Graham’s 50 Year Study – Foolproof?

by The Graham Investor on January 3, 2010

In 1976, Hartman L. Butler spent an hour with Benjamin Graham and the interview is recorded within a fine study of Graham’s life published by The Financial Analysts Research Foundation. During the interview, Graham describes buying groups of stocks that meet some simple criterion for being undervalued, regardless of the industry and without detailed investigation of the individual company. This was anathema to his earlier method – as described in Security Analysis – of going through each stock with a fine-tooth analytical comb.

In the interview Graham mentions an article on three simple methods applied to selecting common stocks which was published in a 1975 seminar proceedings. In connection with this statement, he also mentions a 50 year study he had just completed:

“I am just finishing a 50-year study–the application of these simple methods to groups of stocks, actually, to all the stocks in the Moody’s Industrial Stock Group. I found the results were very good for 50 years. They certainly did twice as well as the Dow Jones. And so my enthusiasm has been transferred from the selective to the group approach.”

… “Imagine–there seems to be practically a foolproof way of getting good results out of common stock investment with a minimum of work. It seems too good to be true. But all I can tell you after 60 years of experience, it seems to stand up under any of the tests that I would make up. I would try to get other people to criticize it.”

Basically the three simple methods (tested separately) were:

1) Look for stocks with Earnings Yield, i.e. E/P twice the prevailing AAA Corporate Bond interest yield (albeit limiting P/E no greater than 10, and no lower than 7, regardless of the bond rate).

2) Look for stocks making a low around 50% of their two year high.

3) Price at two-thirds of book value.

In the article, Graham tabulates the results for all three methods; each method beats the index by a considerable margin, with the P/E method being the best, the 2-year low being second-best.

I found it interesting to read about the 2-year high/low study, because I have previously mentioned the need to pick stocks from the screen that are well off their previous highs – so we know there is sufficient upside potential to make a serious profit. In other words, if a stock on the screen is at $2, but only ever got as high as $2.50 in its history, it would not apparently have as much upside potential as a similarly-priced stock that once hit $10. It would seem from reading these studies that Graham himseld also found this to be true and allowed himself room for at least a 50% return.

It’s also important to remember that in this study, Graham was advising the purchase of a basket of around 30 stocks matching any one criteria of undervaluation, e.g. 2/3 of book. He even went so far as to say “You can’t lose when you do that.” His experience proved that buying a stock at such a criteria was a dependable indication of group undervaluation.

{ 26 comments… read them below or add one }

1 Chris Grimes January 5, 2010 at 9:30 pm

Actually, when you say “allowed himself room for at least a 50% return,” if you buy a stock at 50% and then it returns to it’s normal level, you’ve actually doubled your money. This is a rather major detail, in my opinion, as 50% to 100% is a big difference.

Sorry to drown you in semantics. I think the concept is interesting to say the least.

2 The Graham Investor January 5, 2010 at 9:39 pm

That’s true, Chris….but only if it returns to its normal level. The text says he looked for at least a 50% return: “The target profit in all cases was fifty percent above cost, to be attained within two years.”

3 Wide Moat January 23, 2010 at 10:10 pm

Hi, great blog here and good work. Just one typo… P/E should be E/P, expressed as a percentage. That is, for Graham, never buy a E/P less than 10%, but at least an E/P double the bond rate.

4 The Graham Investor January 24, 2010 at 3:58 pm

Thanks a lot for pointing that out! I’ve updated the post.

5 Jim Allen February 7, 2010 at 6:09 pm

That is a very valuable article. Thanks for providing it here. Graham’s conclusions hgave considerable support in the studies since which are mentioned in the Tweedy Brown piece, “What Has Worked In Investing” available in various places online.

6 The Graham Investor February 7, 2010 at 7:14 pm

Jim: many thanks for reminding me of the Tweedy Browne piece which is a very good read and which I would recommend our visitors read. Here is the link to it: Tweedy Browne: What Has Worked In Investing

7 Christian Troche April 17, 2010 at 11:56 pm

Regarding method #3, Graham and James Rea (Graham’s partner in conducting the referenced studies) made it clear that price should be measured against TANGIBLE book value (i.e. book value after removing goodwill and intangible assets from the calculation). This is an important distinction, as Graham analysed balance sheets on a liquidation basis, and, to my knowledge, he assigned no value to goodwill or intangibles in a liquidation scenario.

The Yahoo! Finance site conveniently provides a current snapshot (from the EDGAR database) of any company’s tangible book value or “net tangible assets” within the Financials/Balance Sheet link.

