Your Ultimate Guide To Graham’s Simple Way Strategy

This article dissecting Ben Graham’s Simple Way investment strategy was written by Evan Bleker. Evan is a private investor and founder of The Broken Leg.

In 1975, Ben Graham packed everything he learned over a lifetime of investing into his final investment strategy, Ben Graham’s Simple Way.

Given that this strategy was built on the culmination of a lifetime of exceptional investing… was it Graham’s best ever strategy?

And, if it’s so simple, where does it leave value investors who are still clinging to Security Analysis?

When classic value investors pick stocks they usually do so using the framework that Graham established in his highly regarded series, Security Analysis. When I started out as a value investor, I made sure to read the classic texts over a number of times, soaking up every ounce of knowledge that Ben laid out. I was convinced that value investing was the only rational way to pick stocks and that Graham’s bible of finance was my ticket to large returns.

I would come home from university and park myself in my parent’s den, flipping through pages, pencil in hand, taking copious notes so I could retain every drop of wisdom. I wasn’t doing anything special – many classic value investors do the same thing. What I didn’t realize, however, was that I was studying what Graham himself had labeled a dated framework.

Over the next 4 or 5 years I took the knowledge I adopted and went out into the market to try to pick exceptional value stocks. I’d filter for good looking value stocks using Google Finance and investment forums then dive into the financials to come up with a valuation.

I remember working on Home Depot. I downloaded all of the financial reports from the company going back 7 years and began reading. With my demanding university schedule, and the job I was working to pay for tuition, it took me a couple of weeks to get through through them in order to come up with a fair value the way Graham had suggested. In the end, Home Depot’s price in the market just did not reflect a bargain – I had to move on and do it all over again to have any hope of filling my portfolio with 20 positions.

Ben Graham’s Radical Shift

What I didn’t realize is that Graham’s thoughts on investing shifted remarkably throughout his life and Security Analysis reflected the thoughts of a man in mid-career. Just before his death in 1976, Graham gave a series of interviews and speeches that really distilled the culmination of his entire life picking stocks. As it turned out, he simplified his approach radically:

“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook “Graham and Dodd” was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I’m on the side of the “efficient market” school of thought now generally accepted by the professors.”

At the end of his life, Graham essentially wrote off his entire body of work as irrelevant to modern investing. Where investors could previously have leveraged his tools to find exceptional undervalued companies, Graham no longer felt that enough undercover opportunities existed to make the tremendous amount of work needed to find them worth while.

But Graham did not write off investing completely. Far from it. Still championing the value investing philosophy, Graham explained how investors could make a fortune in stocks:

“[I recommend] a highly simplified [strategy] that applies a single criteria or perhaps two criteria to the price [of a stock] to assure that full value is present and that relies for its results on the performance of the portfolio as a whole–i.e., on the group results–rather than on the expectations for individual issues.”

This radically simplified approach skipped the need for deep research or financial advisors and liberated investors by making stock picking much easier than it had traditionally been.

Graham’s Simple Way: Ben Graham’s Last Investment Strategy

Ben Graham sat down with Medical Economics editor Bart Sheridan in 1975 to discuss his thoughts on the markets and investing. In the interview, Graham revealed what turned out to be his last and most stunning investment strategy. According to Sheridan, writing at the time:

“In recent years he’s devoted himself to distilling the methods of stock selection he used successfully for nearly half a century into a few easily followed principles. Now 82, Graham has lately gone into association with investment counselor James B. Rea to establish a fund whose investment policy will be based on those principles. Graham believes that a doctor handling his own investments should be able to utilize those same principles to achieve an average return of 15 percent a year or better.”

