Graham Value Stock Portfolio Update

by: Scott's Investments

In January 2012 I announced a new portfolio, a Benjamin Graham "inspired" value stock portfolio. The purpose of the hypothetical portfolio is to track returns for a portfolio of 15 stocks selected based on a variety of valuation metrics. I originally intended to update the portfolio monthly; however, in the spirit of creating a lower turnover, value-driven portfolio, it is now updated approximately once per quarter. I have also added an additional criteria to limit turnover in the portfolio (see below).

The Graham portfolio is an attempt to add a value strategy to Scott's Investments, which is otherwise focused on momentum, trend, income and market timing strategies. There are numerous ways to add market timing or hedging techniques to any stock portfolio, such as shorting the S&P 500 when it trades below a long-term moving average while simultaneously holding a portfolio of long stock positions. However, for the purposes of this portfolio, there will be no additional timing or hedging techniques, but I would encourage readers to explore additional hedging, diversification, and risk management techniques.

The criteria used to select the stocks are listed below. The tools used to perform the screen and backtests are courtesy of Stockscreen123 ("SS123") and Portfolio123 ("P123″).

The actual screen factors are below:

  • Liquidity filter: No OTC Stocks
  • Market capitalization > $100 million
  • Eliminate companies classified in the Miscellaneous Financial Services Industry, most of which are investment companies and funds and not the kind of stocks this all-star tended to seek
  • Current ratio must be at least 1.5
  • Long-term debt must be no higher than 10% above working capital
  • EPS must be above breakeven in each of the last four quarters and in each of the last five annual periods
  • Trailing 12 month EPS most be above EPS in the latest annual period
  • EPS in the latest annual period must be above EPS in the prior year and five years ago
  • The company must have paid common dividends in the last 12 months

The ranking system used as a basis for selecting the top 15 based among those stocks that pass the Graham screen are below:

  • Valuation - 60% of total
  • Trailing 12 month P/E (15% of this category)
  • Price-to-Book (15% of this category)
  • Price-to-Tangible Book Value (35% of this category)
  • Operating P/E, defined as Market Capitalization divided by Business Income, which is Sales minus Cost of Goods sold minus Selling, General & Administrative Expense and omits unusual items (35% of this category)
  • Earnings - 40% of total
  • 5-year EPS Growth Rate (50% of this category)
  • EPS Stability, defined as the standard deviation of EPS over the past 16 quarters, lower being better (50% of this category)

I began tracking this portfolio real-time on January 13th, 2012. As of this writing, the portfolio is up 8.8% including dividends, compared to a positive return of 14% for SPDR S&P 500 ETF (NYSEARCA:SPY) over the same period.

The portfolio has been hampered by big drawdowns in a handful of names, which the quantitative rules continue to define as undervalued. These are excellent examples of the challenges in value investing - a stock could be defined as undervalued for a good reason, and may remain so for a significant period of time, perhaps years or forever if the company has experienced a permanent and material change in operations (a "value trap"). On the other hand, undervalued stocks may lag longer than investors wish, but patient, longer-term investors who aptly select value stocks can be rewarded in the long run.

A real-world application of this portfolio could also utilize stop losses in order to prevent large drawdowns in single positions. However, for the purposes of tracking the portfolio results, all positions are bought and held until rebalancing.

In July a rule was added to help limit portfolio turnover - stocks will only be sold when they drop out of the top 20 in Graham Value screen. Thus, a stock could theoretically drop to the 20th ranking but remain in the 15 stock portfolio if it is a current holding.

An interesting early trend in live tracking is that of smaller, less liquid equities appearing frequently on the list. This makes for a potentially more volatile, higher beta list of equities and also led to some early drawdowns in the portfolio. Given my personal level of discomfort with stocks with ultra low market capitalizations, and especially those based overseas, going forward the screen is required to have a market cap greater than $100 million.

The top 20 stocks based on the screen criteria are listed below:

Ticker Name MktCap
PLPC Preformed Line Products Company 335.36
WDC Western Digital Corp 10862.1
HUM Humana Inc. 11113.65
TESS TESSCO Technologies Inc 191.75
CVX Chevron Corp 220867.88
PAAS Pan American Silver Corp 2924.39
MANT ManTech International Corp 953.96
ALG Alamo Group Inc. 410.3
TRLG True Religion Apparel Inc 637.8
KNM Konami Corp 2855.55
SWM Schweitzer-Mauduit Intl Inc 1274.61
HP Helmerich & Payne Inc. 6134.71
WMK Weis Markets Inc. 1044.49
CF CF Industries Holdings Inc 13748.6
CSH Cash America International Inc. 1197.7
HFC HollyFrontier Corp 9326.48
INTC Intel Corp 109599.02
ABT Abbott Laboratories 52731.09
VLGEA Village Super Market Inc 434.67
HAL Halliburton Co 33324.48

Below are 3, 5, and 10 year backtest results for this screen (with the $100 million market cap requirement) using a quarterly rebalance and .5% slippage to help account for bid/ask spreads and commission costs. The backtest also includes the rule to sell a stock only when it dropped out of the top 20 in the list:

Click to enlarge

Six stocks were sold today:

Symbol Name Purchase Price Purchase Date Percentage Gain/Loss
JST Jinpan International Ltd 6.73 7/17/2012 -12.33%
SVT Servotronics, Inc. 9.18 1/13/2012 -6.32%
CHRM Charm Communications Inc 5.36 7/17/2012 -12.31%
EEI Ecology and Environment 16.2 1/13/2012 -29.44%
ADTN ADTRAN Inc 15.72 10/15/2012 33.46%
CRR CARBO Ceramics Inc. 64.08 10/15/2012 26.56%

As of today's close the current portfolio now consists of:

Symbol Name Purchase Date Percentage Gain/Loss
WDC Western Digital 1/15/2013 0.00%
CSH Cash America International Inc. 1/15/2013 0.00%
PAAS Pan American Silver Corp 7/17/2012 31.68%
TRLG True Religion 1/15/2013 0.00%
MANT Mantech International Corp 2/15/2012 -27.17%
HP Helmerich & Payne Inc. 7/17/2012 32.94%
KNM Konami Corp 1/15/2013 0.00%
ALG Alamo Group, Inc. 3/14/2012 22.79%
CVX Chevron Corporation 1/13/2012 6.93%
SWM Schweitzer-Mauduit Intl Inc 10/15/2012 22.82%
WMK Weis Markets Inc. 1/15/2013 0.00%
PLPC Preformed Line Products Company 3/14/2012 -4.58%
HUM Humana Inc. 3/14/2012 -18.01%
TESS TESSCO Technologies Inc 7/17/2012 18.35%
CF CF Industries Holdings Inc 1/15/2013 0.00%