Mark Hulbert's column in Barron's
WOULD BEN GRAHAM'S famous value-stock investment strategy have protected you in the bear market that began 18 months ago?
The surprising answer, I have found, is "yes." And that's remarkable, since virtually all of the most popular stock-picking strategies, including those that ostensibly fit into the category of "value investing," lost nearly as much as the overall averages during the recent bear market -- if not more.
Ironically, however, few investors actually benefitted from the protection that Graham's strategy could have afforded. His approach fell out of favor several decades ago, when the bull market of the 1980s and 1990s further and further divorced stock prices from fundamental value.
One of the ancillary benefits of the recent bear market, therefore, may be to reacquaint investors with the advantages of paying attention to value.
That would represent a fitting 75th anniversary present to the value school of investing. Back in 1934, Graham (along with David Dodd) wrote what has become the definitive textbook on value investing -- Security Analysis, now in its sixth edition. In fact, this book not only ushered in value investing, it provided the blueprint for fundamental analysis of stocks.
Perhaps not surprisingly, given that Graham developed his approach to investing during the Great Depression, his definition of value was very strict. Instead of defining value in relative terms, as do most value managers today, Graham defined it in absolute terms. That in turn meant that there would be times when few, if any, securities were considered to represent genuine value.
It took exceptional discipline to adhere to Graham's approach in a bull market that was causing stock prices to soar into the stratosphere, and few value managers possessed it. As their clients left them in droves, many value managers chose instead to define value in relative terms: So long as a stock's price-to-earnings or price-to-book ratios were lower than that of most other stocks, a stock satisfied this modern, more liberal definition of value.
That approach may have afforded value managers the possibility of participating in the bull market. But it left them vulnerable as never before to the downside.
Consider two hypothetical portfolios, one of growth stocks and the other of value stocks, constructed by Eugene Fama and Kenneth French, finance professors at the University of Chicago and Dartmouth College.
The value portfolio contained the approximately 30% of stocks with the lowest price-to-book ratios, while the growth portfolio contained the 30% of stocks with the highest such ratios. At the bear-market low earlier this year, the value portfolio was 57% below its peak in the fall of 2007, while the growth portfolio was "just" 42% below.
If value is not defined in relative terms, then how can it be defined? Graham employed a number of criteria, but his primary one was to compare a company's stock price to its net current assets per share. (Net current assets are total current assets minus total current liabilities, long-term debt and the redemption value of preferred stock.) Graham believed that a stock should be bought only if it was trading for less than two-thirds of its per share net current assets.
At the depths of the Great Depression, hundreds of stocks on the New York Stock Exchange satisfied this demanding criterion. That number fell in subsequent decades, however. By the late 1980s and 1990s, there were many occasions in which not one common stock on the NYSE was able to satisfy it. An adviser who stayed true to Graham's criteria, therefore, would have had no choice but to build up an increasingly large cash position in his portfolio.
To those who think that this would have hopelessly handicapped long-term performance, consider the model portfolio contained by Growth Stock Outlook, a newsletter edited for the last 44 years by Charles Allmon. Though Allmon has not purely adhered to Graham's definition of value, he has come closer over the years than any of the other newsletter editors that the Hulbert Financial Digest (HFD) monitors.
Allmon in fact claims almost apostolic succession from Graham, according to Peter Brimelow, in his book on the investment newsletter industry titled The Wall Street Gurus (Random House, 1986). Brimelow quotes Allmon as saying: "'Graham called me on the phone, as I recall in 1969, maybe 1970. He said, 'I've got a copy of your Growth Stock Outlook, and I've been very intrigued by what you're doing here. How are you spotting these values?' I said, 'Mr., Graham, I'm taking a lot of your own criteria and trying to crank in my own for value relative to growth potential.' And he said, 'Well, it's a very intriguing idea. I think if I were young again, that might be the course I would take. It sort of speeds things up a bit'."
True to Graham's legacy, Allmon began building up a large cash position in 1986. With no more than one or two exceptions since then, his model portfolio has been more than 80% cash. Thanks in no small part to the recent bear market, Allmon's newsletter is now in first place for risk-adjusted performance among all HFD-monitored newsletters since 1980, when the HFD began monitoring the newsletter.
What would Graham be advocating now? You might think that he would be increasing his equity exposure, since the number of stocks selling for less than two-thirds of per-share net current assets is starting to grow. But Allmon, at least, remains firmly in the bearish camp, continuing to recommend that subscribers have more than 80% of their equity portfolios in cash.
He wrote recently that "our country appears to be on the brink of the biggest financial firestorm in our 220-year history." Expressing little confidence that the government will get us out of this mess, he adds that "the trick now is to avoid being scalded in a sea of nonsense."
Of the three stocks that Allmon's newsletter portfolio currently owns, the biggest holding is Newmont Mining Corporation (ticker: NEM); he is forecasting "5% to 15% U.S. inflation," which will in turn lead gold bullion to trade over $1,800 an ounce.
The two other stocks that his model portfolio owns are Altria Group (MO) and Philip Morris International (PM).
We can only wonder whether Graham would have approved.
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[This is interesting to me as I have that book The Wall Street Gurus and used to own Allmon's fund until it became Liberty All-Star back in ... 1995.]