8 Kyle Laracey April 18, 2010 at 9:26 am

A great article, but just one question — does the Corp Bond AAA rate apply to a 5yr corp bond, 20 yr? I don’t think Graham specified in the Intelligent Investor (although I don’t quite remember).

Thanks a lot!
Kyle Laracey

9 The Graham Investor April 18, 2010 at 3:34 pm

Definitely the 20 Year.

10 Christian Troche April 19, 2010 at 6:37 am

The St. Louis Fed has tracked the Moody’s Aaa Corporate Bond yield back to January 1919. The current yield (as of March 2010) is 5.27%.

The data series may be found at http://research.stlouisfed.org/fred2/series/AAA

11 Frank Hayes May 12, 2010 at 2:58 am

How can I go about searching for stocks that fit these criteria? Thank you for sharing.

12 Manish May 24, 2010 at 1:11 pm

Although I think it is kind of unnecessary (as it is late to reply), but still I would like to add my points in response to Chris’s suggestions/questions about “allowed himself room for at least a 50% return,”.

I think that 50% appreciation is not for the price and price does not represent the true value. That 50% appreciation of the price is regarding the tangible book value of the stock, as Graham believed that after some point the stock will follow/match its book value (efficient markets concept). With price at 67% of the book value, the appreciation potential is 50% from there to reach the book value assuming there is no degradation in the book value of the stock.

Manish

13 Jeremy May 31, 2010 at 11:16 am

Would number 1 mean ‘at least’ twice the aaa yield?

14 Preston June 14, 2010 at 1:21 pm

Two questions:
1) In Graham’s article his target profit was 50% above cost: so even if the stock jumps 15% in 2 months, that would be an annualized rate of return of 90%, so what he’s saying is I would still hold on to it until it reached 50% of it’s cost (ex. $6 dollar stock sell at $9) correct?
2) I guess I’m still a little worried about the 2 year strategy ending on a bear market–in that case would you continue on and sell your stocks at the target holding perior and then buy your next 2 yr stocks and eat the loss or would you hold onto them and wait for them to go back up since it ended in a bear market?

Any answers would be great. thanks.

15 Christian Troche July 8, 2010 at 11:38 pm

Regarding Jeremy’s question (above), the answer is yes. Graham sought an earnings yield (the inverse of the P/E) at least twice the current AAA-corporate long bond yield. (See http://research.stlouisfed.org/fred2/series/AAA for the current yield.) The current yield is 4.96%, so an intelligent investor should currently seek an earnings yield of at least 9.92% (that translates to a P/E multiple of 10).

Recall, however, Graham ALWAYS sought a margin of safety. Problems can arise when screening for low P/E stocks, as current earnings (i.e. trailing four quarters) can be distorted by recent events (e.g. spiking commodity prices, introduction of a “hot” new product, one-time asset sales, etc.).

Graham suggested investors use a moving average of earnings (i.e. 5-, 7-, or even 10-years) under the current price to smooth out the cyclical earnings volatility experienced by many businesses. James Montier (formerly of SocGen, now at GMO) has written about this metric, referring to it as the “Graham and Dodd P/E.” It is also the same technique Robert Shiller of Yale uses to value the S&P 500, after adjusting for inflation.

16 Christian Troche July 9, 2010 at 12:53 am

Answers for Preston (see comment above):
1) Graham sought a 50% return on price. He did not mention annualizing returns, nor did he consider dividends received in his return objectives. (I believe he saw dividend yields more as a measure of value than as a component of return). His stated selling targets of either (a) a 50% increase above cost or (b) completion of a two-year holding period was his way of enforcing intelligent investing behavior.

Fifty percent was not an arbitrary number, but the logical result of Graham’s value discipline when buying stocks. For example, if a company’s tangible book value was $9/share, Graham would consider buying shares at $6, or 2/3 of the book value. Not only would $6/share provide a sufficient margin of safety between price and value, but a 50% increase in price from $6 would bring the stock price to the $9 tangible book value. Selling the shares at $9 would not only be logical (obtaining fair value for what was purchased at a discount, i.e. tangible assets), but enforces a value discipline, as the margin of safety that once existed in the stock price has disappeared.

(2) Regarding your second question, I’m not sure Graham answered that question specifically, but his many writings, lectures, interviews, etc. provide helpful clues. First, a value investing strategy should be pursued at all times except when the broad market valuation is “dangerously high” (Graham’s term). During those periods, intelligent investors should be content with a cash position until the overvaluation is corrected.

