Chapter 7 of The Intelligent Investor by Benjamin Graham offers up a “Portfolio Policy for the Enterprising Investors: The Positive Side.” In this chapter, there is mention of “The Relatively Unpopular Large Company” which is essentially a Dogs of the Dow investment strategy. Unlike the Dogs of the Dow, this approach does not focus on the highest yielding stocks in the Dow Jones Industrial Average.
The distinction of this strategy is the fact that it is based on the selection of the ten Dow Jones Industrial Average stocks with the lowest price to earnings (p/e) ratio. This group is contrasted with the performance of the 10 highest p/e ratio stocks and the entire index. The performance measures the price change over 5-year periods from 1937-1969 as shown below with our own 1-year comparison from November 4, 2016 to October 10, 2017.
This is the second in a series of reviews of Graham and Dodd's investment classic Security Analysis. This book is credited with providing Warren Buffett and his disciples with the acumen to pick stocks that generate long-term wealth. Although the section of the book that we chose to review is probably the smallest, we feel it is worth examining.
The following paragraph is a continuation of the previous excerpt that we reviewed recently regarding investment timing.
“There are two other major questions of investment timing. The first is whether the investor should try to anticipate the movements of the market-endeavoring to buy just before an advance begins or in its early stages, and to sell at corresponding times prior to or at the onset of a full-scale decline. We state dogmatically at this point that it is impossible for all investors to follow timing of this sort, and that there is no reason for any typical investor to believe that he can get more dependable guidance here than the countless speculators who are chasing the same will-o’-the-wisp. Furthermore, the major consideration for the investor is not when he buys or sells but at what price (Benjamin Graham, David L. Dodd, Sidney Cottle. Security Analysis, Fourth Edition. 1962. Page 70.).
We can’t understand how Graham and Dodd could expect an investor to recognize the upper range of a bull market when they “dogmatically” believe it is impossible to “anticipate the movements of the markets…”. Also perplexing is the belief that buying at a specific price is unassociated with timing of some sort. After all, if a stock is currently overvalued but otherwise “sound” and the price remains the same, then over time the stock will become more fairly valued or undervalued. This suggests that price is better at some times than others. A stock that you wouldn’t buy today because the price is expensive will soon become a stock that is less expensive, in due time.
related article: Graham and Dodd on Market Timing: I
The following is our critique of a passage of the investment "bible" Security Analysis by Graham, Dodd, and Cottle. This book is credited with providing Warren Buffett with the knowledge and background on how to accurately assess stocks. Although we know this book is basically about number crunching, our concern is how this book treats the question of timing of the purchase of stocks. In this regard, Security Analysis says the following:
“Timing Consideration in Investment Policy- The old rule for the ordinary investor was that he should buy sound securities when he had funds available. If he waited for lower prices he would be losing interest on his money; he might “miss his market,” even if prices declined, in any case, he was turning himself into a stock trader or speculator. Much of this view retains its validity. However, the time when the investor should clearly not buy common stocks is during the upper range of a bull market. (Benjamin Graham, David L. Dodd. Sidney Cottle. Security Analysis, Fourth Edition. 1962. Page 70.).”
The core of value investing is to obtain an investment for less than its worth. Professional investors will typically focus on the price to earnings (P/E) ratio which compares the current share price with its per share earnings. Although this is a good gauge, more than one ratio should be considered when assessing an investment. Students of value investing should also be familiar with price to book (P/B) ratio. This ratio (P/B) compares the current share price to the current shareholder equity.
In the book The Intelligent Investor, Benjamin Graham highlights a key concept which combined the two ratios [P/E and P/B] as a gauge on the valuation of a company. These combined ratios are known as the Graham ratio. The computation is elementary, simply multiply the P/E ratio with the P/B ratio. If the product is less than 22.5, the company may be of good value. This thesis is highlighted in Chapter 14 – Stock Selection for the Defensive Investor of The Intelligent Investor. We find this concept to be so compelling that we've decided to back test this ratio against our watch lists from 2012. Continue reading
I'd like to make a correction to my earlier mistake on calculating one of the Graham Rule. On May 14th watch list
, I said that "I ran a new filter through this list using Graham rule of earning yield being higher than twice the long-term rate which I use 10 years T-bill." This isn't the case.
Based on that one criteria, the following five companies (from May 14th) past the test.
||Eli Lilly & Co.
||Goldman Sachs Group
||HCC Insurance Holdings
||Merck & Co., Inc
The AAA yield at the end of April 2010 is 5.29%. Any company with earning yield exceeding 10.58% would qualify under this rule.
This is just one of many rules Graham set. Many other look at the balance sheet for companies' viability if worse case hit. I'll be doing a study on the Dow 30 to see how well the Blue Chip fit into this model. - Art