Drifting to the Dark Side

[Ed_The_Gypsy]

I am rethinking my investment approach. Up to now, I have been a slice-and-dicer mostly with index funds.

This ( Stingy Investor: 8 Graham Stocks for 2010 ) modified Ben Graham approach for picking individual stocks has produced an annualized +11.9% over the past 5 years vs. my self-directed IRA of +5.5% (not adjusting for a withdrawal necessitated by an extended period of unemployment last year) and DW's Mutual Shares Z (MUTHX) which lost -3.5% over the same period with a wild ride to boot. Ben is doing a good job. Warren Buffet only produced +6.5% per annum over the same 5 year period. (I would have checked back 10 years but I only have access to my Vanguard on-line stuff.) Is Berkshire Hathaway too big now?

I have been comfortable with my IRA. It is well diversified and seems to work pretty well. I am not inclined to change what I am doing here...yet.

However, I am thinking of taking charge of DW's Roth, dumping MUTHX and trying my hand at Ben Graham's approach. The track record over the past 10 years is pretty good relative to the S&P 500.

Comments anyone?

[MasterBlaster]

Is this the flavor of the month ?

The "stingy" rules point to stocks that are good values yet are growing at a nice pace. Isn't that what everyone wants ? Do stocks like that actually exist ?

It goes without saying that a portfolio consisting of these linked stocks are higher risk/reward.

How does this model test out over the last 80 years or so ?

Me personally - I am in a show me mode.

[samclem]

If it were me and I were tempted to do something different with a small portion of my portfolio--something less diversified, more concentrated, and likely to be more volatile--I'd try this experiment with my own Roth rather than DWs. Sure, it's all "our" money, but, just for appearances sake . . .

Remember the books and articles on the Dogs of the Dow? A simple method that produced outstanding results for quite a while, but then the magic ended.

On the other hand. Graham is (well, was, RIP) well respected, his methodology is sound, published in advance, and has a long track record. If I were going to take a small portion of the portfolio out for a testosterone-induced adventure, this is probably the route I'd go.

[Ed_The_Gypsy]

Quote:

Originally Posted by MasterBlaster Is this the flavor of the month ? The "stingy" rules point to stocks that are good values yet are growing at a nice pace. Isn't that what everyone wants ? Do stocks like that actually exist ?

A few, it seems. Sometimes.

Quote:

Originally Posted by MasterBlaster It goes without saying that a portfolio consisting of these linked stocks are higher risk/reward. How does this model test out over the last 80 years or so ?

Good question. Ben Graham seemed to like it.

Thanks, MB! I was fishing for feedback.

Anyone else? Has anyone else experience with a Ben Graham approach? Would you consider a small adventure in individual stocks by this method? Not considering betting the farm on this.

[Animorph]

I didn't see the sell criterion listed. Sell at the end of the year? That doesn't sound very Graham like. What did the back testing assume?

[John Galt]

Quote:

Originally Posted by Animorph I didn't see the sell criterion listed. Sell at the end of the year? That doesn't sound very Graham like. What did the back testing assume?

Here is the criteria

TABLE 2: GRAHAM-INSPIRED RULES
1. P/E Ratio less than 15
2. P/Book Ratio less than 1.5
3. Book Value more than 0.01
4. Current Ratio more than 2
5. Annual EPS Growth (5-Yr Avg) more than 3%
6. 5-Year Dividend Growth more than 0%
7. 5-Year P/E Low more than 0.01
8. 1-Year Revenue more than $400 Million



Warren Buffet said this about Benjamin Graham in the preface to The Intelligent Investor,

"To me, Ben Graham was far more than an author or teacher. More than any other man except my father, he influenced my life."

But even if you think The Oracle's 40 year history of 20+% annual growth with Berkshire Hathaway isn't enough proof of long term results, know that Ben Graham ran an open-end mutual fund call Graham-Newman Corp. from 1936 to 1956 which returned 14.7% annually versus 12.2% for the stock market as a whole.

[kumquat]

Well Ed, are you taking a Graham approach or just following Norm Rothery?

Not that Norm is doing too bad, just checking. "Everybody" claims to follow some methodology. Norm tries to follow Graham's. He seems to have done well lately. Can he keep it up and do you want to invest in (mostly) Canadian stocks? Yes, I know, Norm does the US too, but I think he is mostly aimed at Canada.

