The Simplest and Most Powerful Value Investing System Ever Discovered
The following chapter is extracted from my book, Super Investing: 5 Proven Methods for Beating the Market and Retiring Rich. As a Wall Street professional, my job was to research and then create tested profitable investing and trading systems for stocks, bonds, currencies, gold and commodities. Having spent years testing every type of conceivable system, I discovered only a few will make you rich in the long run. This book is all about those proven methods, and the lessons I would teach teenagers and college students to set them on the path to being able to retire rich through investing. I was always fascinated by the goal of creating a means for creating generational wealth, and in this book I lay out all the proven methods you can use to fund that objective.
What most people don’t know is that months before his death, Benjamin Graham gave an interview, published by Medical Economics in September 1976, called “The Simplest Way to Select Bargain Stocks.” During this interview he updated the ideas from his book, The Intelligent Investor. Incredibly, those new ideas seemed to overthrow most of his earlier emphasis on the detailed stock analysis for which he had become known! In the interview Graham said, “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. I feel 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.”
After years of strenuous analysis aimed at determining the value of stock investments, Graham’s new favored investing approach—which he extensively tested—chose stocks according to a very simple formula that required very little thinking or analysis at all. If a stock passed the simple hurdle criteria of his formula, he might buy it without doing all sorts of other complicated analysis.
In this “Simplest Way to Select Bargain Stocks” interview, he revealed this new stock selection criteria for identifying undervalued companies. He felt these simple criteria would outperform his original work and average a return of 15% a year or better on your total investments, plus dividends and minus commissions, over the long run. Here is the basic investing technique he discovered:
First, create as large a list as possible of common stocks currently selling at no more than seven times their latest (not projected) 12-month earnings. While Graham said to select shares with a P/E of less than 7, he explained that he arrived at this criteria because he wanted a earnings-to-price ratio (the inverted P/E ratio) was at least twice the average current yield on top-quality (AAA) corporate bonds. Today we might use a P/E criteria of 10 or even 12. In any case, the low P/E requirement tends to be the first sieve that helps you select underpriced stocks selling at a discount.
Once you have those initial candidates, you are looking to select a portfolio of at least 30 stocks (at a minimum) that not only meet the P/E requirements but also have strong balance sheets. You don’t just want a low P/E but also want companies that are financially strong because they have a satisfactory financial position. His only screening criteria for this condition was that a company should own at least twice what it owes, so its debt should be less than half of its assets. How can you measure this? You can look at the shareholder equity/total assets ratio to get an idea of debt levels. If you look at the ratio of stockholders’ equity to total assets and the ratio is at least 50 percent, the company’s financial condition can be considered sound.
Now for the selling rules. After you buy such a stock, you would sell it after it appreciated by 50% or after two years went by, whichever came first, and then simply repeat the process when funds became available and new stocks met the tests.
In other words, Graham said we should look for companies with a strong balance sheet where the shareholder equity/total assets ratio was greater than .50, and the stock was trading at a bargain because it had a low P/E that was no greater than 7. While today we would certainly use a higher P/E, the selection formula is that simple. The stock must have a low P/E (the level to be decided by market factors) and the company’s stockholder equity to assets ratio had to be 50% or better. This means that if the company was trading for $20 then we would have the potential to be paid $10 if it sold all its assets. When many stocks pass these criteria and you have several contenders to choose from, you should select the ones with the highest ratio or select them using other criteria you might favor.
Today we can do computer studies that might help us tighten these two criteria through additional measurements such as free cash flow, the return on equity, profit margins, minimum market capitalization, earnings growth rates, or even industry. For instance, we might employ Buffet’s rule of avoiding high tech stocks or financial stocks, or sectors Buffett would say were “bad bets” because they were too volatile. We might also try to eliminate companies from consideration that might go out of business because of declining sales over consecutive years. Free cash flow is also important because that’s what a company can use to minimize its debt in times of trouble. Anything that might help determine if a stock would be a takeover candidate would be helpful as well. Even trading volume can be a criteria if we are concerned about liquidity.
