Ben Graham Portfolio: Snazzy Returns from a Vintage Strategy

When it comes to all-star investors, Ben Graham is iconic, being half the Graham-and-Dodd team widely credited with inventing fundamental stock analysis back in the 1930s. But don't think, for even a single minute, that his approach is quaint, old fashioned, or anything like that. The stocks now favored by the Portfolio123.com Graham model, depressed cyclicals and oilfield service firms, are not glamorous. But the performance record of this model shows returns that ought to be snazzy enough by anyone's standards.

Playing offense by playing defense

Ben Graham was a value investor. We all know that. But he doesn't always get as much credit as he should for his attention to company quality. His classic, The Intelligent Investor, wasn't about cigar-butt value (buy a bad company at a price that's so low as to still leave room for you to prosper). In addition to his desire for a good stock price, he also wanted a good company.

What's interesting is how he determined whether a company was good. He was very much attuned to basic survivability; the ability of a company to stay in business even when times were tough. Nowadays, we like to think way beyond that (super growth rates, positive earnings surprises, etc.). But considering when he professionally came of age, the 1930s, I suppose we should understand why he thought as he did. (For details on the Portfoilo123 Graham model, click here.)

This emphasis on survivability is what may cause some to see his approach as quaint. But there's no way we can take a patronizing view of the returns recently generated by the strategy we created based on his strategy. Figure 1 shows the result of a backtest covering the past year (as with all of our all-star models, we limit results to the model's top 15 stocks; the test assumes rebalancing every four weeks).

Figure 1

click to enlarge

Figure 2 provides a close-up of how the model performed during the market's recent recovery since 3/31/09.

Figure 2

So yes, lots of stocks surged recently off the market's bottom. But the Graham stocks surged much more vigorously.

Perhaps there's something to be said for not-going-broke as a measure of company quality.

And by the way, this isn't confined to a post-recession early recovery (or mid-recession bounce, depending on your point of view). The model performed very well since 3/31/01, even in the bullish periods. Click here for details.

The stocks

Table 1 shows the stocks that presently make the grade under our Graham model.

Table 1

There are some very small companies on the list. You might expect to see this with some of the more aggressive all-star models, but find it surprising with a Graham strategy. Actually, Graham did consider the issue of size, but decided to refrain from specifying any minimum, reasoning that the risk we usually associate with extremely small companies ought to be mitigated by their having passed his other basic financial-viability requirements. (For what it's worth, though, adding a requirement that market cap be at least $250 million wound up adding about 11 percentage points to the hypothetical portfolio's 3-31/09 - 7/30/09 backtested performance.)

Looking at the list, we find oilfield services (mainly contract drillers) to be very well represented. Activity in the oil patch has been weak, which seems according to script given the reversal of the oil surge of a few years ago and the giving way to recession, which reduces demand for energy. The firms listed here have incredibly low P/Es, generally at single-digit levels and are suffering huge year-to-year declines in sales and EPS. Similar scenarios can be observed for many other oil-related situations. The ones listed here are distinguished by their ability to withstand industry storms; i.e., by meeting the Graham-inspired survivability tests.

An interesting variation on the oil-service theme is Tidewater (TDW), which operates a fleet of boats that serve offshore drillers by transporting people, equipment and supplies. The company also provides some related services such as pipe laying, cable laying and seismic work. Its results have actually been up year to year through the March quarter. revenues slipped modestly in the June period, but EPS would have been up had the company not recorded an unusual charge relating to the seizure of some vessels in Venezuela. (And you're worried about the risks you face!) Meanwhile, the company carries minimal debt and its returns on investment have been comfortably and consistently in double digits and have even been trending upward. So let's say this is a case of survivability plus.

Outside of energy, we find the likes of Olin Corp. (OLN), which may be a bit recognizable for its Winchester firearms subsidiary, but makes most of its money through chlor alkali products, which, skipping all the mundane details, find their way into such end products as paper, swimming pools (chlorine), household cleansers, bleach, plastics, wastewater treatment products and . . . you get the message. This is a garden-variety cyclical company. Actually, though, it seems to have been becoming a better one lately, having unraveled itself from conglomerate status a decade or so ago and culminating in the 2007 sale of a sizable metals operation. The slimmer company we now see features less debt, comfortable liquidity, improving margins and improving returns on capital.

For Japan-based power-tool maker Makita - ADR (MKTAY), sales have been falling off a cliff. Considering how weak housing is and considering the company makes power tools, what can one expect! But when it comes to the Graham model and its quest for cope-ability, MKTAY is a star. Debt is modest. The current ratio is above 5 and the more stringent quick ratio is above 3. Margins have been holding up quite well all things considered as have returns on capital. We have survivability and then some combined with a single-digit P/E and a price-to-book value ratio near 1.00. Classic Graham! If you're intrigued by the MKTAY theme but would prefer something domestic, take a look at Apogee (APOG), primarily a manufacturer of glass "skin" for commercial buildings. Yes, it, too, is feeling the brunt of horrible industry conditions. But it, too, is a fundamental-financial power. And it is working to cushion some of the cyclical storm by pursuing more smaller-scale international projects and developing proficiency in energy-efficient building skins, to get in on the desire to go green.

