Graham Value Stock Portfolio Update

In January 2012 I announced a new portfolio, a Benjamin Graham “inspired” value stock portfolio.  The purpose of the hypothetical portfolio is to track returns for a portfolio of 15 stocks selected based on a variety of valuation metrics.

I originally intended to update the portfolio monthly; however, in the spirit of creating a lower turnover, value-driven portfolio it is now updated approximately once per quarter. I have also added an additional criteria to limit turnover in the portfolio (see below). The Graham portfolio is an attempt to add a value strategy to Scott's Investments, which is otherwise focused on momentum, trend, income and market timing strategies.

The criteria used to select the stocks are listed below.  The tool used to perform the screen and backtests are courtesy of  Portfolio123 (“P123″).

The actual screen factors are below:

• Liquidity filter: No OTC Stocks
• Market capitalization > $100 million
• Eliminate companies classified in the Miscellaneous Financial Services Industry, most of which are investment companies and funds and not the kind of stocks this all-star tended to seek
• Current ratio must be at least 1.5
• Long-term debt must be no higher than 10% above working capital
• EPS must be above breakeven in each of the last four quarters and in each of the last five annual periods
• Trailing 12 month EPS most be above EPS in the latest annual period
• EPS in the latest annual period must be above EPS in the prior year and five years ago
• The company must have paid common dividends in the last 12 months

The ranking system used as a basis for selecting the top 15 based among those stocks that pass the Graham screen are below:

• Valuation – 60% of total
• Trailing 12 month P/E (15% of this category)
• Price-to-Book (15% of this category)
• Price-to-Tangible Book Value (35% of this category)
• Operating P/E, defined as Market Capitalization divided by Business Income, which is Sales minus Cost of Goods sold minus Selling, General & Administrative Expense and omits unusual items (35% of this category)
• Earnings – 40% of total
• 5-year EPS Growth Rate (50% of this category)
• EPS Stability, defined as the standard deviation of EPS over the past 16 quarters, lower being better (50% of this category)

I began tracking this portfolio real-time on January 13th, 2012.  As of this writing the portfolio is up 6.53% (including dividends) since inception.

The portfolio has been hampered by big drawdowns in a handful of names, which the quantitative rules continue to define as undervalued. These are excellent examples of the challenges in value investing – a stock could be defined as under-valued for a good reason, and may remain so for a significant period of time, perhaps years or forever if the company has experienced a permanent and material change in operations (a “value trap”). On the other hand, under-valued stocks may lag longer than investors wish, but patient, longer-term investors who aptly select value stocks can be rewarded in the long-run.

A real-world application of this portfolio could also utilize stop losses in order to prevent large drawdowns in single positions. However, for the purposes of tracking the portfolio results, all positions are bought and held until rebalancing.

In July 2012 I added a rule to limit portfolio turnover – stocks will only be sold when they drop out of the top 20 in Graham Value screen.  Thus, a stock could theoretically drop to the 20th ranking but remain in the 15 stock portfolio if it is a current holding.

Small cap and less liquid equities appearing frequently on the list. This makes for a potentially more volatile, higher beta list of equities and also led to some early drawdowns in the portfolio. The screen excludes stocks with a market cap less than $100 million.

The top 20 stocks based on the screen criteria are listed below:

Below are 3, 5, and 10 year backtest results for this screen (with the $100 million market cap requirement) using a quarterly rebalance and .50% slippage to help account for bid/ask spreads and commission costs. The backtest also includes the rule to sell a stock only when it dropped out of the top 20 in the list:

Significant drawdowns have plagued the strategy, especially during 2008.  What if we hedged the portfolio during technical weakness in the overall market?

Below are the 10 year results if we are 100% long the 15 stocks in the portfolio when SPY is above its 200 day simple moving average. When SPY is below its 200 day moving average the portfolio is long the 15 stocks and holds an equal short position in SPY (“100% Hedged”).

In the results below the hedge is re-balanced every 3 months. A more active and practical hedge would re-rebalance the SPY hedge on a monthly basis while still re-balancing the individual stocks every 3 months to limit turnover.

Shorting the market may not be practical for all investors and involves carrying costs (not accounted for in the results below), however, inverse ETFs like the ProShares Short S&P 500 (SH) can make hedging more practical for individual investors.

Eight stocks were sold today in the portfolio:

The current portfolio as of today's close:

As of this update, a minimum liquidity filter has also been added, requiring 20,000 shares or greater in average daily volume over the preceding 20 days. KNM did not qualify under this new condition but was retained in the portfolio in order to limit turnover.