Through computer simulations you might even test whether adding some type of earnings growth, cash flow, profit margin, EBITDA or return on equity criteria to Graham’s basic rules might help determine even better candidates. There are all sorts of additional requirements one might test to determine if a stock is financially sound, as well as underpriced. In addition to adding a quality measurement to its selection criteria, one might also see how the methodology performed under different economic models that identified the market environment. These ideas, however, are just possible improvements on something that already works superbly. With only two ratios, Graham’s preliminary selections were finished.
The basic Graham criteria are simple and sound and actually mirror similar criteria that billionaire investors, growth oriented CEOs and private equity firms use to rate takeover candidates. The methodology actually finds stocks using the same basic criteria which private equity firms and other groups who buy companies use to determine what companies to buy as acquisitions. Buying companies is how other larger companies grow, and these criteria often get you in front of all the buying activity because they find strong companies at a discount that buyers usually want to snap up.
Now these very simple valuation rules determine which stocks you might get into, but when do you sell them? In terms of selling rules, Graham’s rules were simple and crystal clear, even more so than CANSLIM. These rules are another key reason why this strategy works so well. Graham said that as soon as an undervalued stock goes up by 50%, sell it. If a stock hasn’t met this price objective by the end of the second calendar year from the date of purchase, then you should also sell it regardless of its price. Thus, you sell when a stock increases by 50% or two years pass by ... or the company gets bought ... or the stock splits.
How did Graham come to his conclusion that this basic method could make about 15% per year? Graham and a team of assistants spent two years back-testing this method for the fifty years between 1925 and 1975, and they found that the return not only more than doubled the return of the Dow Jones average but stood up to any of the tests they would make upon it! Joel Greenblatt, founder of the Gotham Capital hedge fund (that achieved a 50% annual return during the ten years it was open to investors) and author of The Little Book that Beats the Market, also tested the formula for a period between April 1972 and April 1978, which included a severe bear market and market recovery, and found it beat its relevant index by over 10% per year! This is an incredible alpha over a simple buy and hold strategy.
More recent computer simulations, starting in 1965 and running through to 2010, show a 14.3% compound annual growth rate for the simple Graham strategy versus a 6.1% CAGR for the S&P500 index. This was once again far better than buy and hold and safer because buying assets for less than they are worth has tended to somewhat protect you during market crashes. Thus it has worked extraordinarily well over 45 years, and that’s without using any leverage at all! That’s simply amazing. Just as Graham and Greenblatt found, this simple method did much better than the entire market but with far less risk for the investor. It did better than the market as a whole, protected capital during bear market years, and it’s incredibly easy to duplicate on your own simply by using Google Finance to search for companies satisfying the basic two criteria.
One extra source for those who wish to duplicate this investment technique is found in the Inevitable Wealth Portfolio (IWP) newsletter, which was founded by editor Charles Mizrahi to pick stocks according to this technique. The Hulbert Financial Digest has tracked his portfolio returns over time and found them soundly beating the indices, once again adding another analyst to the list of those who have confirmed the validity of this simple Graham technique.
Why does this methodology work so well and why is it such a good candidate for wealth accumulation over the long run? One of the reasons behind its success is that it forces you to sell and take frequent profits of sufficient size. The selling rule forces you to take advantage of any opportunity that realizes a definite sizeable gain in your investment rather than to keep holding onto a stock and possibly see that gain whittle away. You are forced to realize a profit when it is adequate, and then put your money into an entirely new fresh opportunity.
The formula certainly doesn’t know anything about a company, such as the requirement that the company creates new products or services as demanded by the CANSLIM investment criteria. You also don’t need to evaluate the future prospects of a company at all or keep up with news on the corporation. Once it gives you the targeted 50% rate of return, you are forced to get out and rotate your monies into a new candidate with fresh potential. You must liquidate at either a profit or at the two year mark and reallocate your funds to another potential winner.
