Graham Stock Picking Put to the Test

I got lucky to find this entry over at The Stingy Investor.

It is a great follow-up to our very first entry as it outlines examples and practicality of Benjamin Graham's tenets of value investing.

Over the past five years I've used Benjamin Graham's time-tested strategy for defensive investors to uncover undervalued U.S. stocks. So far, the results have been breathtaking.

The performance of each year's Graham stocks, the performance of the S&P500 (as tracked by the SPY exchange-traded fund) and the difference between the two is shown in Table 1. You can see that the Graham stocks have solidly beaten the S&P500 each year*. In fact, an investor who bought each year's Graham stocks, sold, and then bought the next crop of stocks would have gained 369% (or 38% annually**) whereas a buy and hold investment in SPY units would have actually lost 5%.

In fact, The Stingy Investor has a whole "category" set up for Benjamin Graham-related entries and you can read a lot of related material by clicking here.

If you want a more detailed, mathematical review and discussion of this investment style you can click here for a study.

Buffett-esque Mutual Funds

I've set the stage on value investing with some previous entries focusing on Benjamin Graham and Warren Buffett, so why not take the discussion to the next level and highlight a few mutual funds (that produce immediate diversification) that employ the tenets of value investing?

This weekend, the Wall Street Journal ran a piece titled, What kind of mutual fund would Warren Buffett buy?

Finding bargains in any market environment is a challenge. For Mr. Buffett, value is rooted in some basic principles: Think of stocks as businesses; invest in companies that generate more cash than they use; buy shares cheap enough to provide what value guru Benjamin Graham called a "margin of safety" and ignore the thundering market "noise" that could trigger a hasty exit.

"Buffett's principles are still sound and universal," says Robert Hagstrom, manager of the Legg Mason Growth Trust fund and the author of a best-selling book on Mr. Buffett's investing style. "Cash flow and return on capital is about all you need."

Some value-stock darlings include Wal-Mart Stores Inc. and Anheuser-Busch Cos., which appear in the Weitz Value fund, run by Wallace Weitz, and in manager Bill Nygren's Oakmark Fund. Meanwhile, Coca-Cola Co. shows up in Oakmark and Auxier Focus, which is run by another Buffett disciple, Jeff Auxier. Not coincidentally, these stocks are also major holdings for Berkshire Hathaway.

A number of former growth-stock darlings are currently making it through stock screens modeled on Mr. Buffett's investing principles. That's because these companies are trading at attractive discounts to estimates of their "intrinsic market value" -- that is, their takeover price.

Fairholme Fund (FAIRX)
The Fairholme Fund (FAIRX), highlighted in the table above, has been praised in various sources that I've seen recently. This fund is as solid as a fund can be -- a Mid-Cap value fund with a 1.00% expense ratio and a 5-Star rating from Morningstar. How can you argue with results like these?

Just this week the the Motley Fool said

This fund is co-managed by Bruce Berkowitz and Larry Pitowsky, whose dedication to the teachings of legendary investor Warren Buffett have led them to invest nearly 19% of Fairholme's assets in Berkshire Hathaway (NYSE: BRKa)(NYSE: BRKb) stock. Of course, that shouldn't come as a surprise: Berkowitz and Pitowsky tend to eschew wide diversification and concentrate resources on their best ideas, which, as of November, included Canadian Natural Resources (NYSE: CNQ), Leucadia National (NYSE: LUK), EchoStar Communications (Nasdaq: DISH), and Sears Holdings (Nasdaq: SHLD).

So far, the strategy has paid off. Fairholme has beat the S&P 500 by more than 10 percentage points since its inclusion in the Champion Funds portfolio last April. It boasts the same market-crushing record over the past five years.

Legg Mason Value Trust (LMVTX)
The legendary Bill Miller (article database) runs the grandaddy of value funds, Legg Mason Value Trust - the only fund to outperform the S&P 500 for each of the last 15 calendar years. But, LMVTX is not off to the hottest start in 2006.

Stocks, the Asset Class of Choice For Long Term

In keeping with the macro-theme of setting the table for conversation related to equity investing, this article by Dr. Jeremy Siegel (www.jeremysiegel.com/) discusses why stocks remain the asset class of choice for long term return. He also shares some basic fudamentals of equity-analysis.

The following are just some small excerpts from the piece that is worth chronicling:

During the past 204 years (through 2005) stock investors have earned an average 6.8% per year after inflation and that return has been remarkably stable over long periods. Over the past 80 years, real stock returns averaged 6.7 percent per year, and since the end of the Second World War, the annual return has been 6.8 percent. This return includes both capital gains and dividend income and is measured after the effects of inflation have been subtracted. These numbers mean that on average, investors' wealth has doubled in purchasing power every decade in stocks, a feat rivaled by no other asset class.

Stock returns are composed of the sum of the average real return on safe bonds, such as U.S. government bonds, which has been about 3 percent, plus an extra risk premium that has averaged between 3 percent and 4 percent per year. This risk premium has propelled stocks above other asset classes in investor returns.

Earnings Yield

The earnings yield on stocks is analogous to the current yield on a bond, which is the annual coupon received by bondholders divided by the price. If a bond is selling for $1000 and pays $50 dollars a year in interest, we say that the current yield on the bond is 5 percent. If a stock is selling for $100 and earns $5 per share, its earnings yield is likewise 5 percent.

But there is a critical difference between the earnings yield on stocks and the current yield bonds. Bonds, except for a small part of the treasury market called "inflation protected bonds," are promises only to pay dollars. No matter what the growth in the economy or what the rate of inflation, the payment of the principal or the interest will never increase, and could fall if the paying entity has financial problems.

