(By David Brickell) It may have skipped most people's attention, but stock markets are looking cheap. Notable hedge fund manager Joel Greenblatt was this week quoted as saying that the market has only been cheaper 13% of the time over the last 23 years. Historically at such extremes of valuation the average 12 month upside in stocks has been 17%, and over 2 years well over 30%. Given such statistics it's quite remarkable that the investing public is still throwing money at the ill perceived safety of cash and low yielding bonds. Sure, there's always risk in the stock market, but right now there may be more risks to the upside than the downside. Perhaps investors ought to be looking for ways to play stocks that offer great return possibilities while minimising business risk. It turns out there's a deep value formula that promises to do exactly that, concocted by the bargain master himself - Benjamin Graham.
[Related -Market Needed a Yellen Bump and Didn't Get It.]
Graham, for those that don't know, was Warren Buffett's tutor and one of the greatest value investors of all time. We've covered some of the mechanical ways which Graham used to find bargain stocks before in great detail, but alas some of his most famous bargain hunting techniques (such as the esoteric sounding net-net and ncav strategies) can be unsuitable for risk averse investors. The main critique is that these lists tend to be populated with a lot of small microcap stocks that many investors find those too small, too illiquid, too risky and too hard to trade.
[Related -Will The Sluggish US Housing Market Perk Up This Year?]
Ben Graham's Last Will - a money making formula
But Graham developed a much more flexible checklist based formula that allows investors to build portfolios of deep value stocks large or small. We have previously written about this ten point checklist that he developed with aeronautical engineer, James Rea, shortly before he died. It's become known as "Graham's Last Will" and was the result of 50 years of backtests to highlight the top ten best performing stock selection criteria.
The ten checks were split in two groups of five, the first five aiming to highlight 'cheap' stocks with strong return possibilities (using low PE, high yields, good asset backing etc), with the second five aiming to find 'low risk' stocks (not much debt, consistent profitability, good liquidity etc). A company gains points for passing each of the tests. For the geeks amongst us here's the list:
- Earnings Yield of at least twice the AAA bond yield
- P/E ratio less than 40% of the highest P/E ratio the stock had over the past 5 years
- Dividend yield of at least 2/3 the AAA bond yield
- Stock price below 2/3 of tangible book value per share
- Stock price below 2/3 of Net Current Asset Value
- Total debt less than book value
- Current ratio great than 2
- Total debt less than 2 times Net Current Asset Value
- Compound earnings growth over the last 10 years at least at a 7%
- No more than 2 earnings declines in the last 10 years
Societe Generale has recently backtested this checklist since 1992 with quite remarkable results. They show that the resulting score of a stock between zero and ten is extremely predictive of future returns over the next 12 month period. For each score in ascending order the average annualised returns were -2.1% -0.2% 0.0% 0.0% 0.6% 1.0% 2.7% 29.1% 9.9% 36.1% and 48.7%. That's an almost 50% annualised return for stocks ranked 10 - who wouldn't be interested in that?
The trouble is there just aren't that many stocks qualifying for the top scores. In fact according to Soc Gen in that 18 year period there were less than 0.4% of stocks that scored 7 or more and only 3 stocks that scored a perfect ten. Beyond that most of the high scoring candidates appear during big market breaks - e.g. in 2008. Some argue that as a result the Graham and Rea checklist isn't that useful. But this may be shortsighted.
Building a better Graham amp; Rea portfolio
Graham and Rea suggested using a more advanced scoring system to allow any stocks coming within 25% of meeting one of the criteria to win half a point instead of the full one. Some of the criteria are so harsh that this can make a big difference - generating a wider dispersion of scores and offering a greater array of picks in broader market conditions. As a result we can more systematically pick the top ranked stocks by Graham amp; Rea score and track the resulting portfolio over time.
Societe Generale found out that this top decile portfolio outperformed the market by 8.1% per year over an 18 year period from 1992 to 2010 - a greater than 700% return over 18 years and triple the market return!. While these deep value stocks are punished in market breaks, their moderate valuations and low corporate risk profiles ensure that when good times return their share prices really shine.
We've just added this version of Graham's scoring system to the Stockopedia screener. The ratio is called the 'Graham Deep Value Score' and we've generated a (still in testing) 'Benjamin Graham Deep Value Screen' that highlights qualifying names. We can't find any stocks that pass 9 or 10 criteria in the UK market at present, but there are plenty that offer a score of 7 or greater. As ever in a deep value screen you find some interesting names in the list - notably we spotted BAE Systems. , Albemarle amp; Bond Holdings (LON:ABM) and Asian Citrus Holdings (LON:ACHL) as standout names.