The Simplest Way To Beat The Market (Part 1)

by: Tal Davidson
Summary

Ben Graham's "Stock Selection Criteria for the Defensive Investor" were published 70 years ago.

The strategy still beats the market with 2x higher average annual returns.

Its low volatility will help you sleep well at night.

The first article in a series which covers every aspect of this superb strategy.

What if I told you that there is a simple way to beat the market by 100% (yes, twice the market returns) on average, with minimal risk and low volatility?

What If I told you that beating the market only requires an hour of your time once every year?

What would you think if I'd say that anyone can implement this simple strategy within his or her own bank or brokerage account?

Well, If anyone would have told me that before I knew what I know today - I would call him A FRAUD and walk away.

But hold on...don't walk away so quickly.

Not only that there is a simple low-risk way to earn twice the average annual returns of the S&P 500, but the system is in the public domain for....70 years!

Yes, it's not a typo. Everyone who knows their way of investing has either read or heard on Benjamin Graham's Stock Selection Criteria for the Defensive Investor, but only a few implement it. Ben Graham made the strategy famous when he published it in his 1949 book "The Intelligent Investor."

You will not find professional investors touting Graham's Stock Selection Criteria for the Defensive Investor. It would kill their business. At the end of the day, they need to sell their ETFs, Managed Accounts, Mutual Funds, or Hedge Funds. They live off of their 1%, 2%, or god forbid 2% and 20%. Yet individual investors are so better off investing in a small basket of safe and cheap companies. The data which I'll show here is striking.

This article is the first out of a series in which I will walk you through Graham's "Defensive Investor" Strategy step by step. Hopefully, by the end of the series, you would feel confident enough to implement it yourself. In this first article, I'll discuss what makes the strategy unique. In future articles, I will delve more into the philosophy behind the strategy, how I've modified it, how it performed in the past and why it works so well. I've also written detailed implementation instructions here.

You don't need to dump your current investments. You can allocate a small portion to Graham's strategy, even as little as $15K, and let it run for a while to see how it behaves and how you feel about it.

Let's dive now into the strategy's unique characteristics.

Superior Returns

Well, how good are the returns? Oh, baby, they are real good.

The following figure presents how my implementation of Ben Graham's "Defensive Investor" strategy has performed over a period of 19 years, from June-30th 1999 to June-30th 2017:

Over that period, the strategy returned 607% (6x times your money) vs. the S&P 500 which returns merely 146%. That's 11.48% per year vs. S&P's 5.21% per year (including reinvestment of dividends).

Low Volatility

Typically strategies which outperform the market come with excessive volatility. Higher volatility means that the portfolio suffers from amplified up and down movements in its total value. That's usually a price you ought to pay for earning more.

All things equal, volatility is undesired. It bears an emotional strain and often causes even the most disciplined investors to make judgment mistakes driven by their fear or greed. Volatility also impairs liquidity, as a downward trend may occur at the exact moment that you need to cash out.

When investing quantitatively, volatility is a prime concern. We aim to increase the returns of a quantitative strategy's while reducing its volatility. Not an easy feat nonetheless. We look at several statistical metrics to assess volatility, each with its peculiarities. I will elaborate on those metrics in a future article. The first metric we shall examine is the Standard Deviation of portfolio returns. A lower figure represents a less volatile portfolio behavior. The second metric is the Beta. A beta lower than 1 implies more moderate volatility than the market (as represented by the S&P 500). A Beta higher than 1 means a portfolio with higher volatility than the market.

Examining the portfolio's volatility since inception, Standard Deviation (%) of Graham's portfolio was only 11.64%, which is roughly 30% lower than the S&P 500's 14.62% figure. Zooming into the last three years of the simulation, the Standard Deviation of the model was still smaller, with 9.67% vs. the S&P 500's 10.50%.

Beta since inception was a mere 0.47 (vs. the S&P 500 Beta of 1), and 0.33 for the last three years.

Those figures are outstanding, considering that the "Graham's Defensive Investor" portfolio is comprised of stocks which are part of the S&P 500.