I have a small percentage of our portfolio following Norm. However, I'm a Canuck so there is a smaller FX risk. Do what feels good, but YMMV.

[ERD50]

Quote:

Originally Posted by John Galt Here is the criteria TABLE 2: GRAHAM-INSPIRED RULES 1. P/E Ratio less than 15 2. P/Book Ratio less than 1.5 3. Book Value more than 0.01 4. Current Ratio more than 2 5. Annual EPS Growth (5-Yr Avg) more than 3% 6. 5-Year Dividend Growth more than 0% 7. 5-Year P/E Low more than 0.01 8. 1-Year Revenue more than $400 Million

I am skeptical that something like this could provide an advantage in the long run. Maybe it did once upon a time. But that is a pretty concise list, and these days computers can identify the stocks that meet those criteria, and scoop them up in a fraction of a second. Then there aren't any, and that buying has driven their price out of those criteria (or has lessened the advantage to near zero).

And if the criteria worked, I'm sure there would be a number of mutual funds devoted to the system, and that would have the volume to dry up the benefit.

The following is not scientific at all, but I've bought stocks in the past that probably met most of those criteria. They crashed and burned. I learned that were underlying reasons that their P/E ratio was less than 15, etc, etc. So it wasn't undervalued at all, the value reflected what the market determined, and the market was right (more or less). None of those criteria tell us if the company has a product pipeline that has peaked and dried up, with no future 'hits' (or they have a string of 'hits' in the pipeline), or a management change is being made (positive or negative), or a competitor is about to clean their clock (or become less competitive).

My observation is that it isn't enough to identify some factors that indicate a good investment. Because others will identify that, and the stock will reach a level that reflects that. I think one needs to find a stock that one thinks is mis-understood by the market, and invest appropriately (short or long). But that means you think you know something that the market doesn't. But if they don't recognize the value now, can you wait long enough for them to turn around?

-ERD50

[Ed_The_Gypsy]

Animorph, it appears that one sells out every year. No, that does not sound like Graham. And it is chasing capital gains, while I am more interested in dividends these days.

kumquat, apparently Graham published more than one method. Here is an excerpt from a 2008 article in RealMoney.com by Tim Melvin:

Quote:

Another chapter contained comments Graham made to the Medical Economist in 1976. Graham told the interviewer that he had been testing a method for selecting cheap stocks that had a margin of safety as well as potential for gains. Apparently, Graham had a lot of time on his hands in retirement, as he had tested these methods over 20 years and found they doubled the market return. I did a quick and dirty backtest today and found similar results for the past 20 years. The method was simple: He wanted an earnings yield twice that of the AAA bond but never more than 10 times earnings. As a financial test, the company should own twice what it owes. With AAA bond yields around 5.5%, this equates to a max P/E ratio of 9 times earnings. After adding the equity and debt constraints I found 205 stocks that fit the criteria.

(Sorry, I can't find the link anymore.)

[Ed_The_Gypsy]

ERD50, excellent point.

I recall now that John Dorfman, of Robot Stocks fame, advocated looking closely at each stock produced by his screen. Mechanical screens should not be followed blindly.

[Ed_The_Gypsy]

One point is, could I do better than MUTHX? I have already, in my own IRA. I guess the real question is, what do I replace Mutual Shares with? That needs to be done regardless.

[Gone4Good]

Quote:

Originally Posted by ERD50 I learned that were underlying reasons that their P/E ratio was less than 15, etc, etc. So it wasn't undervalued at all

Funny how that works.

To know whether a "value" stock is a true value, you actually have to understand why its priced the way it is. And you have to have an appreciation for what expectations are built into that price. Because in the end, it will only prove to be a "value" if those expectations end up being too pesimistic. So you also have to know why the market is getting the story wrong.

That is not a job for a part-time stock picker.

[Hamlet]

It can be a job for a part-time stock picker if it is only a small portion of your assets and you focus on a few companies you know well.

I have a dozen companies or so that I follow pretty closely, and every once in a while the market makes a pretty big mistake with them.

A couple of examples--

McDonald's was priced like they were done for in 2002 and 2003. I've worked for the company, and been a customer my whole life. Their franchise is about as close to unbreakable as they come (although they certainly did their best in 2002 and 2003). My shares have more than tripled since I bought them.