Stock returns are much different. Stocks are claims to real assets -- land, capital, property, ideas, trademarks and patents, among other assets that produce real goods and services. Over long periods of time the evidence is overwhelming that the price of stocks will keep up with rising prices of the goods and services firms produce. As a result, the return on stocks is best described as a "real" return, and not just a nominal or money, such as bonds offer investors.

The long run data are consistent with the view that the earnings yield predicts real stock returns. Since 1871, the first year that definite data on aggregate stocks earnings is available, the average price-to-earnings on stocks is 14.4. That means that investors have paid on average $14.40 for every dollar of current earnings.

The historical earnings yield on stocks, which is one over the P-E ratio, has therefore been 6.9 percent. That is virtually identical to the average real return on stocks over this period.

Earnings Yield and Future Stock Returns

As of early March, the projected 2006 earnings on the firms in the S&P 500 Index is $84.81. With the index level recently at 1286, this leads to a P-E ratio of 15.16 and an earnings yield of 6.59 percent. Some view operating earnings as a too-optimistic way of looking at the profits since analysts are often overly optimistic about firms' prospects.

To avoid this, we can take the ultra-conservative "core earnings" concept that was developed in 2002 by Standard & Poor's Corp. that strips away accounting conventions used by firms to inflate their earnings. Standard & Poor's projects core earnings for 2006 at $77.32, which leads to an earnings yield of about 6 percent, the best conservative forecast of future real returns on stocks.

A 6 percent real, after-inflation return may not seem great compared to the 13 percent real returns enjoyed by investors during the booming 1980s and 1990s, but it certainly looks good compared to what is now offered by bonds. Long-term U.S. government bonds now offer a yield just above 4.5 percent, but this is before inflation is subtracted. With a 2.5 percent forecast rate of inflation, this leaves a real, after-inflation return of only 2 percent. This looks right since the US Government's inflation protected long-term bonds also offer yields of about 2 percent.

The difference between the 6 percent forward looking real returns on stocks and the 2 percent on bonds is gigantic, especially when measured over the long run. A $100,000 placed in a 30-year inflation protected U.S. government security will yield about $181,000 after inflation in 30 years. In contrast, a diversified stock portfolio at 6 percent real return will yield $574,000 of purchasing power, more than 3 times as much as in bonds.

The bottom line is that stocks still offer far better returns than fixed income investments. And given what I had written previously in this column about real estate, I think that stocks will also outpace the returns on real estate over the next decade. Stocks are the place to be for long-term investors. Future columns will show how investors should structure their portfolio to take advantage of these gains.

Dr. Siegel is currently the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania, has written and lectured extensively about the economy and financial markets. He frequently appears on CNN, CNBC, NPR, and others networks and is a regular columnist for Kiplinger's with contributions to The Wall Street Journal, Barron's, Financial Times, and other national and international news media to his credit. He is the author of numerous professional articles and two books: "Stocks for the Long Run" and, most recently, "The Future for Investors."

The Intelligent Investor

I figure that the first post on a blog needs to a 'defining' entry on the proposed topic of the blog. Since we're starting this blog to focus on investing (and personal finance issues), I want this entry to be the most valuable entry that this blog will ever see.

I've recently had a few close friends (and family) ask me some relatively untargeted questions related to the expansive topic of 'investing'. How am I supposed to answer the question, "Can you help me with some investing?" in 100 words or less?

Since I have no reason to know how sophisticated, (un)educated, or (in)experienced an acquaintance may (or may not) be...this entry is therefore designed to be the most important piece of investing advice that I could ever give to anyone. It is advice that can be valued by the most amateur of novices or by the most accomplished expert -- read the authoritative bible on investing - The Intelligent Investor; The Definitive Book on Value Investing by Benjamin Graham.

What could be better than the book that Warren Buffett calls "By far the best book on investing ever written"?

Jason Zwieg has contributed to modern versions of the book and has a nice set of resources where one can Read About The Intelligent Investor. He also does a great job asking and answering the questions - "who was Benjamin Graham and why should I care". Additionally, this link highlights many of Graham's principals of value investing and this link asks and answers the

Over time, I hope to outline and discuss the philophies in the Intelligent Investor on this blog. In the meantime I will defer to the following comments from Amazon.com to highlight the book:

Among the library of investment books promising no-fail strategies for riches, Benjamin Graham's classic, The Intelligent Investor, offers no guarantees or gimmicks but overflows with the wisdom at the core of all good portfolio management.

Since its original publication in 1949, Benjamin Graham's book has remained the most respected guide to investing, due to his timeless philosophy of "value investing," which helps protect investors against the areas of possible substantial error and teaches them to develop long-term strategies with which they will be comfortable down the road.

The hallmark of Graham's philosophy is not profit maximization but loss minimization. In this respect, The Intelligent Investor is a book for true investors, not speculators or day traders. He provides, "in a form suitable for the laymen, guidance in adoption and execution of an investment policy" . This policy is inherently for the longer term and requires a commitment of effort.

Where the speculator follows market trends, the investor uses discipline, research, and his analytical ability to make unpopular but sound investments in bargains relative to current asset value. Graham coaches the investor to develop a rational plan for buying stocks and bonds, and he argues that this plan must be a bulwark against emotional behavior that will always be tempting during abrupt bull and bear markets.

Over the years, market developments have borne out the wisdom of Benjamin Graham's basic policies. Here he takes account of both the defensive and the enterprising investor, outlining the principles of stock selection for each, and stressing the advantages of a simple portfolio policy.

Related Links:
(1) Motley Fool: Who was Benjamin Graham

(2) Warren Buffett Secrets: Biography of Benjamin Graham

(3) Deeper Blog: Book Review