The investment world is no stranger to apparent greatness that doesn't last. Every year, a number of fund managers will post stellar returns, catching the eye of the media and the public. Then many, if not most, of their funds disappoint the following year—and over the long term. That's why I try to focus on investors with truly long-term track records, those whose greatness is, in fact, lasting.
In terms of lasting greatness, no investor fits the description better than the late Benjamin Graham. Known as the "Father of Value Investing"—and the mentor of Warren Buffett—Graham's investment firm posted annualized returns of about 20% from 1936 to 1956, far outpacing the 12.2% average return for the broader market over that time.
But the success of Graham's approach goes far beyond even that lengthy period. For nearly a decade, I have been tracking a portfolio of stocks picked using my Graham-inspired Guru Strategy, which is based on the "Defensive Investor" criteria that Graham laid out in his 1949 classic, The Intelligent Investor. And, since its inception, the portfolio has returned 224.3% (13.3% annualized) vs. 43.0% (3.9% annualized) for the S&P 500.
Even with all of the fiscal cliff and European debt drama in 2012, the Graham-based portfolio has had a particularly good year. While the S&P 500 has notched a solid 13.7% gain (all performance figures through Dec. 17), the Graham portfolio is up more than twice that, gaining 28.5%.
Good Companies, Cheap Shares
The secret to the Graham strategy's success isn't in any sort of investing alchemy. It's that Graham's Defensive Investor approach used criteria that got to the heart of what good business and good investing is. He wanted to invest in financially sound firms, so the model I base on his writings looks for companies with current ratios of 2.0 or higher, a sign of strong liquidity.
It also wants a company's net current assets to be greater than its long-term debt. Graham didn't require stellar growth numbers—my Graham-based model wants total earnings per share growth to be at least 30% over the past decade, a pretty low target. But he did want to know that a company was a steady, consistent earner—EPS cannot have been negative in any of the past five years.
Of course, as the Father of Value Investing, Graham wanted to get shares of firms like these on the cheap. My Graham approach looks at a stock's price/earnings ratio using both trailing 12-month (TTM) earnings and three-year average earnings; neither P/E should be above 15. Then, it takes the higher of those two P/E ratios and multiplies it by the price-to-book ratio. The product should be no higher than 22.
By focusing on firms with these attractive valuation characteristics, Graham gave himself what he termed "a margin of safety", meaning that even if the companies unexpectedly struggled, their shares were cheap enough that they probably wouldn't take much of a hit. Safety also showed up in Graham's approach in other ways, such as his reluctance to invest in technology stocks, which he found too risky.
My Graham-based model also excludes tech stocks, and, due to the debt requirements in the model, it essentially excludes financial stocks.
Here are a handful of its current favorites. Keep in mind that you should always consider such picks in the context of a well-diversified portfolio.
Sasol Limited (SSL): This South African firm ($28 billion market cap) makes a wide range of chemicals, as well as liquid fuels and electricity, and operates in more than three dozen countries around the globe. My Graham model likes its 2.12 current ratio and $4 billion in net current assets vs. $1.5 billion in long-term debt. It also likes the price: Sasol trades for 11.2 times three-year average EPS and 1.87 times book value.
P.H. Glatfelter Company (GLT): Pennsylvania-based Glatfelter ($725 million market cap) makes specialty papers and fiber-based engineered materials. The firm's financials look solid -- it has a 2.03 current ratio and $236 million in net current assets vs. $219 million in long-term debt. So does its valuation, with shares trading at an 11.9 TTM P/E and 1.33 times book value.
Moog (MOG.A): Aerospace & defense firms aren't getting a lot of love these days because of the fiscal cliff's potential impact on the U.S. defense budget, but my Graham-based model likes this New York State-based A&D firm, which makes precision motion control products used in aircraft, satellites and space vehicles, missiles, industrial machinery, wind energy, medical equipment, and more. Moog ($1.7 billion market cap) has a 2.33 current ratio, $885 million in net current assets vs. $671 million in long-term debt, and its shares trade for 13.1 times three-year average earnings and 1.32 times book value.
NTT Docomo (DCM): This Japan-based mobile telecom power ($64 billion market cap) has about seven times as much in net current assets ($15.4 billion) as it does long-term debt ($2.2 billion). It also has a 2.2 current ratio, and trades for 11 times TTM EPS and 0.95 times book value.
Helmerich & Payne (HP): H&P ($5.8 billion market cap) is an oil and gas well driller that has taken in more than $3 billion in sales in the past year. The Oklahoma-based firm has a 2.35 current ratio and $514 million in net current assets vs. $195 million in long-term debt. And its shares trade for 13.8 times three-year average EPS and 1.51 times book value.
I'm long SSL, GLT, DCM, and HP.
John Reese is a money manager, the author of The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies (Wiley, 2009) and editor of Validea Hot List. Click here for more on his newsletter.
