I am going to start our look at various valuation techniques with an old favorite.
In an interview shortly before he died, Ben Graham said most people would be better off with a simple quantitative value model. He suggested buying stocks with debt-to-equity ratios of less than 50 and P/E ratios of less than 10. He suggested buying a portfolio of about 30 stocks. Graham claimed that over a period of 50 years, this simple approach had earned an average rate of return of about 15%. In their excellent book Quantitative Value, Wesley Gray and Tobias Carlisle looked at the strategy from 1976 through 2011 and found that the average rate of return was 17.8%, well above the broader market's return of 11.05%.
Although less quantitatively talented than these two, I was able to sit down and do a 15-year back test of this very simplistic approach yesterday while watching the Orioles put an opening-day beat-down on Tampa Bay. I found that over the last 15 years, this approach, with annual rebalancing, earned a return of 16.07% compared to the S&P 500 return of 3.29%. For the 10-year period, the return was 13.3% vs. 5.79%, and over the past five years the differential was 14.49% for Graham and 11.86% for the S&P. This approach was not as lumpy as many value strategies, as it outperformed the market in 12 of the past 15 years.
I sat down this morning and ran the screen. I limited my universe to companies of greater than $500 million in market cap, and adding Ben Graham's really simple criteria, this resulted in an interesting universe of 62 companies.
Although energy is certainly represented on the list, it does not dominate it as it does many other value screens today. If you want to include energy, you have a choice of some of the more financially sound companies like Phillips 66 (PSX), Hess (HES), Marathon Oil (MRO) and National Oilwell Varco (NOV).
Several insurance companies make the list as well. As we want a diversified portfolio, I would go with market leaders Met Life (MET) and Aflac (AFL). Although I have always favored buying it in a bear market, I don't recall the last time I didn't have at least a small position in National Western Life (NWLI). I would also include shares of Reinsurance Group of America (RGA) in my portfolio.
Chicken makes the list of cheap stocks as well. Both Sanderson Farms (SAFM) and Pilgrims Pride (PPC) are on the list of stocks to consider for your Graham portfolio. Chicken is seen as a cheaper, healthier alternative to beef, which has seen sharp price increases in the past year, and these two chicken processors should continue to benefit from this shift in eating habits.
The idea is not to play favorites and equally weight the portfolio, but I confess to being pretty happy about seeing Virgin America (VA) on the list of Graham portfolio stocks. Airlines are going to see strong benefits from low fuel prices, and Virgin has been gaining ground since debuting in the U.S. in 2007. It used the proceeds from the IPO in November to pay down debt, and this company looks well positioned going forward.
Auto parts are on the list of unlevered cheap stocks as well. Auto and light-truck sales have been strong the past few years and companies that sell to original equipment manufacturers as well as the aftermarket have done very well. Both Modine Manufacturing (MOD) and Meritor (MTOR) should be considered for the Graham portfolio of cheap stocks based on P/E ratio.
One of the hardest sectors for value investors to get money to work has been health care. Accretive Health (ACHI) makes our list of stocks giving us some health care exposure. The company provides revenue cycle management services for hospitals and health care providers in the United States. This covers everything in the process, including patient registration, insurance and benefit verification, medical treatment documentation and coding, and bill preparation and collection from patients and third-party payers. Health care is one of the fastest-growing segments of the U.S. economy, so it's nice to have at least one stock in the sector included in our portfolio.
The Graham two-factor approach is strictly quantitative. It is based on two numbers, so deep analysis is needed to build a portfolio. You simply run the screen and put together a diversified portfolio of the stocks you find. In spite of its simplicity, it has handily and consistently beaten the market.
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