Berkshire Hathaway was priced very low during the height of the tech boom. I bought my first class B share during that time, and it is 4 times the price today that it was then. Berkshire was also pretty cheap for the week or so after 9/11. People initially got scared because they were going to have to pay out a couple billion in insurance claims. What they didn't realize is that Berkshire was going to benefit from much stronger insurance pricing going forward. It took the market a couple weeks to figure that out, but I was able to add to my position at very reasonable prices in the meantime.

Likewise, after 9/11, Intimate Brands (Victoria's secret) became very cheap for completely unexplained reasons. I bought them at 9 times earnings. I had doubts that the terrorists were going to prevent women from buying fancy underwear. They doubled within the year, and I sold after The Limited decided to re-aquire them. The Limited eventually spun off most of the crappy stores and became mostly Victoria's Secret. They got cheap again during the financial crisis. Once again, I suspected that women would still buy fancy underwear, and the stock when from 10 to 19 in less than a year.

As a part-timer, I don't find enough mistakes in the market to invest all of my money, but I do find the occasional mistake.

Note-- I also find "mistakes" where the market was right and I was horribly wrong, so I won't quit my day job or put the bulk of my money into stuff like this. A big chunk of my money is invested in large cap stocks that as a group perform very much like the S&P500 (go figure). The rest is in mutual funds that spread my allocation into the other equity asset classes (small cap, foreign, etc.).

Quote:

Originally Posted by . . . Yrs to Go Funny how that works. To know whether a "value" stock is a true value, you actually have to understand why its priced the way it is. And you have to have an appreciation for what expectations are built into that price. Because in the end, it will only prove to be a "value" if those expectations end up being too pesimistic. So you also have to know why the market is getting the story wrong. That is not a job for a part-time stock picker.

[ERD50]

Quote:

Originally Posted by Hamlet As a part-timer, I don't find enough mistakes in the market to invest all of my money, but I do find the occasional mistake.

Good examples. I agree with you that it appears that the market over-reacts from time to time (I have no scientific/statistical basis for this), and those can be opportunities for the small investor.

I don't have much faith/confidence (or maybe just dwindling risk-tolerance with age) in *my* ability to identify those (and that is not a comment/judgment on others ability), and it's tough to benchmark yourself with a few individual stocks. These days, something really has to be screaming at me to get my interest, and even then, my bet is low enough to not make much material difference either way.

While the numbers can help you evaluate the risk, it seems to be more of a judgment on the market psychology, a bit of gut feel - pretty hard to quantify. But if you can do it and be right more than you are wrong, well there ya' go!

I wouldn't be surprised if there are computers chomping away this very microsecond, trying to identify 'emotional' over-reactions in the market that they can take advantage of

I recall that I read years ago, that the one strategy that held up over time was buying out-of-favor stocks. The idea there too was that the market over-reacted. People tended to dump their losers, there was little expectation for the out-of-favor stock to return to their former glory, so if/when it did, the rise brought higher than average gains. The 'herd mentality' of investors is to buy winners, and they felt this would always be a factor, effectively over-valuing good performing companies, and under-valuing poor performers. Are there enough of these for a mutual fund to identify, invest in and maintain diversification, and not move the market with the buys? Maybe not. And what would you call the fund, the "Crappy Company Fund", or "The Stocks no one wants Fund", " "Other Peoples Trash Fund"? So the conundrum (as their reasoning goes) continues to exists.

But it is certainly more exciting than indexes!

-ERD50

[haha]

Quote:

Originally Posted by ERD50 I recall that I read years ago, that the one strategy that held up over time was buying out-of-favor stocks. The idea there too was that the market over-reacted. People tended to dump their losers, there was little expectation for the out-of-favor stock to return to their former glory, so if/when it did, the rise brought higher than average gains. The 'herd mentality' of investors is to buy winners, and they felt this would always be a factor, effectively over-valuing good performing companies, and under-valuing poor performers. Are there enough of these for a mutual fund to identify, invest in and maintain diversification, and not move the market with the buys? Maybe not. And what would you call the fund, the "Crappy Company Fund", or "The Stocks no one wants Fund", " "Other Peoples Trash Fund"? So the conundrum (as their reasoning goes) continues to exists. But it is certainly more exciting than indexes! -ERD50

This is a pretty good strategy, but it feels bad and I imagine that a mutual fund following this might not become very large because there necessarily will be long periods of underperformance and people like to sell that type of fund. Also, the when a real stress hits the market and stays for a while, you look at these dogs and ask yourself-"What was I thinking"

