Winnipeg. The Graham model likes its manageable long-term debt and low 0.97 P/B ratio.

These three stocks get a perfect 100-per-cent score from my Graham-based model. Two Canadian-based stocks also rate highly, with Toronto-based Harry Winston Diamond and Calgary-based oil services firm Precision Drilling Trust earning scores of 86 per cent.