Benjamin Graham’s Strategy Still Beats the Market
Benjamin Graham was more than just the mentor of his famous protégé, Warren Buffett, or the founder of value investing.
He was a masterful investor in his own right.
And his strategies continue to outperform the market today.
Graham effectively gave birth to the field of security analysis and established himself as a first-class investor during his years managing the Graham-Newman Corporation with his business partner, Jerome Newman.
Over the years, the firm generated an annualized return of 21% compared with the broad market’s annual return of 12%.
But the firm’s great success was due to Graham’s simple – yet contrarian at the time – insight, which he summarized in the firm’s 1946 shareholder letter…
“To purchase securities at prices less than their intrinsic value… with particular emphasis on purchase of securities at less than their liquidating value.”
Of course, the struggle of analysts has always been to define a company’s intrinsic value.
Calculating the intrinsic value of a company requires thorough analysis. But such analysis was not always easy in a fast-paced market.
Graham knew that it was helpful to have a “guesstimate”… a simple pen-and-paper method for estimating a company’s value on the fly.
In his book Security Analysis, Graham laid down just such a pen-and-paper formula. And over time, he revised it until it took on the following form:
Basically, each component breaks down as follows…
- EPS is the company’s trailing 12-month earnings per share.
- 8.5 was the average price-to-earnings ratio for non-growth stocks, as calculated by Graham at the time.
- g represents the long-term growth forecast of the company.
- 4.4 was the average yield on AAA rated bonds, as calculated by Graham at the time.
- And Y is the current average yield of AAA rated bonds.
Once you plug in the numbers, the formula hands you an estimate for a stock’s intrinsic value, which you can then compare with the market price of the stock.
If it’s trading beneath its intrinsic value, it’s potentially a “Buy.” And if trading above its intrinsic value, it’s likely not worth buying.
But despite the success this formula – and strategies derived from it – handed Graham and his followers, almost no one uses it today.
Investment analysis has become increasingly complicated, with a plethora of analytical methods used to calculate a company’s intrinsic value.
Even so, how would a portfolio based on this strategy perform against the market today?
I tested it out…
As you can see, the cumulative return of a model portfolio that implemented Graham’s strategy consistently outperformed over time.
The portfolio screened for stocks that were members of the Dow Jones Industrial Average and were trading for half of their intrinsic value (as expressed by Graham’s formula) or less.
Such data demonstrates that sometimes very simple methods yield great results.
And value investing – despite those who claim its heyday has passed – still proves effective in a modern, data-intensive marketplace.
Know the value of what you buy, and pay as great a discount as possible.
It’s good personal finance… and even better investing.
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