Lately, anything vehicular can give nightmares to even the hardiest of investors. And no, that wasn't the downward segment of a roller-coaster in your dreams; it was the recent income statement for Spartan Motors (SPAR). But at least this company isn't a carmaker. It makes chassis for recreation vehicles (Was that supposed to make us feel better?), ambulances, fire trucks and the kinds of military vehicles that should be able to drive over an exploding land mine and survive (they actually do that). OK. I really don't want to think about RVs, but I'll force myself. The demographic group, older Americans, who like them is growing, and there is a reason we use the phrase "business cycle" instead of "business perpetual." (It's a cycle: What we see now won't be the case forever.) Meanwhile, the fire and emergency markets are OK by comparison. Military depends on government procurement, but as of now, there are a lot of SPAR vehicles in the field, thereby enabling the company to build a nice spare parts business. As to the numbers, it's starting to sound like a broken record after the other companies discussed: great balance sheet, strong liquidity, margins and returns holding up, and, of course, incredibly low valuation metrics. Cope-ability on the bargain counter, classic Ben Graham.

Finally, about those single-digit P/Es I mentioned: it's normal to see them if EPS are expected to fall off a cliff. Actually, though, most of these companies already have one or two deeply depressed quarters in the count. So the single-digit multiples are being measured on earnings that are already well below peak levels. So don't dismiss them too quickly.

Disclosures: No positions

Comments

[Joseph L. S...:]

This article deserves far better than a single response from some shill working for iamned.com. (Note to Ned: I’ve never been to your site and, if this is the way you build your business, I imagine your advice is as smarmy and underhanded as your smarmy and underhanded way of hijacking readers from legitimate sites…)

Mr. Gerstein, thank you for working the old-fashioned way: doing solid research on some fine companies that represent true value in an age of flim-flammery. They may or may not out-perform in the near term, but as the master wrote 67 years ago: "In the short run, the market is a voting machine but in the long run it is a weighing machine."

You’ve weighed in with some real value.

Jul 31 11:50 AM

[speeddaimon:]

"This article deserves far better than a single response from some shill working for iamned.com. (Note to Ned: I’ve never been to your site and, if this is the way you build your business, I imagine your advice is as smarmy and underhanded as your smarmy and underhanded way of hijacking readers from legitimate sites…)"

Joseph,
Let me clue you in since it seems you're not familiar with this moron. His original handle on the board was Cetin, he managed to get a negative 5000 rating before SA editors threatened to boot him. Since then he logs in under a ton of aliases, each of which get shut down once the editors fing out about it. His entire goal is to drive traffic to the travesty he calls a blog which is not only poorly written, has no basis in reality, and manages to misspell nearly every other word. I just mark him negative one and report abuse hoping that eventually the SA editors will implement a probationary period for all new posters.

Jul 31 12:04 PM

[Wisdom vs. ...:]

good article Marc, thanks, i have RFIL & Smith, not wild about ensco (think ensco will be down for a loong time), will take a look at a couple of these others

Jul 31 12:59 PM

[Investing I...:]

Interesting article - thanks - graham is a good strategy. problem with YOUR strategy is you have very high turnover - about 10% per month. Your excess profits will be eaten up by your trading costs.

Jul 31 03:45 PM

[Tom Armistead:]

I am long OLN and I think strategies based on Graham's thinking are a good idea anytime but especially in an environment that is somewhat similar to the 30's when many of his ideas were developed and tested under difficult conditions.

Marc I am a fan and I got the idea for some of the stocks I own off various lists you have published here on Seeking Alpha.

But the "backtesting" here strikes kind of a sour note, better to have been pushing such a strategy for the past 6 months than looking backward and saying look at the results that could have been achieved.

Jul 31 04:26 PM

[Marc Gerstein:]

Actually, my plan is to do this as an ongoing series with a collection of All-Star screens (Graham is one of seven I have now). So we will have plenty of opportunities to revisit the performance testing after we have experience in real time.


On Jul 31 04:26 PM Tom Armistead wrote:

> I am long OLN and I think strategies based on Graham's thinking are
> a good idea anytime but especially in an environment that is somewhat
> similar to the 30's when many of his ideas were developed and tested
> under difficult conditions.
>
> Marc I am a fan and I got the idea for some of the stocks I own off
> various lists you have published here on Seeking Alpha.
>
> But the "backtesting" here strikes kind of a sour note, better to
> have been pushing such a strategy for the past 6 months than looking
> backward and saying look at the results that could have been achieved.

Jul 31 06:46 PM

[helplessobs...:]

Since Graham introduced his valuation procedure in the 1930s there have been many modifications. Graham's acid test was a going concern whose the market capitalization was less than the value of its tangible assets. Can the companies listed meet this extremely difficult test?

Jul 31 09:54 PM

[half_Graham...:]

Thank you, Marc. This is one of the few good articles that people can really extract good ideas.

I currently own a small position on Tidewater, and am on close watch of Makita. Oln, Apog and Spar did not came to my radar before, because they are too small cap (under 2B) by Graham's standard (if I understand the master correctly). But after all, they are all quite classic Graham value investment opportunities on all other aspects.

