A Graham And Dodd Approach To Market-Plus Returns

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Includes: BFOR, CLM, FAB, FUND, FVAL, PWC, QVAL, QVM, SOR, VLUE, VUSE
by: Tom Au, CFA

Summary

Ben Graham preached that an investor should first aim for "satisfactory" returns, and only later, try to "beat the market.".

Most investors, in fact, mainly want to "participate" in the market, and do so with reasonable safety.

A Graham approach to managing "market performers" offers a chance to beat the market.

The first question is why we should buy stocks over bonds or money market instruments? The (current) answer is that the record in the twentieth century showed that "cash" produced only a 4% return a year on average, bonds averaged 5% a year, and stocks recorded total returns (dividends plus capital gains) averaging 10% a year.

The downside is that stocks are more volatile than cash and bonds, typically by a factor of two or three or more times. While you can make more money with stocks, you can also lose more, especially in bad years like 2000 and 2008. Stock investing works best if pursued over a period of years, perhaps decades, allowing for bad years to be canceled out by good years.

Still, most people want to be invested in the stock market. That's partly because they want the supposedly superior returns, relative to other asset classes, and partly because they don't want to be left behind by other people, who are presumably chasing these historically superior returns.

People have grown less confident of their stock picking skills since Ben Graham's time. Instead, they want to capture the "market" return through broad and diverse exposure to groups of stocks. That appears to be the reason behind the trend to using "baskets" such as ETFs (Exchange Traded Funds). One solution that mimics ETFs is to buy (and then manage) a basket of blue chip stocks. The Dow 30 Industrials is as good a proxy as any for such stocks.

Current and former Dow stocks that appear to have been market returners for the past few years include telcos A T&T (NYSE:T), Verizon (NYSE:VZ), consumer goods provider McDonald's (NYSE:MCD), health providers J&J (NYSE:JNJ), Merck (NYSE:MRK) and Pfizer (NYSE:PFE), and financials JP Morgan Chase (NYSE:JPM) and Travelers (NYSE:TRV), and tech companies such as Cisco Systems (NASDAQ:CSCO), Intel (NASDAQ:INTC), and Microsoft (NASDAQ:MSFT). Over long periods of time, this has been true for the defense companies Boeing (NYSE:BA), General Electric (NYSE:GE), and United Technologies (NYSE:UTX), although their short term cycles are often out of sync with the market's.

Other standbys have not done this much, including American Express (NYSE:AXP), Coca-cola (NYSE:KO), International Business Machines (NYSE:IBM) Proctor & Gamble (NYSE:PG), and WalMart (NYSE:WMT). (Even so, a major holder of these companies, Berkshire Hathaway (BRK), has been a market performer for the past decade because of the success of its other operations.)

Disney (NYSE:DIS) and Home Depot (NYSE:HD) have been outperformers for most meaningful periods of time. Apple (NASDAQ:AAPL), Goldman Sachs (NYSE:GS), Nike (NYSE:NKE), United Health (NYSE:UNH), and Visa (NYSE:V) are former growth stocks that were outperformers before they (recently) joined the Dow; the jury is still out on how they will perform as Dow stocks.

The chemical companies, DuPont (DD) and 3M (NYSE:MMM) have been outperformers over the past few years, but that appears to be a cyclical phenomenon; expect only market performance going forward from these two. In the opposite vein, Caterpillar (NYSE:CAT) has been a recent underperformer for cyclical reasons and is a prospective market performer. On the other hand, the energy stocks, Chevron (NYSE:CVX) and Exxon (NYSE:XOM) have been underperformers for most of the current decade. They seem to be on a three decade cycle, with one decade of underperformance (1980s and 2010s), one of market performance (1990s and 2020s), and one of outperformance (1970s and 2000s).

Ben Graham did most of his buying in the middle 60% of the stocks in terms of strength. He did his best to avoid the stock of companies that were "headed" for bankruptcy, basically the bottom 20% of the universe (although he would sometimes buy their stocks after the companies went bankrupt for a workout). He would also avoid the fastest-growing (and typically the most expensive) 20%. Instead, it was on the middling stocks that he was able to work his "magic."

Stock prices tend to follow a trend line determined by earnings, and also to fluctuate in a band determined by sentiment, extending on either side of the trend. Such trends and bands are best featured by the charts of services such as Value Line. (In the interest of public disclosure, please note that I worked at Value Line for over ten years.) Similar insights might be obtainable by using e.g. Chuck Carnevale's FAST Graphs featured here on Seeking Alpha.

Graham's strategy was to buy stocks near the bottom of their price bands, and to sell near the top of those bands. The kinds of blue chip stocks referred to above have trends and bands that are well enough established to follow this strategy with considerable safety. Provided that the trends are reasonably stable, the strategy will give you enough beta to match the market on a risk adjusted basis, while the Graham tactic of buying below the trend and selling above it will give you alpha.

At the "top" of that "middle" 60% are tomorrow's breakout stars. Apple Computer has, from time to time, been in this category. Smaller cap candidates for such a breakout were featured in this article. Basically, you want a concentration in a few such stocks, up to 10%-15% apiece in your portfolio, with tradable "market-plus" performers like those described above, making up the rest.

A portfolio properly constructed and managed in the above way should outperform the market over time. With the small to mid cap stocks, your outperformance will come from holding them for their growth; with the blue chips, your outperformance will come from "range" trading. Sell either category of stock when it appears that they are too expensive, relative to their past, or if the investment thesis (either "growth" or "market performance") appears to be breaking down.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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