Well, I'll tell you a secret. Not every implementation of Graham's "Defensive Investor" strategy is that good as the one I'm showing in terms of volatility. While Graham described his stock selection criteria in great detail in chapter 14 of his seminal book "The Intelligent Investor", he did not specify how stocks should be selected out of those that met his criteria. I have experimented with many ranking and selection mechanisms and have found the 3-year Beta metric to be a superior factor to any other selection criteria. I believe that selecting the lowest Beta of the stocks meeting Graham's criteria not only lowers volatility but improves risk-adjusted returns as well.

Low Asset Turnover

Here's a quick riddle: What makes practitioners (persons investing to make money) different than academics (persons who write papers on how they would invest if they had the money)?

The answer: Taxes and fees.

In real life, we have to pay fees on our transactions, and Taxes on our capital gains (unless one invests solely in non-taxable accounts).

Therefore, we should judge investment strategies on how they would perform on an after-tax after-fees basis.

The rule of thumb to lower taxes and fees is to trade less. The less frequent your buys and sells, the lower your overall brokerage bill and tax bill.

The nice thing about my implementation of Graham's strategy is its low asset turnover. See the "Annual Turnover of 17.68%" figure in the table above. This means that on average, upon every yearly rebalance date; I only need to sell 17.68% of my portfolio. Assuming an equal-weighted 15-stocks portfolio, that would mean replacing 2 to 3 stocks every year. Not a big deal.

Moreover, I would pay capital gains only on 17.68% of my portfolio each year. Compare that to a portfolio with an annual turnover rate of 60% or 70%, not uncommon among quantitative strategies. The tax bill on such a portfolio would be much higher and eat up into the portfolio's gains.

Easy to Implement

The portfolio whose performance I'm showing above consists only 15 stocks, rebalanced annually. Upon each rebalance, typically only 2-3 stock holdings are being replaced. The effort in maintaining such a portfolio, if you perform the screening yourself, is less than an hour.

Sleep Well at Night

Graham called his method "Stock Selection Criteria for the Defensive Investor" to emphasize the safety of his selections. We are told that earning more involves more risks. Benjamin Graham and his famous disciples, Warren Buffett and Walter Schloss, have taught us that it's the other way around. We earn more because we buy cheaply. We bear less risk because we buy cheaply. Risk and earning potential are correlated, but opposite to conventional wisdom. Higher returns are often correlated to lower risks, and not to higher risks as academics will tell you.

Graham advocates choosing stocks among large and prominent companies. We have defined our stock universe to be the S&P 500; all are large and prominent companies. Graham instructs us to purchase stocks with a 10-year history of profitability and a 20-year history of paying dividends. While we have relaxed the dividend requirement somewhat, requiring only five straight years of dividend payments, we believe that those profitable dividend paying stocks are among the safest of the S&P 500, on average.

By the way, I keep repeating this term, "on average," and it's important. I do not write it as an afterthought. I will elaborate on that point in one of my upcoming articles.

Lastly, Graham directs us to impose a valuation criterion. Stocks are limited on their P/E multiple or the product of P/E and P/B. High-flying growth stocks are thus excluded. The strategy will not select Amazon as a holding, nor Facebook and nor Tesla. The algorithm coldly and rationally looks at the data, not at any "story" involving the stock.

Holding 15 rationally-selected safe and cheap stocks result in incurring low risk, allowing one to sleep well at night.

The risk is naturally not zero, and an unfortunate selection of failing stocks could occur, but on average and over the long term, the risk is diminished by all means possible.

Recap

It doesn't get any simpler than that. Investing in a basket of large and prominent companies, with a long history of profitability and dividend payments, at a price which is not excessive - beats the market. The best results could be achieved when the holdings are the lowest Beta stocks among those that meet the criteria above. A simple mechanical strategy of holding 15 such stocks and rebalancing yearly delivered 2x the S&P 500 average returns in a 19-year backtest, with significantly lower volatility than the markets. The Graham Defensive Portfolio free stock screener does all the heavy lifting and lists the lowest-Beta Graham's Defensive stocks, enabling anyone to create such a portfolio quickly and confidently.

(figures generated by portfolio123.com)

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.