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The rules of smart investors

I'm a big fan of Benjamin Graham's investment techniques and frequently use strategies from the father of value investing to uncover interesting Canadian stocks.

With markets looking a bit shaky in recent days, it's an opportune time to focus on Mr. Graham's defensive approach, which I've used profitably for over a decade.

Mr. Graham, a Wall Street money manager who honed his strategies during the darkest days of the Great Depression, detailed the method in his book The Intelligent Investor, which was first published in 1949. Although his writing style might appear a touch archaic to modern eyes, his work remains a classic. (You can also get up an updated version with more modern commentary by Jason Zweig, which was published in 2003.)

The Intelligent Investor was the first book on investing that made sense to me - and it wasn't for lack of trying other tomes. But don't take my word for it. Mr. Graham's most famous student, Warren Buffett, endorsed it as 'by far the best book about investing ever written.'

Mr. Graham's instructions for defensive investors were quite strict. He sought cheap stocks with low price-to-earnings ratios and low price-to-book-value ratios. But he also wanted a measure of safety and favoured larger stocks with solid track records.

His rules are summarized in the accompanying table at the bottom of the article. At first glance, they seem quite reasonable. Problem is, they also tend to rule out nearly all North American stocks.

But taking a slightly more relaxed approach has been quite profitable. My more lenient set of Graham-inspired criteria are also shown in the table.

My rules remain very demanding. Over most of the last decade only a handful of U.S. stocks passed the test each year. Mind you, the method uncovers many more candidates during downturns and over 40 made the grade near the market bottom in 2009.

Despite their low numbers, the U.S. stocks picked by my Graham-inspired rules have done very well since I started writing about them in 2000. As a group they've climbed an average of 19 per cent a year, which is far better than the 2.1 per cent annual advance achieved over the same period by the SPDR ETF, which tracks the S&P 500 index.

Don't get too excited, though. It's difficult to imagine that such a large degree of outperformance will persist over the long-term. In addition, even the most focused value investor will likely want to buy more than just a few stocks. (Less seasoned investors should opt for well-diversified portfolios.) As a result, it is also important to look further afield to supplement one's portfolio.

I recently expanded the search into Canada, and screened for stocks on the TSX. According to S&P Capital IQ, only two stocks pass muster: Algoma Central Corp. (ALC) and Dorel Industries Inc. (DII.B). They are well worth considering but be aware that Algoma Central tends to be thinly traded. It recently announced a 10-for-1 stock split, via a stock dividend, which should help trading volumes.

Both firms were covered by The Globe and Mail earlier this year. Sean Silcoff profiled Montr al-based Dorel, a maker of bicycles, ready-to-assemble-furniture and kids. products, in July's Report on Business magazine.

Algoma Central, a shipping line, was scrutinized by Globe Investor's Martin Mittelstaedt in the spring. It is part of the E-L Financial (ELF) empire, which owns 25.4 per cent of the shipping company. I've followed both firms for years and think that E-L Financial is also worth checking out. After all, I happen to own some of its shares.

Here's that table I referred to earlier, with my rules of investing:

Benjamin Graham's own criteria Rothery's Graham-inspired rules
Stocks with: P/E ratio < 15 Stocks with: P/E ratio < 15
P/BV ratio < 1.5 P/BV ratio < 1.5
Current ratio > 2 Current ratio > 2
Earnings growth of 33% over 10 years 5-yr. avg. EPS growth > 3%
Uninterrupted dividends over 20 years Positive 5-yr. dividend growth
Some earnings in each of the past 10 years Positive annual earnings for past 5 yrs.
Revenue > $100-million Revenue > $400-million

First published in the Globe and Mail, November 11 2012.

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