If we delve further to fathom the reasons behind the astounding long term success of this technique, the formula basically identifies companies that have been doing fine and then suddenly fall off trend. Good stocks become an undervalued situation when prices become severely depressed because of high doses of pessimism or uncertainty about the company’s immediate future. You may have heard of irrational exuberance, but there is also such a thing as irrational pessimism which is a case of extreme negative expectations that have gone too far. Negative emotional extremes can often hit stocks hard and depress share prices more than they should. These simple Graham valuation criteria help you find those situations where stocks become cheap but the stocks themselves represent good companies, so they basically identify solid dollars selling for pennies. Since some of these companies are very troubled, not all of the stocks identified by these criteria turn out to be good bets, but that’s the case with all investment strategies. You just want to see if you consistently come out ahead in aggregate if you religiously follow this strategy for a large number of stocks, and that the method generally works throughout all types of different market environments.
Basically, a portfolio of such good companies—which is why Graham insisted on at least thirty companies or more—represents a good bet on true values eventually reasserting themselves as companies resolve problems and their futures become clear. If the future turns out better than expected, the depression pushing down any stock’s prices would be lifted, and that stock would then go up significantly like any other case of mean reversion. Buying a basket of such shares insures an additional measure of diversification so that you are buying value with a sufficient margin of safety. Buying a basket of such stocks also helps prevent self-destruction because with Graham’s method, only a portion of shares outperform the market, so it isn’t necessarily a good stock picking system for extreme outperformers. It simply creates a portfolio of undervalued stocks whose prices currently incorporate negative expectations about the future, but buying them cheaply represents a good bet that, given enough time, produces an overall great aggregate return.
A common argument against this technique is the fact that just because a stock is cheap doesn’t mean it won’t get cheaper. Hearing of the methodology, investors always worry about how you can protect yourself from a further drop in prices for all these companies. After all, CANSLIM protects you from catastrophic loss by using a tight 7-8% stop loss, but there is no stop loss here. Since most investors have heard they should cut losses early and take small loses to prevent big ones, the lack of any such protections worries some investors even though historical testing shows little chance of catastrophic risk. In this case, it turns out that you are protecting yourself by the fact that the downside is already limited because shares have already fallen so much in price. The downside is limited by the fact that prices have already fallen a lot for a good company with little debt.
You are also protecting yourself via the diversification strategy of buying many such stocks, each a “good” company and each at low value-based prices. These are not showy, high flyer companies but just good, basic, salt of the earth companies. In describing these undervalued companies, Walter Schloss mentioned they were mostly secondary rather than top grade companies, usually had little sex appeal, and were usually just struck with trouble at the time of purchase. They were not flashy, but you were buying good companies cheap. Warren Buffett liked buying great companies at a discount, so his basic strategy is to only buy a few of those companies and to wait a long time for such opportunities. This strategy is for a more active investor who buys many more opportunities that are good, but not great, and so it needs the protective power of more diversification. That is the difference between this method and Buffett’s method of betting deeply by concentrating his funds in only a few holdings.
Since poor future expectations or recent bad performance were already reflected in the low share prices when a stock was initially identified as an undervalued candidate, it just turns out that investing in those already depressed prices does not hurt you much in downturns (because most of the price drop has already been factored in) while a turnaround to good performance will produce amplified returns. If more negative expectations turned out to be true, history shows that the stocks selected this way would only turn down a little more, or not at all. Since the downside was therefore somewhat limited, you simply needed a long term time horizon, which Graham found to be two years, to wait for the initial pessimism or uncertainty to be resolved, at which point the share prices would bounce back due to mean reversion.
