The Legacy of Ben Graham, in ETF Form

By Murray Coleman

For years, star stock pickers with a yen for bargain bin fare have been crediting Benjamin Graham's research for much of their success.

But it's not just the Warren Buffetts of the active management world who are big fans. So is John Gambla. His name isn't known in too many households across America. That could change, however, if his latest project comes anywhere near the success of its lofty premise.

Gambla's a portfolio manager and managing director at Hyde Park Investment Ltd. The investment shop has created a trio of indexes that seek to capture the best of Graham's theories. Those benchmarks form the basis of the recently launched Nuveen-sponsored ELEMENTS exchange-traded notes. (See related story.)

The ETNs cover large-cap value (NYSE: BVL); provide exposure to the total U.S. stock market while tilting to value (NYSE: BVT); and target small-cap value (NYSE: BSC) corners.

"It's not ridiculous to try to reduce an active manager's methodology to an index. Ben Graham had laid out a number of specific formulas he used with a very specific methodology," Gambla said.

Sure, you can go to a number of different Web sites and get stock recommendations based on Graham's theories, he admits. But the problem is that many of those take a very literal translation of their master's strategy, according to Gambla.

The benchmarks for the ELEMENTS ETNs aren't trying to replicate verbatim Graham's favorite valuation ratios, he says. "Graham developed a fantastic methodology which we're trying to update and bring into a more contemporary format," Gambla said.

Tweaking Modern Portfolio Theory

That means the Hyde Park indexes are trying to incorporate the concepts of diversification into Graham's concepts. "We're trying to apply advances in modern portfolio theory using the power of computers without disturbing the essence of Graham's strategy," Gambla said.

In a nutshell, here's how it works. Hyde Park's computers screen along seven broad categories. Those relate to: earnings quality, valuations, forward price-to-earnings ratios, dividend yields, profitability, debt and financial liquidity, and measurements relative to industry peers.

"Each of those general categories in some shape or form have some tie back to Graham's approach to investing," Gambla said. "Some have clearer relationships than others. But we didn't just willy-nilly try to go out and re-create how Benjamin Graham approached investing."

Each stock is ranked from zero to 100 (the best). The large-cap value index takes the top 50 names, and the small-cap value as well as the total stock market use 100 each. They're rebalanced every six months and reconstituted every year.

No foreign stocks are counted. For large-cap stocks, nothing less than $10 per share is included, while for small-caps, nothing under $5 per share is considered. Hyde Park's computers also screen for various liquidity measures.

"This has been extremely challenging and tremendously rewarding. It's something we're really proud about accomplishing," Gambla said.

Trying to capture the works of famous past stock-pickers is hardly a novel idea. Countless Web sites hawk computer-generated stock picks based on Graham's theories. Even Jason Zweig, now a Wall Street Journal columnist, has tried to update the work of "The Father of Value Investing" by penning his own book.

"I'm a huge fan of Ben Graham. I view him as one of the first quantitative managers," Gambla said.

Nobody can really argue with that claim, since Graham died in 1976. But like those that've tried in the past, Gambla points to a wealth of writings left behind by Graham as well as reviews of his work by a legion of others.

"Graham looked at data in a very rigorous manner," Gambla said. "He was very objective and consistent in his analysis."

These days, quant managers upload huge amounts of data and use computers to crunch and sort out patterns. Graham didn't have such access to computers. But he ranked stocks based on certain metrics for various types of businesses.

Essentially, Graham's process wasn't a whole lot different than today's quant managers use, Gambla says. The biggest change in today's modern quant world has been the amount of data and speed that an automated process can add to the basic Graham methodology, he adds.

Not All Are Disciples

But some aren't so sure. Count financial author and advisor Richard Ferri as highly skeptical about the new indexing approach.

"This was bound to come along at some point," said the chief executive at Portfolio Solutions LLC. "We'll probably see the same thing with an ETF replicating the work of Warren Buffett at some point."

Ferri says he doubts that computers can fully capture what Graham or Buffett went through in picking stocks.

"Real humans making subjective decisions—that element just can't be replicated by computers," he said. "If it were that simple, a lot of people would be rich by now. But it's great marketing—something with sizzle that brokers can try to peddle to their clients."

• More on choosing the right ETF

Comments

[dg arc:]

good idea in a long term bull market but in todays bear market as useful as mud flapps on a tortoise

2008 Aug 20 08:48 AM

[David Lentz:]

Don't we already have such a fund?

I believe it's called Berkshire Hathaway.

2008 Aug 20 09:49 AM