Ha

[Nords]

Quote:

Originally Posted by Ed_The_Gypsy I am rethinking my investment approach. Up to now, I have been a slice-and-dicer mostly with index funds. This ( Stingy Investor: 8 Graham Stocks for 2010 ) modified Ben Graham approach for picking individual stocks has produced an annualized +11.9% over the past 5 years I have been comfortable with my IRA. It is well diversified and seems to work pretty well. I am not inclined to change what I am doing here...yet. However, I am thinking of taking charge of DW's Roth, dumping MUTHX and trying my hand at Ben Graham's approach. The track record over the past 10 years is pretty good relative to the S&P 500.

Ed, are you not working hard enough yet?

What you're proposing is a plan to devote considerable more effort to your investment plans than you've heretofore had to exert. Your first challenge is to screen for the companies, followed by getting to know them, followed by determining an entry point, accompanied by perpetual monitoring, followed by determining when to part ways with them. In the hopes of earning more profits than most people have made during the century's two worst recessions (so far). Everyone's a genius in a rising market-- the time to truly acid-test your ideas (and to live with their results) would have been 2007-2009.

And even more courageously, you're considering doing this with spouse's IRA instead of your own. You could quietly experiment with your own portfolio and selectively lie boast about your successes while ignoring your not-yet-successes. But no, you're going to compound the challenge by subjecting yourself to the harsh lights and withering reviews of a spouse audit.

Keep in mind that Ben Graham lived & breathed this stuff in academia, including spending a couple hours a day in classrooms jawboning his ideas with guys like Buffett-- and Schloss and Ruane and most of a Valhalla of 20th-century value investors. Buffett has spent hours a day (and evenings and weekends) for over 60 years reading newspapers and trade publications and company SEC filings. He's not skimming the Yahoo! stock quotes and running a few screens. He and Graham and the rest of them spend/spent 99% of their time jogging in place so that they're able to move fast when the world goes to hell 1% opportunities rise. Looks easy in the retrospective biographies and media interviews, but it's not easily done.

OTOH I, like you, have always looked upon these apparently rational investing concepts and wondered whether I'm good enough to make it work. The answer has turned out to be "Yep, pretty good" but it's... a lot of work. On top of your day job.

So if you're going to spend the rest of your life wondering "What if?" then you should limit the damage do this with 10-15% of your portfolio. Take a year or even two years to get to know your companies while waiting for their inevitable short-term stumbles into value territory. Get cheap and haggle with limit orders. After you buy, instead of selling on the calendar you should figure when the holding is getting fully priced. When your gains start to overtake your margin of safety then you should mechanically (and unemotionally) take some profits off the table by brutally executing a few sell orders. Or at least sell some covered-call options.

I'm surprised that UncleMick hasn't checked in yet with his comment about testosterone poisoning. This is the only treatment, although I'm not sure there's a cure.

Quote:

Originally Posted by Ed_The_Gypsy Warren Buffet only produced +6.5% per annum over the same 5 year period. (I would have checked back 10 years but I only have access to my Vanguard on-line stuff.) Is Berkshire Hathaway too big now?

Quote:

Originally Posted by Ed_The_Gypsy Anyone else? Has anyone else experience with a Ben Graham approach? Would you consider a small adventure in individual stocks by this method? Not considering betting the farm on this.

Buffett would castigate a five-year shareholder as a short-term dirty market timer.

Is Berkshire too big? Compared to what... Phillip Morris Altria and Exxon?

It's too big to garner the eye-popping returns you're seeking. However it's quite capable of allowing sleep-at-night security with index-beating recession-proofing returns and an occasional double-digit year. It also doesn't have to contend with high management fees, fund bloat, and excessive turnover. Better still it has a great board (which will preserve the company's spirit long after Buffett's departure), it's riding a nice long-term wave from the share split and the S&P500, and when Buffett is out of the picture it has the prospect of paying a good dividend.

"Knowledgeable investors" and "credible analysts" (there's a couple oxymorons) feel that the company is no longer selling at blue-light special values, but it's also not yet fairly valued. I plan to do a little rebalancing at $85/share and some real partying hard looks at $90/share. I would feel uncomfortable owning it at over $100/share without at least buying some put options.