With this valuation methodology, you are basically identifying stocks that are good solid bets. You are not using a methodology that requires a precise prediction of a stock’s present value or future value. You are not making any predictions or forecasting anything at all. You are just trying to select a basket of good companies that have already experienced some negative expectations about their future (which are perhaps overly pessimistic), and because you are buying them cheaply together with a basket of other bargains, it turns out to be a good bet in aggregate. If we look at the technique with dispassionate simplification, the basic idea is that if you have some way to figure out what something is worth and pay a lot less (J. Paul Getty’s rule), then it doesn’t matter what the market does in the meantime. Just give yourself enough time for a mean reversion return to higher values, and you’ll make money. The proof is that after testing the idea over fifty years, it works over the long haul even though the ride can be bumpy at times.
The importance of having an adequate holding period and the fortitude to withstand periods of adversity cannot be overemphasized for the long term value investor. As Buffett might say, volatility is not the same as risk when you use this type of investment methodology, and since your methodology is to buy value at depressed prices, you must take advantage of an exceptional bargain situation regardless of market volatility. Even Greenblatt found that his own “Magic Formula” strategy, which evaluates stocks using just the two metrics of earnings yield and return on capital, often produced a bumpy ride. His own cheap and good stock strategy, developed after analyzing Graham’s work, was down five out of every twelve months on average even though it showed a 30% annual return over seventeen years.
In his book How to Be Rich, billionaire J. Paul Getty also said, “It is possible to make money—and a great deal of money—in the stock market. But it can't be done overnight or by haphazard buying and selling. The big profits go to the intelligent, careful and patient investors, not to the reckless and overeager speculator. The seasoned investor buys his stocks when they are priced low, holds them for the long-pull rise and takes in-between dips and slumps in stride.” Volatility, it seems, is something to be generally ignored if you can buy an asset for less than it is worth. An incredible number of mega-wealthy investors understand this principle, and so they eschew the quick “get in, get out” mentality of traders because they invest their monies in undervalued assets for the long run and never worry about short term market volatility. As many popular books have recently pointed out, millionaires differentiate themselves from poor people because of many characteristics, and one of these characteristics is the fact that they tend to think long-term.
Many people have investment time horizons that are far too short for them to make money with this two year technique, or they hold stocks far too long and then lose all their gains as in our Citibank tale. Thus, you need patience and discipline to succeed with this highly recommended methodology. In settling for less—just a 50% return if you can get it—and then recycling that money into a fresh new opportunity, you end up going home with more money than you do by searching for large winners. As long as a country’s economy doesn’t self-destruct while you are holding these value investments (as long as we assume the nation avoids implosion or destruction), the basic Graham methodology predicts that the market will eventually recognize a greater value for your undervalued shares and reflect that through higher share prices.
This strategy reminds me of one story about John Templeton, founder of the Templeton Funds, who like Buffett also became a billionaire through his personal investing strategies and investment management services. The Templeton story is that he bought $100 of every stock trading below $1 on the NYSE stock exchange back in 1939 when Germany was at war with Europe. Protecting himself by buying a basket of shares, he ended up buying 104 companies for a total of $10,400. Even though 34 of those companies went bankrupt, this strategy turned his initial sum into $40,000 four years later when U.S. industry picked up as a result of the war. Hence, diversification is one means of protection which Graham worked into this methodology since not every stock picked this way is a winner.
Incidentally, John Templeton is another individual who can be juxtaposed beside Crassus. Duplicating the philosophy of Getty to “buy when everyone else is selling and hold until everyone else is buying,” he attributed much of his success to his ability to think independently and avoid the herd, buy when there’s blood in the street (good values), stay disciplined, avoid stress and stay happy. His philanthropic activities have totaled over $1 billion, causing him to be named one of the most influential people in the world for the good his wealth has done. Templeton, like Buffett (Carnegie and Gates), proved beyond the shadow of a doubt that great wealth could be put to great good use for the world’s betterment.
