Profiting from Ben Graham's least known deep value formula

Friday, Oct 12 2012 by
Profiting from Ben Grahams least known deep value formula

It may have skipped most people's attention, but stock markets are looking cheap. Notable hedge fund manager Joel Greenblatt was this week quoted as saying that the market has only been cheaper 13% of the time over the last 23 years. Historically at such extremes of valuation the average 12 month upside in stocks has been 17%, and over 2 years well over 30%. Given such statistics it's quite remarkable that the investing public is still throwing money at the ill perceived safety of cash and low yielding bonds. Sure, there's always risk in the stock market, but right now there may be more risks to the upside than the downside. Perhaps investors ought to be looking for ways to play stocks that offer great return possibilities while minimising business risk. It turns out there's a deep value formula that promises to do exactly that, concocted by the bargain master himself - Benjamin Graham.

Graham, for those that don't know, was Warren Buffett's tutor and one of the greatest value investors of all time. We've covered some of the mechanical ways which Graham used to find bargain stocks before in great detail, but alas some of his most famous bargain hunting techniques (such as the esoteric sounding net-net and ncav strategies) can be unsuitable for risk averse investors. The main critique is that these lists tend to be populated with a lot of small microcap stocks that many investors find those too small, too illiquid, too risky and too hard to trade.

Ben Graham's Last Will - a money making formula

But, towards the end of his life, Graham developed a much more flexible checklist based formula that allows investors to build portfolios of deep value stocks large or small. We have previously written about this ten point checklist that he developed with aeronautical engineer, James Rea, shortly before he died. It's become known as "Graham's Last Will" and was the result of 50 years of backtests to highlight the top ten best performing stock selection criteria.

The ten checks were split in two groups of five, the first five aiming to highlight 'cheap' stocks with strong return possibilities (using low PE, high yields, good asset backing etc), with the second five aiming to find 'low risk' stocks (not much debt, consistent profitability, good liquidity etc). A company gains points for passing each of the tests. For the geeks amongst us here's the list:

  1. Earnings Yield of at least twice the AAA bond yield
  2. P/E ratio less than 40% of the highest P/E ratio the stock had over the past 5 years
  3. Dividend yield of at least 2/3 the AAA bond yield
  4. Stock price below 2/3 of tangible book value per share
  5. Stock price below 2/3 of Net Current Asset Value
  6. Total debt less than book value
  7. Current ratio great than 2
  8. Total debt less than 2 times Net Current Asset Value
  9. Compound earnings growth over the last 10 years at least at a 7%
  10. No more than 2 earnings declines in the last 10 years

Societe Generale has recently backtested this checklist since 1992 with quite remarkable results. They show that the resulting score of a stock between zero and ten is extremely predictive of future returns over the next 12 month period. For each score in ascending order the average annualised returns were -2.1% -0.2% 0.0% 0.0% 0.6% 1.0% 2.7% 29.1% 9.9% 36.1% and 48.7%. That's an almost 50% annualised return for stocks ranked 10 - who wouldn't be interested in that?

The trouble is there just aren't that many stocks qualifying for the top scores. In fact according to Soc Gen in that 18 year period there were less than 0.4% of stocks that scored 7 or more and only 3 stocks that scored a perfect ten. Beyond that most of the high scoring candidates appear during big market breaks - e.g. in 2008. Some argue that as a result the Graham and Rea checklist isn't that useful. But this may be shortsighted.

Building a better Graham & Rea portfolio

Graham and Rea suggested using a more advanced scoring system to allow any stocks coming within 25% of meeting one of the criteria to win half a point instead of the full one. Some of the criteria are so harsh that this can make a big difference - generating a wider dispersion of scores and offering a greater array of picks in broader market conditions. As a result we can more systematically pick the top ranked stocks by Graham & Rea score and track the resulting portfolio over time.

Societe Generale found out that this top decile portfolio outperformed the market by 8.1% per year over an 18 year period from 1992 to 2010 - a greater than 700% return over 18 years and triple the market return!. While these deep value stocks are punished in market breaks, their moderate valuations and low corporate risk profiles ensure that when good times return their share prices really shine.

We've just added this version of Graham's scoring system to the Stockopedia screener. The ratio is called the 'Graham Deep Value Score' and we've generated a (still in testing) 'Benjamin Graham Deep Value Screen' that highlights qualifying names.  We can't find any stocks that pass 9 or 10 criteria in the UK market at present, but there are plenty that offer a score of 7 or greater. As ever in a deep value screen you find some interesting names in the list - notably we spotted BAE Systems. , Albemarle & Bond Holdings (LON:ABM) and Asian Citrus Holdings (LON:ACHL) as standout names.

In order to see the full list you'll need to be a subscriber - if you aren't there's a two week free trial available. We'll start tracking the performance of the strategy shortly - in the meantime I'd be interested in hearing your thoughts.  We'll soon be turning this checklist into an 'app' in line with other metrics such as the Magic Formula, Piotroski F-Score and Montier C-Score.

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As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.

