Some Value Investing History
Is 2008 the Year Buy-and-Hold Came to Die?
A Small Company with a Big Future
Benjamin Graham, the father of value investing, taught an investment class at the Columbia University business school for 28 years. Students in Graham’s classes were taught from the textbook, “Security Analysis,” written by Benjamin Graham and David Dodd. Several of Mr. Graham’s students became top-notch investors, including the Oracle of Omaha, Warren Buffett. Mr. Buffett not only studied under Ben Graham, but later worked for Graham as an apprentice.
In 1984, Buffett returned to Columbia to give a speech commemorating the 50th anniversary of the publication of “Security Analysis.” During his speech, Buffett presented his own investment performance record as well as those of Bill Ruane, Tom Knapp and Walter Schloss. Each of these men, including Buffett, posted investment results that far exceeded the returns of the stock market indexes. Buffett noted that each of their portfolios varied significantly in the number and type of stocks, but every manager adhered to Benjamin Graham’s investment principles.
The investment principles taught by Graham at Columbia University became legend in the field of professional stock analysis. Fortunately, Benjamin Graham made his principles easily accessible to all investors by writing the classic book, “The Intelligent Investor,” which Warren Buffett described as “by far the best book on investing ever written.”
All of the principles that I use in the Cabot Benjamin Graham Value Letter were taught to me at Babson College by Dr. Wilson Payne, another of Mr. Graham’s students at Columbia.
In the “Intelligent Investor,” Graham set forth the principles that form the foundation of value investing. Value investors seek to purchase undervalued stocks at prices that are clearly below the true or “intrinsic value” of a company.
One quick (but not totally accurate) measure of a company’s intrinsic value is book value: companies with stock price to book value (P/BV) ratios of less than 1.00 are considered to be undervalued. In addition, price to earnings (P/E) ratios should be no greater than 9.00. The P/BV and P/E ratios together with Graham’s other tests for quality and value provide a methodology which all value investors can follow to achieve stock market success.
Many value investors adhere to the old buy-and-hold forever theory. The past year, though, has been a brutal time to be a buy-and-hold investor. According to Morningstar, 95% of all mutual fund managers lost more than 27% last year. Holy cow!
The Standard & Poor’s 500 Index (before dividends) dropped 21.85% for the 10 years ended December 31, 2008. The buy and hold strategy that many value investing gurus recommend has clearly not worked well during the past 10 years. Jeff Macke on CNBC’s Fast Money went so far as to proclaim “2008 will go down as the year buy-and-hold came to die.”
Oh no, what do we value investors do now?
I am focused on a little known Benjamin Graham strategy for investing that will undoubtedly, in my opinion, lead to success in this difficult stock market and in future markets. In his book, “The Intelligent Investor,” Graham advised you, the investor, to always hold bonds in your investment portfolio. His recommendation is clear: “We recommend that the investor divide his holdings between high-grade bonds and leading common stocks; that the proportion held in bonds be never less than 25% or more than 75% with the converse being necessarily true for the common-stock component.”
We believe Benjamin Graham’s bond/stock allocation is the best approach to follow in the current difficult stock market environment and in the future: (1) when the stock market is low and undervalued, hold 25% bonds and 75% stocks. (2) when the stock market is high and overvalued, hold 75% bonds and 25% stocks. When the stock market begins to go from being undervalued to overvalued, gradually reduce your stock portion and buy more bonds or bond ETFs.
How do we determine when the stock market is undervalued or overvalued? Benjamin Graham detailed methods to estimate the current value of stocks. We apply Mr. Graham’s methods to determine the current value of the 30 stocks that make up the Dow Jones Industrial Average. The methodology is based upon the 10-year financial history of each company, including the P/BV and P/E ratios.
Our current value estimate for the Dow Jones Industrial Average lies within a range of 8,300 and 12,370. Our estimated range varies somewhat from month to month. We expect the range to decline slightly in 2009 as companies report weak financial results during most of the year. The spread of the range will likely remain in the vicinity of 4,300 points.
According to Benjamin Graham’s methodology, if the Dow is 8,300 or below, your portfolio should contain 25% bonds or bond ETFs and 75% common stocks. If the Dow is 12,370 or higher, your portfolio should contain 75% bonds or bond ETF’s and 25% stocks. Our current recommendation is to invest 25% of your portfolio in bond ETFs and 75% in common stocks.
In 1987, I attended an investment conference and heard Andrew Tobias speak. Tobias is the author of “The Only Investment Guide You’ll Ever Need” and many other books. He advised investors to lighten common stock holdings when the stock market is making new highs, and invest more heavily when the stock market is making new lows. Sell when the market is high and buy when the market is low is certainly good advice. However, not all of us have as good a “feel” for the stock market as does Andrew Tobias.
Tobias’ simple advice for value investors is easier to follow than the Benjamin Graham current valuation approach, but may be too vague or simplistic to provide the best results. In Cabot Benjamin Graham Value Letter, we publish the current value estimate range for the Dow Jones Industrial Average every month for our readers. We do the calculations; our readers follow our numbers and advice. Whichever approach or method you choose, Graham or Tobias, stick with it, and you will prosper.
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My stock pick for today is a small company in the aerospace industry. Kaman (KAMN) manufactures bearings, parts and subassemblies for commercial and military aircraft and helicopters. The company has been a supplier of commercial and military aircraft parts and subassembly systems for over 50 years. Kaman’s products can be found in nearly every commercial and military aircraft manufactured in North America, South America and Europe.
The company’s earnings per share (EPS) jumped 30% in 2008 and will likely increase 20% in 2009 and 2010. We expect recent acquisitions to add significant sales and EPS during the next couple of years. Kaman has a strong balance sheet, which will enable the company to make additional acquisitions during the next several years despite the tight credit markets.
Recent new contracts, including major contracts for the Boeing 787 Dreamliner and the Sikorsky MH-92 helicopter, will further enhance growth despite difficult economic conditions. Kaman shares sell at 9.3 times current EPS and at less than book value. Dividends provide an attractive yield of 3.1%. Buy Kaman (KAMN) now.
J. Royden Ward
Editor of Cabot Benjamin Graham Value Letter
Editor’s Note: Cabot Benjamin Graham Value Letter follows the time-tested value investing system laid out by Benjamin Graham, the father of value investing. Warren Buffett, Graham’s student and follower, recently said that now is the time to buy, when stocks are cheap and other investors are afraid to make new purchases. Let Editor J. Royden Ward, who was also taught by one of Graham’s students, be your guide through the value investing landscape. Click below to get started today.