With Graham’s system, buying companies at depressed prices (because things look pessimistic) is to some extent duplicating Templeton’s ideas of buying when “blood is in the street” or “everyone else is selling.” Graham’s rules also put into practice the words of John Neff who said, “Buy stocks that look bad to less careful investors and hang out until their real value is recognized.” As Warren Buffett once noted, if a business is worth a dollar and you can buy it for 40 cents, something good may eventually happen. Thus you now have a methodology to weigh the value of potential holdings, and can accumulate a portfolio of good bets where the criteria suggests there is a gap between price and value. Then you must simply wait to sell. It’s like a pawn shop that buys marketable assets for less than they are worth so that they can later be resold at a profit when a buyer is eventually found. You are only hoping for a 50% profit, but in two years’ time at the max.
The bonus factor to this methodology is that it was tested throughout all types of bear markets and it still performed great under the very conditions you would most be worried about. As a long term method for capital appreciation and gaining wealth, this one is therefore a winner! At the very least you are buying good assets for cheap (at prices less than their fair value), and history shows the tendency of a mean reversion to fair (or better) prices in your favor whenever you give those investments enough time. Our next chapter will show some simple criteria which might even be used to improve the selection mechanism of this basic technique, but it’s already exceptional as is.
Famed investment manager Mario Gabelli, whose own investment methodology also involves searching for undervalued assets, also employs Graham’s two-year time horizon, and this is possibly a rule that in various forms might be applied to many other investment strategies if it increases their performance. If a stock has not moved up in two years time of waiting then perhaps it will continue to go nowhere. Thus you should then re-allocate your funds into a new stock that has a fresh chance to appreciate.
As for Graham’s 50% selling rule, it is also favored by famed value investor Walter Schloss who achieved a 15.7% CAGR over the 45 years from 1956 to 2000 (compared to the market’s return of 11.2% per year), which also puts him in the ranks of the best investors of all time. Nearly rivaling Buffett’s return, Schloss said he chuckled at those who were reluctant to buy Buffett’s Berkshire Hathaway stock because it never produced dividend income. If you grow your assets as much as Buffett did, he said, you can just sell some shares to get any income you need, but some people lose sight of the big picture because they are overly focused on dividends. We should remember this remark when we come to the topic of dividend investing.
Schloss’s personal value investing method was to keep an eye out for companies making new price lows (especially a three year low) where management owned the stock. His screening criteria also included looking for stocks that didn’t have a lot of debt and were selling for less than their book value. Such criteria are the crux of being selective. Schloss once summarized his approach saying, “We want to buy cheap stocks based on a small premium over book value, usually a depressed market price, a record that goes back at least 20 years … and one that doesn’t have much debt.” Incidentally, stocks also often get bought out when they trade at significant discounts to their book value, too.
Schloss always strove to buy assets at a discount rather than to purchase earnings because earnings were unreliable and could change dramatically in a short time. Basically, he wanted to buy stocks that were depressed in price but where the company was not going broke. He preferred value over popularity, and like Buffett preferred to stay away from industries outside of his circle of competence. Since he noted that very few people become millionaires buying bonds, Schloss always avoided bonds (even though they pay a guaranteed return) since they limited your gains while inflation reduced your purchasing power, and their guaranteed return was rarely positive after inflation. Bonds simply sacrifice the potential of higher returns for lower volatility. Hence, he was similar to Buffett who said he “would always pick an investment strategy that over five years could give him a 12% compounded annual return, but that was volatile over one that promised a stable 8% return annually.”
Like Buffett, Walter Schloss also said to ignore the overall economy and the market with its gyrations, and never made forecasts or predictions. Because he did not like forecasts, this is another reason why he always preferred buying assets at a discount to buying forecasted earnings. It is very hard to predict the future and whether a company’s good fortunes will continue, so when a stock he purchased achieved an exceptional rate of return he simply banked the profits, ignored whether that stock went much higher, and then tried to do it again. If he didn’t own it anymore then he put it out of his mind.
