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So easy, so profitable
Benjamin Graham's Simple Way

If you're looking to pick up a few good value stocks, Benjamin Graham's Simple Way will tickle your fancy. Graham, who taught Warren Buffett, was the father of value investing. The system he outlined in his 1976 article, "The Simplest Way to Select Bargain Stocks" has since become a staple of savvy investors.

I highlighted the Simple Way to MoneySense readers in February 2004 when I provided a list of stocks that fit Graham's criteria. I'm pleased to report that these stocks produced a 31.3% return in 20 months. The S&P500 was up only 13.1% in that time, so the Graham stocks thumped the market by 18.2 percentage points. (For those of you scoring at home, the Graham results include dividends and the buyout of InVision Technologies for $50 U.S. a share last year.)

Such results aren't unusual. Back in 1976, Graham found that his method had provided 15% average annual returns during the prior 50 years. When we annualize the MoneySense experience, our Graham stocks did even better, with average annual returns of 17.7%.

Graham's Simple Way is built on two fundamental rules stocks should be both cheap and relatively safe.

Cheap: Graham insisted that any stock he invested in must have an earnings yield that was at least twice as large as the average yield on long-term AAA corporate bonds. At the start of September, the yield on 20-year AAA U.S. corporate bonds was 4.9%. So Graham would have selected only stocks with earnings yields of 9.8% or more.

How do you calculate the earnings yield on a stock? 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 9.8% or more is roughly equivalent to searching for stocks that possess a P/E ratio of 10.2 or less.

Safe: Graham also insisted his chosen companies carry little debt. This tends to make them less risky than debt-laden firms. He stuck to stocks with leverage ratios (the ratio of total assets to shareholders' equity) of two or less.

When it came to selling, Graham suggested waiting for either a 50% profit or for no later than the end of the second calendar year after purchase. If, as Graham recommended, MoneySense readers had sold after a 50% rise in a stock's price then the average annual performance of the 2004 Graham stocks would have dropped to 15.5% still well above the 7.6% annual gain for the S&P500.

With Graham's criteria in hand, I used the deluxe stock screener to narrow the universe of U.S. stocks down to 172 interesting candidates. Because more than two times as many candidates made the grade this year as when I compiled my original MoneySense list, I decided to focus on U.S. stocks with market capitalizations of more than $2.5 billion (all figures in U.S. dollars), up from the $500 million minimum I used in 2004. As a result, Stewart Information Services and Fresh Del Monte Produce, which were 2004 Graham stocks and would have made this year's list as well, fell off solely because of their modest market capitalizations. My current buy list is shown in Bargain bin 2005.

Company Industry Market Cap ($M) Price* P/E Ratio Leverage Ratio Dividend Yield
Chevron Corp (CVX) Oil and gas 127,955 $62.71 10.01 2.0 2.9%
Occidental Petroleum Corp (OXY) Oil and gas 33,195 $84.80 8.9 1.9 1.5%
Phelps Dodge Corp (PD) Copper 10,425 $110.25 6.5 1.9 1.4%
Nucor Corp. (NUE) Steel and iron 8,824 $57.90 6.5 1.7 1.0%
Computer Sciences Corp (CSC) Information technology 8,232 $44.72 7.5 2.0 0%
MGIC Investment Corp. (MTG) Surety and title insurance 5,809 $62.05 9.5 1.5 1.0%
Ashland Inc. (ASH) Oil and gas refining 4,511 $60.55 2.2 1.8 1.8%
Radian Group Inc. (RDN) Surety and title insurance 4,363 $50.69 9.1 2.0 0.2%
Allied Capital Corp. (ALD) Credit services 3,908 $29.03 6.9 1.5 8.0%
M.D.C. Holdings, Inc. (MDC) Residential construction 3,342 $76.40 7.9 1.9 0.9%
IPSCO INC (IPS) Steel and iron 3,086 $65.23 5.4 1.5 0.7%
Louisiana-Pacific Corp (LPX) Lumber 2,804 $25.69 8.8 1.5 1.9%
DreamWorks Animation SKG (DWA) Movie production 2,682 $26.26 7.6 1.8 0.0%
Novell Inc. (NOVL) Application software 2,501 $6.82 7.2 1.9 0.0%
Source: Sept. 1, 2005 *All prices in U.S.

A word of caution about this year's list. The fortunes of the two largest stocks, Chevron and Occidental Petroleum, are tied to oil and gas prices. Both firms are currently as profitable as pirates - much to the chagrin of drivers - because oil prices are sky high. But commodity stocks often follow a boom-and-bust cycle. Their numbers look great during the boom, but the bust destroys both profits and share prices. When it comes to commodity businesses you should be extra cautious. Keep an eye on underlying commodity prices to avoid overstaying your welcome.

Note, too, that no stock-picking method is perfect. I have high hopes for the stocks on this year's list, but you should use these names as a starting point and not as your final destination. Do your own research before investing in any of the stocks listed here.

From the October 2005 issue.

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Disclaimers: Consult with a qualified investment adviser before trading. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, financial advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. More...