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Author: StarryNightShade Big red star, 1000 posts Old School Fool Home Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 46842  
Subject: Selecting stocks the Ben Graham way Date: 12/7/2004 7:52 PM
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[This is a duplicate of a post made on the 'IV Value Central' board.]

Some time ago (May 2003 to be more precise) I tried to apply Ben Graham's principles to create a couple of stock portfolios, one for the “conservative” investor and one for the “aggressive or enterprising” investor. [Note that the term “investor” implies that the “aggressive investor” was still considered by Ben Graham an investor and not a speculator.]

Over a series of several posts I assessed results of stock screens to identify qualifying stocks to create two portfolios of 5 stocks each. Regrettably at that time I could not find more than that number of stocks without duplicating industries within a portfolio (or stocks across the two portfolios). This is substantially less than the 20 stocks that Ben Graham recommended for a diversified portfolio. Nevertheless fools do rush in….which is exactly what Ben was trying to prevent I guess.

The following post was the conclusion of the series:

http://boards.fool.com/Message.asp?mid=19395220

But just to save you the effort of wading through those posts, I'll summarize below:

Conservative Portfolio

Ben Graham's criteria for the conservative portfolio are:

1. An Adequate Size
For Industrials - more than $500 million in sales
For Utilities - more than $250 million in assets

2. A Strong Financial Condition
For Industrials - Current Assets more than 2 X Current Liabilities
Long Term Debt less than net working capital (i.e. Current Assets less Current Liabilities)
For Utilities - Total Debt less than 2 X the Book Value of TANGIBLE Equity

3. Good Earnings - positive in each of the last 10 years

4. Dividends - a continuous record of paying dividends in each of the last 20 years

5. Growth - an increase of at least one-third (+33%) of the most recent three year average compared to the three year average 10 years ago (i.e. the earnings for 1999-2002 are 1/3 more than the earnings for 1989-1992)

6. Good Value in terms of earnings yield - the current price is less 15 times the AVERAGE EPS for the LAST THREE YEARS (i.e. Price-earnings or PE ratio < 15). There is a potential modification to this as in one corner of his book Ben Graham inverts the PE to produce the earnings yield in percentage and compares it to the long term US Bond yields. So to allow some leeway here I relaxed this criteria so that the average earnings yield would be less than the average long term bond yield, which results in a modified criterion of 17 instead of 15.

7. Good Value in terms of book value - the current price is less than 1.5 times the current tangible book value (i.e. equity less goodwill and other intangibles). (i.e. the price-book or PB ratio < 1.5). This criterion can be modified if the PE ratio is less than 15 (i.e. the PB can exceed 1.5 if the product of the PE X PB is less than 22.5, which is 15 X 1.5).

The portfolio that was created comprised the following stocks with their purchase prices as of 1 May 2003 and number of stocks purchased.

Hawaiian Electric (HE) [Electric Utility] / 150 shares @ $40.73
Haverty Furniture (HVT) [Home Furnishing Stores] / 450 shares @ $13.53
Reliance Steel & Aluminum (RS) [Metal Fabrication] / 350 shares @ $17.56
Pulte Homes (PHM) [Residential Construction] / 100 shares @ $57.69
Kellwood Co. (KWD) [Textiles – Apparel/Clothing] / 200 shares @ $29.99

The total cost of this portfolio was $30,286.00 including a cost of $35.00 per transaction. [Discounted cash flow analysis was used to confirm that these stocks did represent value for cost.]

Since that time both HE and PHM shares have split.

The holdings, share prices as of 30 November 2004 were:

HE / 300 shares @ $28.25
HVT / 450 shares @ $20.15
RS / 350 shares @ $39.91
PHM / 200 shares @ $55.26
KWD / 200 shares @ $34.81

The market value as of 30 November was $49,525.00 with accumulated dividends of $1,213.55. This represents a total return of 67.5% over a year and a half.

In comparison, an index tracking mutual fund (TD US Index) has increased in value from $7.62 per unit to $9.78 per unit, with a dividend of $0.11 per unit. This is a total return of 29.8%.

Aggressive Portfolio

A second portfolio was created according to Ben Graham's aggressive criteria, which are:

1) Size - no limitations
2) Financial Condition - Current Assets > 1.5 times Current Liabilities
3) Earnings - no deficit in each of the last 5 years
4) Dividends - currently a dividend is paid
5) Growth - Last year's earnings greater than earnings 5 years previous
6) Value (PE) - PE < 10 (modified to 13 based on current bond yields)
7) Value (PB) - PB < 1.2

The stocks selected with shares purchased and prices were:

Skywest (SKYW) [Regional Airline] / 450 shares @ $13.61
Standard Pacific Corp (SPF) [Residential Construction] /200 shares @ $30.76
Building Materials Holdings (BMHC) [Home Improvement Store]/ 500 shares @ $12.46
Burlington Coat Factory (BCF) [Apparel Store] / 350 shares @ $17.60
Commercial Metals (CMC) [Basic Materials Wholesaler] / 375 shares @ $16.08

Total cost including$35.00 per transaction was $30,871.50.

[Note that stocks included in the conservative portfolio were excluded from this portfolio to allow the creation of an amalgamated portfolio.]

As of 30 November share prices were:

SKYW / 450 shares @ $19.03
SPF / 200 shares @ $56.01
BMHC / 500 shares @ $36.45
BCF / 350 shares @ $23.31
CMC / 375 shares @ $45.34

Total market value as of this date was $63,151.50 with accumulated dividends of $566.50. This is a total return of 106%.

Well that's it you think, this is a winning stock selection strategy. Not so fast….there's a big BUT and that “BUT” has got to do with a thing called “risk”. Simply showing that one group of investments had a greater return over another group is meaningless if risk is ignored. Would you be impressed if I told you that my corporate bonds had a higher return than my treasury bills? You shouldn't because the corporate bonds represented higher risk and for assuming that higher risk I should expect a higher return. So a comparison must consider risk, but what is “risk”? How is it defined? Having decided to go off the deep end (or am I rushing in where angels fear to tread again), I will leave that for the next post.

Cheers

SNS
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