Second, Graham would have likely approved an investor committing funds over an extended period of time, perhaps several quarters. (Joel Greenblatt, a noted value investor, endorses this strategy in his “magic formula” concept.) This way, various groups of stocks “mature” at different points in the market cycle. Of course, the 50% selling discipline forces an investor out of stocks in a rising market, and the margin of safety concept doesn’t allow reinvestment of funds until values are available.

(Note: in a taxable account, selling into a bear market can create “assets” for the investor in the form of tax-losses that can be used to offset capital gains taxes for both current-year and future gains, and new investment opportunities should be readily available.)

In the end, regardless of bull or bear market, taxable or qualified account, the 2-year selling discipline should still be enforced, because if a catalyst for a higher stock price hasn’t materialized within two years, it is reasonable to assume better opportunities exist for the intelligent investor.

17 Jim Allen September 26, 2010 at 6:41 pm

Perhaps one way to judge if the market is “dangerously high” would be that there is a dearth of opportunities to acquire issues at a price that affords good value with an adequate margin of safety.

I am wary of applying a test, such as 2/3rds tangible book value” mechanically. A few years back, I came across one stock that was selling for less than net cash per share. I was elated! But when we went in to check it out, the company had never made a dime in any year of its existence, and was burning through the cash until it did. It had yet to demonstrate, let alone prove, it was a viable business.

I am a firm believer in getting your hands dirty in annual reports, with all footnotes, for as many years back as one can stand, and not relying on summaries, compilations, or databases. You can never be sure when the database has been corrupted through blunder, or misunderstanding between the compiler and you. Blundering into some Enron-type bogus accounting mess by applying tests mechanically, without verifying your figures rigorously would be disastrous.

18 Gene October 23, 2010 at 12:10 pm

Good work! Is there a way to update the Piotroski screen, now? Thanks.

19 Luis Castillo October 25, 2010 at 2:44 pm

Great Article!!

Regarding the Graham’s three methods (the earning yield, the 2/3 of price/book and the 2 years 50% of the high price). Did Graham or anyone around him test the three methods together? I mean, screening the whole stock market with the 3 criterials at the same time. I did it, and by today october 25th , MTU reached the 3 criterial: EY= 9.10%, price/book= 0.646 and the current price is $4.71 the 50% is $7.065 ( high on october 24 of 2008 was around $ 7.04).

Even though, ROE is low (5.82%), no insiders nor institutions have investment there. I would like to know, what you think putting together the 3 criterial.

Luis

20 Thomas Tenentka January 11, 2012 at 4:32 am

Hi Investorfriends,

I´ve purchased on the 02 nd and 3 th february last year (2011) 10 net nets from your screener
and I will represent the results next month.
Best regards from Germany

21 The Graham Investor January 12, 2012 at 4:17 pm

Look forward to that, Thomas.

22 Adrian May 9, 2012 at 5:38 am

Has anyone else noticed these beaten down Chinese stocks are way too undervalued? The “China RTO” has been the focus of short seller hit pieces in recent times, and as far as I can tell only one or two have actually been convicted of any wrongdoings. A lot of them are now selling under their NNCA because of the fear that has been spread. Some are trading for ridiculous PE ratios, EDS for example, a real business, trading at less than NNCA and a PE of less than one. What’s going on here? What am I missing?

23 The Graham Investor May 13, 2012 at 4:00 pm

I have no idea what’s going on with these, but one thing is for sure – I don’t like them showing up on the screen. At the moment I’m trying to figure out how to filter them out – most likely it will need to be by address. Best advice would be to leave these well alone.

24 Adrian May 13, 2012 at 7:01 pm

Any reason in particular you want to avoid them? I used your screener to buy four of these stocks and after just a couple of months they have become very profitable. I believe they are the best value stocks on here. From what I can tell they were sold off mainly because they were listed using RTO (reverse take-over). This is a totally legit way to get listed. Berkshire-Hathaway and others were RTO.

25 The Graham Investor May 14, 2012 at 5:46 pm

I just find Chinese penny stocks a little scary because many of them have little or no corporate governance and often fail to file financial reports by deadlines. More power to you if you find them profitable, though!

26 Ryan Chandler February 21, 2013 at 11:18 pm

I think you have #1 slightly off. When the AAA rate is than 10. When AAA rate are > 7%, Graham advocates a maximum P/E of 7. You’re basically saying that Graham advocated not buying stocks that were selling for < 7x earnings, which I don't think is accurate.

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