Guru Screen: Ben Graham Still Beats The Market

 



Guru Screen
Ben Graham Still Beats The Market
John Reese, Validea Hot List 04.20.07, 12:00 PM ET

Among the cognoscenti of value investing, Benjamin Graham is a revered figure. The first superstar strategist on Wall Street, he is actually the father of modern securities analysis and was Warren Buffett's teacher at Columbia University. As regular readers of this column know, I believe you can be successful by consistently following the strategies of Wall Street's best investors, and Graham is the granddaddy of them all.

Though he died in 1976, his books are still in print, and his investment philosophy is still widely studied. Among those who follow my guru strategy approach to investing, he is also held in high regard. Currently, out of the dozen or so strategies I follow, the one that I base on Graham's writings comes in No. 2 in terms of total return.

Since I've been tracking the guru strategies starting in July 2003, the Graham strategy has provided a 177.2% return. That compares with a 46.8% return from the S&P 500 during the same time period. Keep in mind that this is not backdating or theorizing. This impressive return is based on nearly four years of applying the Graham strategy's discipline to the market.

Graham is the classic value investor. He sought out companies that were performing well and operated in basic businesses--nothing too esoteric (hence his disciple Buffett's tendency to steer clear of technology and other types of businesses that he says he doesn't understand). In addition, to improve his chances of making money, Graham would buy stocks from such companies only if they were trading at a discount to what he thought they should be.

Make no mistake, the Graham strategy is a highly selective one, and some investors and analysts argue that because The Intelligent Investor, Graham's book on which I base the methodology, was published in 1949, the exact approach is too rigorous and outdated. With a return that's nearly triple that of the market over the last four years, I beg to differ.

The Graham strategy wants to see earnings per share grow at least 30% over 10 years. But it doesn't just look at the first and last year's EPS. It averages the earnings of the first three years of the 10-year period and then averages the last three years of that same 10-year period.

Likewise, when looking at the price-to-earnings ratio, Graham uses the average EPS of the last three years, not just the most recent year. By using the average EPS over three years and not just the common one year, Graham cleverly overcomes the distortion when the EPS is unusually high, low or even negative in one of the comparison years. This is particularly helpful with cyclical companies.

Because of its superb record, and the strategy's ability to find deep value stocks, I want to present a few ideas that the Graham screen recently uncovered.

Jakks Pacific: This toy manufacturer has a strong current ratio of 2.64 (meaning that it has a lot of liquid assets relative to the size of its debt), has had consistent and hefty (404%) EPS growth over the past 10 years, has a modest (13.10) price-to-earnings ratio and a reasonable price-to-book ratio of 1.17. When multiplying the P/E by price-to-book ratios, the number cannot exceed 22; in Jakks' case, it comes to 15.33. Very nice.

Encore Wire: A manufacturer of copper electrical building wire and cable, Encore has an impressive current ratio of 9.98. The company's long-term debt is $99 million, less than a third of its net current assets of $333.9 million. Over the past five years, EPS has consistently been positive, and over the past 10 years, it has grown an impressive 342.6%. The stock has a P/E of only 9.0 (using the three-year average), while the P/B ratio is 1.78. Multiplying the P/E and P/B ratios comes to 16, well below the 22 maximum allowed.

Posco: According to Morningstar, South Korea-based Posco is the third-largest steel maker in the world. It is a favorite of the Graham strategy because its current ratio is 2.41, long-term debt is but 35% of net current assets, the P/E ratio is 2.4, the P/B is 1.69 and multiplying the P/E with the P/B produces the remarkably low figure of 4.06.

Muellar Industries: Muellar manufactures metal and plastic products used in air conditioning, plumbing, heating, machinery and automobiles. Its current ratio is an impressive 3.04, its 10-year EPS growth has been 69.3%, EPS has been positive in each of the past five years and its P/E ratio is 10.7, while its P/B ratio is 1.92. Multiplying the P/E and P/B comes to 20.54, just below the 22 maximum allowed by the strategy.

Novamerican Steel: Canadian-based Novamerican manufactures steel and aluminum. Its current ratio is a high and impressive 3.36. Its long-term debt is only $2.5 million, while its net current assets are $227.5 million--net current assets are a whopping 91 times long-term debt. In addition, EPS has grown 363.9% during the past 10 years. The P/E ratio is 12.83, while the P/B is 1.58. When combined, they come to 20.27.

These are five companies that are performing well financially, while having stock prices that are modest, given the companies' performance. The Graham strategy is itself performing well. I would say the prospects for all of these companies' stocks appear quite good.

John P. Reese is founder and CEO of Validea.com and Validea Capital Management. He is also co-author of The Market Gurus: Stock Investing Strategies You Can Use From Wall Street's Best. Click here for more of Reese's insights and analysis, and to learn about subscribing to the Validea Hot List. At the time of publication, John Reese and his clients were long on Jakks Pacific, Encore Wire, Posco and Muellar Industries.