In my research on Tidewater, I noticed the following 2 characteristics of the company, and I would really appreciate if you could share with me your views on their:

1. As a business, TDW's earning seems to be quite subject to boom and bust of the industry it is in. In the past 10 years, its net margin before tax fluctuate between 8% (in 2004) and 40% (in 2007). This makes it less "a sure thing" when compared with company more stable, such as Cognizant Technology (CTSH) .

2. The way Tidewater conducts business and stays competitive is quite capital intensive. For the past 10 years, it spent more than 100% of its net earning on building and buying new vessel. This makes it less favorable when compared with requires smaller capital, such as Makita or Coach (COH).


Many thanks!

Aug 01 05:43 AM

[User 351327:]

Hmm...all very nice, but seems like you missed the major point Ben made back in the day. Stick with stocks that cost less than $10/share, have a P/E less than 10 and pay a dividend. That was the advice I took from the book back in 1983, and it has made for simple investing and 50% returns since last November. That was his other advice: sell when you have made 50% return on your investment; sell when you have lost 50% of your investment. I've sold most of my investments using the first piece - harder to follow the second in this market.

Aug 01 06:58 AM

[frosty:]

"Finally, about those single-digit P/Es I mentioned: it's normal to see them if EPS are expected to fall off a cliff." - Actually, some of these companies have long histories of single digit P/E's (TDW and OLN in particular). That's not necessarily important however. The prospect of P/E improvement from the present is what's important, assuming that earnings will increase, of course. So if TDW moves from its 6.3 P/E (where it was last year) up to 8 or 10 (where it was in prior years) there will be a 33% to 67% appreciation in stock price if earnings remain flat. If earnings increase, there will be a multiplier effect. This is probably the secret that Graham discovered - that temporarily low P/E quality stocks have a multiplier edge over "growth" stocks. It seems less of a challenge for TDW to go from 6.3 to 10, than for GOOG to go from 30 to 50. Admittedly, GOOG has been there, but that was in the go-go days.

Aug 01 08:52 AM

[tedster98:]

I held Olin for awhile, or it's high dividend, but the stock was just too slow a mover and not really noticed. I may have sold a bit prematurely, but it still seems as though the company sits on the sideline for popularity.

One of the chief attractors of Olin was its firearm ammo division. With the current administration this would have seemed like a smart play - consider Ruger and Smith & Wesson - both stocks of which have gone through the roof. But Olin did not, which I found odd. This tells me there is something more troubling.

Aug 01 09:21 AM

[Alphameister:]

When we can execute trades of any size for under $10 a trade, why worry about turnover rates? This virtually "friction-free" marketplace given to us by discount brokers is a very welcome revolution.


On Jul 31 03:45 PM Investing In The future wrote:

> Interesting article - thanks - graham is a good strategy. problem
> with YOUR strategy is you have very high turnover - about 10% per
> month. Your excess profits will be eaten up by your trading costs.
>

Aug 01 09:43 AM

[searcher:]

Once again, a great article that elicits intelligent and relevant commentary. Thanks Marc.

Aug 01 12:02 PM

[Uncle Larry:]

Something that I learned from Ben Graham is look for increasing revenue, income, book, etc by averaging the last 3 years (2008, 2007, 2006) and average of years 10,11 and 12 years ago and see if there is a definte increase the key numbers over that time. Doubling of the numbers is very nice.

I am using years 2001, 2000, 1999 because these are the numbers that I have on my S&P report
Book value - 5.25 (current) vs 7.00 (past) down
Revenue - 2,065 mill vs 1,378 mill
Operating income - 233 mill vs 155 mill
Assets - 1,700 mill vs. 1,100 mill
Debt Current & Long term - 664 mill vs 549 mill
Cash flow - 199 mill vs 112 mill
Dividend 80 cents/ share vs 83 cents/share down

I suppose since the sales at the Winchester division is so go that should raise the target price (heh).

Aug 01 12:47 PM

[bassetti:]

Handicapping stocks is always an variable enterprise and Graham's method is probably as good as any other. But it seems to me the whole question is moot. Why buy any of these stocks whose prospects are clouded and whose charts are uninspiring when you can buy the Qs? Which are in a verifiable uptrend.

If you were going to buy them (except for SPAR) you should wait until they make new highs. This method might spare you stranded and inert capital.

The truth is that stock handicapping is no longer necessary in the modern era.

cordially yours,
edwards-magee.com

Aug 01 02:27 PM

[The Hammer:]

To bad you did not run this list at the depths of gloom in March. I own a couple on the list, but have learned to avoid cos that are real cheap with entrenched self serving mgts and crony boards.
An excellent strategy to follow and protect ones capital.
keep up the good work.
The Hammer

Aug 06 04:38 PM

[euroazn:]

Very Nice! I'm a value (Graham-Dodd) investor myself and I have had ESV and OLN in my portfolios...... wondering what to do with OLN randomly rising though.

Also didn't see AIZ on the list, any reason?

Aug 27 07:20 PM