Once you start creating factor seasonal charts, you will see that they can often help you with all these forms of value investing. Whenever you generate a list of stocks that satisfy Graham’s valuation criteria, you can simply find the companies at or near their seasonal lows (perhaps adaptive seasonal lows or factor seasonal lows), and consider investing in those over others since the seasonal low explains a portion of the price drop. Stocks that suddenly meet Graham’s valuation criteria exactly at the time of an expected seasonal low or right before a seasonal climb is due, often quickly rebound to higher prices. A seasonal chart can also help you determine when you might want to risk holding stocks for the possibility of a little more return, or when you might get out early because you are just shy of the 50% gain but heading away from a seasonal peak.
Perhaps the most interesting point about Graham’s methodology is that it seems to turn the entire field of detailed stock analysis, which he started, on its head! Graham is one of the grandfathers of the entire field of detailed stock analysis, and thus directly responsible for the existence of thousands of stock analysts all over the world who try to pick superior stocks, and yet whose mutual funds rarely beat the market return. Despite helping to launch this field, near the end of his life, he wrote the following in Common Sense Investing: The Papers of Benjamin Graham:
I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity years ago when our textbook “Graham and Dodd” was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I'm on the side of the “efficient market” school of thought now generally accepted by the professors. … I favor a highly simplified approach that applies a single criteria or perhaps two criteria to the price to assure that full value is present and that relies for its results on the performance of the portfolio as a whole—i.e., on the group results—rather than on the expectations for individual issues.
In this book, Graham once again revealed the methodology we have reproduced here. At that time he preferred a P/E ratio of 7 times the reported earnings for the past twelve months, but mentioned you could use other criteria such as a current dividend return above 7%, or price no more than 120 percent of book value, etc. These parameters are something you must test using historical simulations to improve upon. Nonetheless, all the various value investing methods he developed consistently grew assets at 15% per annum or better, which was twice the performance of the DJIA for a fifty year period! That’s fifty years, which satisfies my criteria for a long term positive track record for a simple system that is objective, easy to duplicate on your own, and fundamentally sound. He discovered a clear, manageable investing system that diverts your attention away from things that aren’t important while focusing you on the things that are the most important for your long term success.
An even better method than this, he once mentioned, earned 20% per year over three decades of testing, and involved buying common stocks at less than their working capital or net current asset value (giving no weight to the plant and other fixed assets and deducting all liabilities from current assets). Unfortunately, this type of opportunity is scarce and therefore doesn’t have the wide applicability of the method we have gone over, but illustrates how powerful a value investing strategy can be even when it is incredibly simple.
All in all, you should definitely consider using value investing to manage a substantial proportion of your stock portfolio. You can do it yourself using Graham’s rules as they are very simple to use, and just studying his investing principles can revolutionize your investing style. You can also find a portfolio manager with a good track record who is devoted to undervalued opportunities (value investing) like this and park a portion of your funds with them for the long run. Better yet, you can divvy up a portion of your funds into several units and park those monies with several such managers. I am convinced that quiet value investing, rather than chasing after the high flyer stocks touted by Wall Street, should be one of the cornerstones to the growth of your wealth.
A caveat is in order when selecting fund managers, however, because while many claim they are value investors the truth is that most are not. A study by Lakonish, Shleifer and Vishny examined 1,300 pension funds and scored them as to the various rules of value investing. They found that while many claimed to be value oriented, the vast majority of their portfolios were no different than the broader market index, and only slightly weighted toward value investing. Fund managers commonly say they are value investors, but are simply not! Thus it is easy to see how managers deceive themselves into thinking they are doing something they are not, and easy for you to see why the professionals have a difficult time beating the market.
If you aim to duplicate this strategy yourself then whether you increase your leverage or not based on the market climate, analytical fundamental models or other analysis methods, and whether you write options on your stocks to collect extra premiums so you “get paid” while waiting for them to be sold (which we’ll discuss in the next chapter), this is the basis of a outperforming investing technique that any investor can use. You can even go on to manage a fund based on these principles. These principles exploit the cycles of pessimism and optimism (irrational exuberance) of the public that undervalue and then overvalue securities. As history shows, you can use that bobbing back and forth between emotional extremes to your advantage.
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