Graham laid out what has been dubbed by close followers of classic value investing Ben Graham’s Simple Way investment strategy. The strategy couldn’t be more simple, relying on just 3 selection criteria:

  1. Buy stocks that have an earnings yield twice the AAA bond yield or more
  2. Never buy stocks for more than 10x earnings; a PE of 7x is always allowed
  3. Make sure each stock has an equity to assets ratio of 50% of more

 

Graham’s Simple Way Earnings Yield

Graham’s criteria called for an earnings yield of twice the AAA bond yield. According to Graham:

“One of the ways to determine what you should pay for stocks at any given time is to look at what quality bonds are yielding. If bond yields are high, you want to buy stocks cheaply, meaning you will look for relatively low P-Es. And if bond yields drop, then you can pay more for the stock and accept a higher P-E. As a rule of thumb in pricing stocks this way, I select only those issues whose earnings-to-price ratio-simply the P-E in reverse-is at least twice the average current yield on top-quality (triple-A) corporate bonds.”

As Graham explains, the earnings yield is just the reciprocal of the PE ratio. A PE of 10, for example, would be an earnings yield of 10%. A PE of 20x would be an earning yield of 5%. How?:

“Just double the bond yield and divide the result into 100. Right now the average current yield of AAA bonds is something over 7 percent. Doubling that you get 14, and 14 goes into 100 roughly seven times. So in building a portfolio using my system, the top price you should be willing to pay for a stock today is seven times earnings. If a stock’s P-E is higher than seven, you wouldn’t include it.”

By comparing the earnings yield to the corporate bond yield, we’re invited to view a stock as an “equity bond,” allow an investor to compare a stock investment against other investments made available by firms. Warren Buffett has said that interest rates act as financial gravity in the world of finance – specifically government bonds. The higher the government bond yield, the higher corporate bond yields have to be to compensate investors for added risk and entice investors to buy corporate debt. The higher bond yields are in general, the higher earning yields on stocks have to be to entice investors.

But, stocks are arguably more risky than corporate bonds and definitely more risky than government bonds. Here, Graham demands a much larger yield, more than making up for any added risk (ie. demanding a much larger margin of safety). This excessive compensation also sets up great returns as stocks revert back to a more normal earnings yield.

Graham’s Simple Way 7x & 10x PE Rules

Graham explained that he had tested his strategy back over 50 years. As part of that testing, he found that good returns could be achieved with his low PE strategy if you kept a few basic rules in mind.

“However, in my opinion, you should never buy a stock with a P-E ratio over 10 no matter how low bond yields get. Conversely, in my system, a P-E of seven is always allowable no matter how high bond yields go.”

A PE ratio of over 10x is excluded from contention so that investors are focusing on very cheap firms. As the PE ratio increases, you run the risk of buying more expensive firms relative to the market’s historic PE ratio.

The S&P 500’s historic average PE ratio is roughly 16x. When Graham was writing, it was closer to 14 or 15x. When you look at stock valuations with this historic perspective, a PE of 10x equals a 1/3rd discount to the historic average market PE. Any higher than that and you’re not getting that minimum 1/3rd margin of safety Graham demands.

Based on this historic PE figure, a PE of 7x grants an investor roughly a 50% discount. Market periods characterized by tiny PEs are also both rare and occur prior to a very large bull market. In short, buying stocks during these periods means setting yourself up with strong odds of achieving great returns.

Graham’s Simple Way 50% Equity to Assets Rule

Graham spent a lot of time early in life looking at a firm’s interest coverage, debt to equity, debt covenants, current ratios, etc, in order to find companies that were financially sound. At the end of his life, however, he favoured a simple rule:

“An easy way to check [to see if a firm is on solid financial footing] is to look at the ratio of stockholders’ equity to total assets; if the ratio is at least 50 percent, the company’s financial condition can be considered sound.”

Graham’s Simple Way 50% equity to assets rule helped him to avoid firms that were at risk of insolvency. This alone was a solid check for financial soundness and helped boost returns.

Concerned investors can take this a step further and require a Current Ratio of 2x, satisfying Graham’s preference for companies that “own twice as much as they owe”. That would also help investors focus on firms with solid liquidity. Firms with large Current Ratios can easily cover their short term liabilities and avoid technical default.

Graham’s Simple Way Portfolio Rules

Graham’s Simple Way selection rules provide extremely simple guidance for stock selection. Buying a basket of these firms should allow an investor to put together a very solid portfolio with a high probability of outperforming the market over a 5 year period.