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BAE Systems plc is a defense, aerospace and security company. The Company operates in five segments: Electronic Systems, which consists of the Company's United States and United Kingdom-based electronics activities; Cyber & Intelligence, which comprises of its United States-based Intelligence & Security business and United Kingdom-headquartered Applied Intelligence business, and covers the Company's cyber, secure government, and commercial and financial security activities; Platforms & Services (United States), which comprises its United States-headquartered Land & Armaments business, and the United States-based services and sustainment activities; Platforms & Services (United Kingdom), which comprises its United Kingdom -based air, maritime, combat vehicle, munitions and shared services activities, and Platforms & Services (International), which comprises the Company's businesses in Saudi Arabia, Australia and Oman, together with its 37.5% interest in the MBDA joint venture. more »

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Albemarle & Bond Holdings PLC is a United Kingdom-based company. The Company’s services include pawnbroking, gold buying, cheque cashing, travel money and western union. The Company sells luxury watches, gold jewellery, silver jewellery and diamond jewellery. more »

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Asian Citrus Holdings Limited, along with its subsidiaries, principally is engaged in the agricultural industry. The Company operates in two segments: agricultural produce segment, engaged in the planting, cultivation and sale of agricultural produce, and processed fruits segment, engaged in the manufacture and sale of fruit juice concentrates, fruit purees, frozen fruits and vegetables. The Company's subsidiaries include Access Fortune Investments Limited, A-One Success Limited, Newasia Global Limited, Raised Energy Investments Limited, Asian Citrus Management Company Limited, Asian Citrus (H.K.) Company Limited, Beihai Perfuming Garden Juice Co., Ltd., BPG Food & Beverage Holdings Ltd. and Chance Lead Holdings Limited, among others. more »

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  Is BAE Systems fundamentally strong or weak? Find out More »

5 Comments on this Article show/hide all

UK Value Investor 13th Oct '12 1 of 5

I haven't seen that one before, and I'm surprised by how close it is to what I do, although the details are all different.

Basically he looks at:

  • high earnings yield
  • high dividend yield
  • financial strength through good working capital liquidity and low levels of interest bearing debt
  • good long-term growth
  • consistent long-term growth

That pretty much ticks all my boxes for a sensible approach to investing in businesses. Ben Graham does it again...

Newsletter: UK Value Investor
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Isaac 13th Oct '12 2 of 5


Is it possible to get an insight in your portfolio please?

I think you write interesting articles, books and have a good screening tool behind you. And I think you have been in the Investing scene for a while.

I would be interested to learn more about your portfolio performance as well as the main strategies you personally use and how that has evolved if you are willing to share?

thank you

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thebuffoon 14th Oct '12 3 of 5

In reply to UK Value Investor, post #1

I haven't seen that one before, and I'm surprised by how close it is to what I do, although the details are all different. ......pretty much ticks all my boxes for a sensible approach to investing in businesses. Ben Graham does it again...

There's nothing new; but it's good to see it being aired for another generation.

If you haven't already,  I really would encourage you to read the Intelligent Investor.

Of course, having gone through the depression, with people going bankrupt, and some eschewing the elevator for a faster route down to the ground floor, the security of investment capital was most certainly at the forefront of everyones mind.

There were far more companies satisfying his original criteria than there are now.  As we all know, we really make our money by buying judiciously. It's a lot harder now.




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Edward Croft 14th Oct '12 4 of 5

This chart is a bit old, but it shows the % of companies over time passing both 2.5 of the 'return' criteria and 2.5 of the 'risk' criteria in the Graham formula across different equity markets of the world. Societe General have used this as a key indicator of market value in recent years. It's clear that when more than 10% of stocks are qualifying for this screen there's often a buying opportunity.  It's certainly highlighted the bottoms during previous market crises.  What is interesting though about the scenario today is that bond rates are being held suspiciously low by coordinated central bank policies.  As 2 of the criteria above depend on AAA bond yield comparisons the number of stocks qualifying for this screen today may be inflated somewhat.  Nonetheless we can clearly see that there's a lot of value in the stock market by this measure.  

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tomomo 28th Nov '14 5 of 5

In reply to Edward Croft, post #4

Ed I'm struggling to find the Soc Gen paper you refer to here and in the recent Interactive Investor article -- is it available online, and do you have reference? Thanks.

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About Edward Croft

Edward Croft

CEO at Stockopedia where I weave code, prose and investing strategies to help investors beat the stock markets. I've a background in the City and asset management but now am more interested in building great stock selection tools for the use of investors online.   Traditionally investors online have had very poor access to the best statistics, analytics and strategies for the stock market and our aim is to set that straight.  High Quality fundamental information has been prohibitively expensive in the past and often annoyingly dull. People these days don't just want to know the PE Ratio and look at a balance sheet. They expect a layer of interpretation over data, signal from noise and the ability to know at a glance whether a stock is worth investigating or not. All this is possible using great design and the insights gleaned from quantitative research.  Stockopedia is where we try to make it happen ! more »


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