Ben Graham Portfolio: Snazzy Returns from a Vintage Strategy

by: Marc Gerstein

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 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 (NYSE: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. (NYSE: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 (NASDAQ: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 (NASDAQ: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 (NASDAQ: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