So simple it works

Value investing is so easy that your grandfather can do it — that is, if he follows the advice of Ben Graham, the grandfather of value investing. Back in 1976, Graham, a Wall Street financier and Columbia University professor, developed what he called The Simplest Way to Select Bargain Stocks. Investors who followed his approach have been riding the gravy train ever since.

MoneySense readers have been among those who have profited handsomely from Graham’s Simple Way. Since I started picking Simple Way stocks for MoneySense in 2004, the method has handily outperformed the S&P 500 each and every year. Assuming you purchased equal dollar amounts of each Simple Way stock, stashed them in your RRSP, and rolled the profits into new Simple Way stocks each year, you would now be sitting on a gain of 59% in 44 months, not including dividends. Over the same period, the S&P 500 advanced only 27%, less than half as much as the Graham picks.

Skeptics will put the recent success of the Simple Way stocks down to luck. I beg to differ. The 14% annualized return provided by the Simple Way since 2004 is close to what the master himself would have predicted. Back in 1976 Graham calculated that if you had followed the Simple Way, you would have achieved fairly consistent 15% annual returns during the prior 50 years. Thirty years later, his system is still churning out results in line with historical returns.

Picking stocks using the Simple Way is like doing the two-step. In the first step, you seek stocks that are cheap and in the second you keep those that are relatively safe. Graham defined a cheap stock as one with an earnings yield that was at least twice as large as the average yield on long-term AAA corporate bonds. The yield on 20-year AAA U.S. corporate bonds was 6.1% when I selected this year’s new batch of Graham stocks, so I looked for stocks with earnings yields of 12.2% or more. (If you’re confused by all this talk of earnings yields, no need to fret. The earnings yield on a stock is simply the earnings per share divided by the share price. It’s the inverse of the more popular price-to-earnings ratio. An easy way to convert an earnings yield to a P/E ratio is to divide 100 by the earnings yield. So, looking for stocks with an earnings yield of 12.2% or more is roughly equivalent to searching for stocks that possess a P/E ratio of 8.2 or less.)

We now come to the safety step of the Simple Way. Graham insisted on investing with a margin of safety because he had suffered through the crash of 1929 and witnessed the carnage that resulted from companies carrying too much debt. He insisted that his chosen companies be well-capitalized to protect themselves against bad times. For safety’s sake, Graham stuck to stocks with leverage ratios (the ratio of total assets to shareholders’ equity) of two or less.

Finally, we come to the question of when to sell Simple Way stocks. Graham suggested waiting for either a 50% profit or for no later than the end of the second calendar year after purchase. I take the more straightforward approach of selling the previous crop of Graham stocks whenever I pick a new bunch.

With Graham’s criteria in hand, I used the MSN.com deluxe stock screener to find a short list of this year’s interesting candidates. I narrowed it down by focusing on those U.S. stocks with market capitalizations of more than $1.5 billion. (All figures are in U.S. dollars.)

The 2007 Bargain Bin is crammed with old economy stocks, many of them from the oil and gas sector. Patterson-UTI Energy (PTEN) of Texas, Helmerich & Payne (HP) of Oklahoma, and Unit (UNT) of Oklahoma all drill for oil and natural gas, primarily in the southwest U.S. Hercules Offshore (HERO) of Texas is yet another driller, although it conducts most of its business in the shallow waters of the Gulf of Mexico.

If you’re in a gambling mood, keep an eye on IPC Holdings (IPCR), which provides hurricane reinsurance. IPC’s fortunes rise or fall depending on the severity of each year’s hurricane season. If this year proves to be as bad as 2005, when Hurricane Katrina slammed New Orleans, IPC will suffer. On the other hand, the company could gush profits if the season is mild. The bottom line is that buying IPC is like playing a game of hurricane chicken and is not for skittish investors.

Those of you who like computers should take a look at Western Digital (WDC), the only tech company to make this year’s list. It makes hard drives for computers and is faring well despite aggressive competition, but the market isn’t giving it a lot of credit for its success.

I have high hopes that Graham’s method will continue to do well in the long run, but all the usual warnings apply. Use Graham’s list as a starting point for further research and not the final destination. If you don’t understand a company, or feel qualms about it, you should follow the maxim of Warren Buffett, the best known of Graham’s students, and put the decision in the “too hard” pile. After all, there are lots of Graham style bargains out there and you don’t have to swing at each and every pitch.