The Graham/Buffett Value Barbell Strategy

by: Illuminati Investments

The notion of a "barbell" strategy is certainly not a particularly innovative one, the concept being that by concentrating your exposure to the extreme ends of a particular spectrum of choices, you can enjoy exposure to the increased returns one side might offer while offsetting some of the risk by averaging out the negative aspects. This might involve holding long and short duration bonds while eschewing intermediate term ones, or buying a few small cap stocks to complement a portfolio of mostly large cap holdings, accelerating returns when times are good and protecting most of your capital when things go south. Whether or not this is always advantageous is debatable, but I have found that a barbell strategy that fits my investment style quite well, and I believe it can help deliver good returns with some margin of safety.

It is based on the investment methods of two of the most respected value investors: Benjamin Graham, widely considered to be the "father of value investing", and his student Warren Buffett, who has built upon this foundation to compile one of the best long term track records of any investor. Graham's margin of safety concept that stocks should only be bought when they trade at a significant discount to the intrinsic value of the company they represent ownership in forms one end of the barbell. The other end is embodied by Buffett, who with additional influence from Philip Fisher and Charlie Munger, extended this concept to include great companies with competitive advantages that can be tremendous values over the long run if you buy them at a cheap, or even fair, prices.

Companies that represent the Graham end of the spectrum fittingly include Harbinger Group (NYSE:HRG), which currently trades at a market cap $200M less than just their nearly $1B stake in Spectrum Brands (NYSE:SPB), despite also owning other assets, including an improving insurance company that they bought at a huge discount. The stock finally seems to be getting noticed by the supposedly efficient but certainly slow-reacting market, rising over 20% in just the past week, but remains significantly undervalued on the potential of the promising insurance company that you are still basically getting for free.

Another stock that looks dirt cheap is Actions Semiconductor (NASDAQ:ACTS), a stock that trades at about half the cash on their balance sheet due to the stigma surrounding small cap Chinese stocks and their reluctance to accelerate their buyback program, stubbornly choosing to pour money into R&D spending that has kept them from being consistently profitable. However, this strategy may have paid off with the development of a new chip for Android devices that has the potential to drastically increase revenues and profits in the near future. Hopefully management will come to their senses and buy back as much stock as possible before then to further enhance this effect.

Since China is where you'll find the most beaten down stocks, we could also consider Lihua International (NASDAQ:LIWA) or Silvercorp Metals (SVM), both of which have endured continued short attacks despite delivering consistently strong earnings. These so far unfounded insinuations have led investors and analysts to ignore the tremendous growth prospects of each; Lihua is nearing the completion of several new smelters that will double their production capacity, and Silvercorp has an increasingly promising Ying Mine.

Investors in extremely risky stocks like these must consider the fact that unrealized potential might instead turn into unrealized losses, but I believe the risk of holding these speculative stocks can be mitigated by also owning strong companies at the other end of the value spectrum. The first of these, Silver Wheaton (NYSE:SLW), enjoys what I believe is the best business model in the world, providing capital to gold mining companies in exchange for the right to buy future silver production for around $4 an ounce. While it might be more expensive than Silvercorp, as a silver streaming company and not a true miner, it does not have the same operational risk and deserves a premium valuation. However, it still trades at a discount to the price of silver, which I believe is absurd, given that it's a cheaper way to gain leveraged and hedged exposure to silver.

Another solid company to offset risk would have to be Costco (NASDAQ:COST), which might have the second best business model in the world, where loyal customers pay to shop there. This is a classic Buffett stock that will never appear cheap because it is too good a business, but should deliver consistent earnings for years to come. It would be expected to thrive in either a good economy or a recession, with the potential for growth overseas or through their underestimated online business.

Finally, I would point out a company that encompasses both ends of the spectrum at once, EMC Corporation (EMC). It owns an 80% stake in VMWare (NYSE:VMW), which would never be mistaken for a value stock itself, despite trading at an infinitely lower P/E ratio than fellow cloud computing competitor, (NYSE:CRM). This stake makes up over 60% of EMC's market cap, obscuring the strength of EMC's core data storage business, but should continue contributing growing earnings to the parent company. So you get exposure to Buffett's maxim that growth and value are joined at the hip, while enjoying the Graham margin of safety, since if EMC were ever to spin off the rest of VMW, it would unlock tremendous value and allow them to shine alone as the best of breed company in the ever-expanding data storage industry.

Finally, I'd be remiss if I didn't mention Buffett's own company, Berkshire Hathaway (NYSE:BRK.B), which is obviously the ultimate collection of stocks shading towards his end of the value spectrum, yet trades with a historically low valuation only slightly higher than book value. Furthermore, in the name of Graham's margin of safety concept, you can actually purchase it at a discount through closed end funds that trade at over 20% less than their Net Asset Values, namely BIF, BTF, and DNY, which respectively are 27%, 26%, and 19% concentrated in Berkshire Hathaway, any of which would provide a solid base to a value barbell strategy that could give your porfolio the workout it needs to shape up and stay healthy for the long run.

Disclosure: I am long (ACTS), (COST), (EMC), (HRG), (LIWA), (SLW), (SVM). I may initiate a short position in either (CRM) or (VMW) to hedge against their influence on EMC

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