Top Five Stocks in My Graham-Based Portfolio

Includes: ATW, ELP, ESV, RS, SNY
by: John P. Reese

Today, many investors look to Warren Buffett for advice about the stock market and the economy. But before he became one of the world's richest men and greatest investors, there was someone whose investment advice Buffett himself cherished: Benjamin Graham. And Buffett was far from alone. Known as "The Father of Value Investing", Graham inspired a number of famous "sons" -- Mario Gabelli, John Neff, John Templeton, and, most famously, Buffett, are all Graham disciples who went on to their own stock market greatness.

Graham's strategy has also benefited me greatly, forming the basis for one of my best-performing "Guru Strategies" (computer models that are each based on the approach of a different investing great). Since its July 2003 inception, a 10-stock portfolio picked using the Graham strategy has gained 184.9%, or 15.4% per year. The S&P 500 over the same period has gained just 19.7%, or 2.5% per year.

(Currently, access to this market-crushing strategy (and several of my other Guru Strategies) is available for free through Seeking Alpha's Investing App Store.)

But before you check that out, it's worth learning a bit about Graham the man, and about the remarkable strategy that is still generating big returns more than 60 years after he wrote about it. Born in England in 1894 as Benjamin Grossbaum (his family later changed its surname to Graham during World War I, when German names were viewed with suspicion), Graham built his reputation -- and fortune -- by using an extremely conservative, low-risk approach to investing. To him, preserving one's original capital was every bit as important as netting big gains, and two factors from his early years may show why.

The first was Graham's own family's fall from financial comfort to poverty not long after his father died when he was nine. The second involved his first major business venture, an investment firm he founded with Jerome Newman. Just three years after opening, the stock market crash of 1929 and the Great Depression arrived, and Graham's clients, like just about everyone else, were hit hard, according to Graham biographer Janet Lowe. Graham worked without compensation for five years until his clients' fortunes were fully restored.

Having lived through both his own family's financial troubles and the market crash, it's no surprise that the strategy Graham laid out in his classic book The Intelligent Investor was a conservative, loss-averse approach. To Graham, an investment wasn't something that could be turned into quick, easy profits; anything that offers such "easy" rewards also comes with substantial risk, and Graham abhorred risk. True "investment", he wrote, deals with the future "more as a hazard to be guarded against than as a source of profit through prophecy."

In terms of specifics, Graham's approach limited risk in a number of ways, and my Graham-based model lays out several of those methods. For example, one key criterion is that a firm's current ratio -- that is, the ratio of its current assets to its current liabilities -- is at least 2.0, showing that the firm is in good financial shape. The approach also targets financially sound firms by requiring that long-term debt not exceed net current assets.

Two other criteria the Graham method uses to find low-risk plays: the price/earnings ratio and the price/book ratio. Graham wanted P/E ratios to be no greater than 15 (and, as another signal of his conservative style, he applied this standard to P/Es using both trailing 12-month earnings and three-year average earnings, to ensure that one-year anomalies didn't skew the ratio). For the price/book ratio, he used a more unusual standard: He believed that the P/E ratio multiplied by the P/B ratio should be no greater than 22.

Finally, in terms of earnings growth, the Graham-based approach looks for solid, steady earners -- not fast-growing hotshots. A firm must have grown earnings per share by a total of at least 30% over the past decade, not a particularly tough target. But, perhaps more importantly, it also cannot have posted negative EPS in any of the past five years.

These are tough standards to meet, and, usually, few stocks pass my Graham-based model at any given time. But those that do have performed exceptionally well. With that in mind, here's a handful of stocks that are at the head of the class, earning a perfect 100% score and a spot in my exclusive Graham-based portfolio:

Sanofi-Aventis SA (NYSE:SNY): The Paris-based pharmaceutical giant ($93 billion market cap) is up more than 17% since joining the Graham portfolio in early September. It has a strong balance sheet, with a current ratio of 2.4 and more than twice as much in net current assets ($20.2 billion) as long-term debt ($9.7 billion). It's also selling for a very reasonable 10.5 times trailing 12-month earnings, and 1.39 times book value.

Reliance Steel & Aluminum (NYSE:RS): One of the largest metals service center companies in the U.S., Reliance ($3.3 billion market cap) sports a healthy balance sheet, with $1.3 billion in net current assets vs. $944 million in long-term debt and a current ratio of 2.92. It also sells for 13.4 times trailing 12-month earnings and 1.2 times book value, both of which make it a bargain according to the Graham approach.

Atwood Oceanics (NYSE:ATW): Like shares of most offshore oil drillers, this Texas-based company was hit hard by the Gulf oil spill crisis. But my Graham-based model saw that as an opportunity to pick up shares of a solid firm on the cheap. Since it added ATW to the portfolio in early September, the stock is up 27%. It likes Atwood's 3.2 current ratio, 10.6 P/E (using three-year average earnings), and the fact that its net current assets are greater than its long-term debt.

Ensco PLC (NYSE:ESV): Like Atwood, this U.K.-based offshore drilling company is from an industry that has taken a lot of heat this year. But it's been in the Graham portfolio since Jan. 22, and has performed quite nicely despite the industry problems, gaining more than 15%. It has a current ratio of 3.19, more than four times as much net current assets as long-term debt, and it's cheap -- the stock trades for 11.3 times trailing 12-month earnings and just 1.15 times book value.

Companhia Paranaense de Energia (NYSE:ELP): This Brazil-based utility ($6.6 billion market cap) specializes in hydroelectric power plants. It has a solid 2.06 current ratio and more net current assets ($1.1 billion) than long-term debt ($846 million). It's also trading at a reasonable price: 13.4 times trailing 12-month earnings and 1.2 times book value.

Disclosure: I'm long SNY, RS, ATW, ESV, and ELP