As for individual stocks, a Ben Graham approach is probably the least dangerous method of screening. Take your time, don't feel rushed to buy, and keep up at least 5-10 hours a week of research/monitoring. If you feel that's too much effort (or just too hard to do) then you're not doing it right. There's a reason that so many people are index-fund investors.

Quote:

Originally Posted by Ed_The_Gypsy One point is, could I do better than MUTHX? I have already, in my own IRA. I guess the real question is, what do I replace Mutual Shares with? That needs to be done regardless.

Cheaper mutual shares, or cheaper exchange-traded fund shares in major indexes?

You might find some happy hunting grounds among the stocks in the Dogs of the Dow, the Dow Dividend Achievers ETF (DVY) and the S&P600 Small-cap Value ETF (IJS). Note that many of them are sold by "value investors" when their rising stock prices cause their dividends to decline from 5% to around 2-3%.

[Hamlet]

Yeah, I have to admit that there hasn't been much point to my dabbling in individual stocks.

For every couple of "brilliant" investments I make, there is one that is a disaster, which pretty much makes index funds a better choice with less hassle.

I agree that the numbers are only a small piece of it. The "numbers" had me investing in MCI-WorldCom at the end. The "numbers" were cooked, and in hindsight that should have been obvious.

More important that the numbers is an evaluation of the moat of the business and the quality of management. That is always going to be a fuzzy calculation.

Quote:

Originally Posted by ERD50 Good examples. I agree with you that it appears that the market over-reacts from time to time (I have no scientific/statistical basis for this), and those can be opportunities for the small investor. I don't have much faith/confidence (or maybe just dwindling risk-tolerance with age) in *my* ability to identify those (and that is not a comment/judgment on others ability), and it's tough to benchmark yourself with a few individual stocks. These days, something really has to be screaming at me to get my interest, and even then, my bet is low enough to not make much material difference either way. While the numbers can help you evaluate the risk, it seems to be more of a judgment on the market psychology, a bit of gut feel - pretty hard to quantify. But if you can do it and be right more than you are wrong, well there ya' go! I wouldn't be surprised if there are computers chomping away this very microsecond, trying to identify 'emotional' over-reactions in the market that they can take advantage of I recall that I read years ago, that the one strategy that held up over time was buying out-of-favor stocks. The idea there too was that the market over-reacted. People tended to dump their losers, there was little expectation for the out-of-favor stock to return to their former glory, so if/when it did, the rise brought higher than average gains. The 'herd mentality' of investors is to buy winners, and they felt this would always be a factor, effectively over-valuing good performing companies, and under-valuing poor performers. Are there enough of these for a mutual fund to identify, invest in and maintain diversification, and not move the market with the buys? Maybe not. And what would you call the fund, the "Crappy Company Fund", or "The Stocks no one wants Fund", " "Other Peoples Trash Fund"? So the conundrum (as their reasoning goes) continues to exists. But it is certainly more exciting than indexes! -ERD50

[Ed_The_Gypsy]

Say, this one produced some sparks, eh? I was getting bored with some of the non-financial threads.

First off, MUTHX is a dog. It has to be replaced. "With what?" is the question.

This is only one option I was looking at. Actually, I am considering the IJS ETF as a replacement. I should have long ago. IJS has a similar 10-year performance to BRK-B. It is an unmanaged index AND it actually pays a dividend.

This Roth is less than 5% of our stash, by the way.

And, I still have my BRK-B shares, which have seriously outperformed MUTHX over 10 years.

Quote:

...On top of your day job.

Funny you should couch it that way, Nords. As it happens, I am without a day job at the moment. Forced retirement may be here. That is why I had time to eyeball this stuff in the first place.

Quote:

Ed, are you not working hard enough yet?

Excellent point, hermanito! You know my weakness. As I am fundamentally lazy and unsuited for honest labor, I will look at BRK-B or IJS as a replacement.

I think I will just play with Ben Graham on paper for a few years.

[Nords]

Quote:

Originally Posted by Ed_The_Gypsy As it happens, I am without a day job at the moment. Forced retirement may be here.

Congratulations?

[kcowan]

As a Canuck, I am considering the Norm Rothery approach. He publishes his picks in November and you are expected to do rebalancing then and every subsequent November. So it is a bunch of trades once a year. I will not bet the farm on it but it seems to be worth a 10% allocation.