But, it’s not enough to pick stocks – an investor also has to know when to sell his holdings to realize his profit. This is where Graham’s Simple Way portfolio rules come in to play:

  1. Make sure you have a well diversified portfolio of 30 or more stocks
  2. Sell a stock after a 50% rise in price
  3. If a stock has not advanced in price at the 2 year mark, sell regardless of price

 

A Well Diversified Portfolio of 30 or More Stocks

Diversification is key for making this strategy work. Cheap stocks have a higher probability of producing an investment profit but they don’t all work out. Also, Graham’s stated “15% per year” performance (or roughly double the market’s return) is a return figure that characterizes the group – not each and every stock! Some stocks will definitely produce returns well above the stated average while other stocks will surely disappoint.

“To give yourself the best odds statistically, the more stocks you have to play with, the better. A portfolio of 30 would probably an ideal minimum. If your capital is limited…”

If you hold a large enough number of stocks then your portfolio is more likely to achieve the returns characteristic of Simple Way stocks.

Sell a Stock After a 50% Rise In Price

One of the biggest problems value investors face is knowing when to sell a stock. There’s almost as many sell strategies as there are stock selection strategies. Recognizing this, Graham gave some solid instructions:

“First you set a profit objective for yourself. An objective of 50 percent of cost should give good results.”

At first this looks looks like an arbitrary profit cut-off… but remember that Graham did a lot of backtesting on his strategy and likely identified this 50% target based on the results he obtained over a 50 year period.

Why would you cap your profit at 50% when your stocks could rise much higher? Why doesn’t intrinsic value factor into your selling criteria?

It’s a good question and the answer comes down to philosophy. Graham is implementing a mechanical value strategy, similar to the high performance deep value strategies we cover in our VIP Newsletter.

A mechanical value strategy uses strict – well selected – rules to automate buy and sell decisions to simplify investing and sidestep investor biases. The aim is to come up with rules that boost long term performance for your portfolio while reducing risk. Rather than focus on individual stock picks, adjusting for factors specific to each investment, mechanical strategies aim to manage “the forest” despite individual variation “from tree to tree”. This sort of investing is ideal for the small investor.

If Still Holding, Sell At The Two Year Mark

Some stocks, known as value traps, will trade under fair value for years. They’re difficult to avoid because a stock that you thought was a good buy could always become a value trap. Our high performance deep value strategies incorporate rules that help avoid value traps, but Ben Graham had a different tactic:

“You have to set a limit on your holding period in advance. My research shows that two to three years works out best. So I recommend this rule: If a stock hasn’t met your objective by the end of the second calendar year from the time of purchase, sell it regardless of price. For example, if you bought a stock in September 1976, you’d sell it no later than the end of 1978.”

Setting a holding period limit makes sure that you’re not stuck holding a stock forever waiting for it to go up.

Ben Graham’s Simple Way Performance Expectations

Graham’s study of the strategy suggested that investors could earn exceptional returns over the 50 year period.

“…in the long run, you should average a of 15 percent a year or better on your total investment, plus dividends and minus commissions. Over all, dividends should amount to more than commissions.”

What’s more, Graham found it to be a very dependable way to beat the market over periods of at least 5 years in length.

We backtested Graham’s Simple Way strategy, from 1999 to 2016, a period of 17 years, to see how it performed in our modern markets. There’s always a worry that a great stock strategy would fail to produce great results as more people find out about it and the stocks become easier to find. The results were surprising:

Graham's Simple Way

Ben Graham’s Simple Way 1999 to 2016 Performance

We tested a 12 month rebalancing period rather than Graham’s 50% sell rule and skipped the 2 year holding period restriction, so it’s possible that we had more “value traps” in our portfolio than Graham did.

Despite this, Graham’s Simple Way strategy clearly beat the market. While Graham said the strategy roughly doubled the market’s returns long term, earning 15% returns, our model portfolio came in at an 11.4% CAGR against an unusually week market. The S&P 500 returned just a 3% compound annual return over the time period.

It’s also interesting to see that the strategy struggled to beat the market over the last 7 years, from 2009 to 2016. But, an investor would not have lost money if he stuck to the strategy… and that’s more than a lot of amateur investors can say.

The last 7 years have been bad for value investors, generally, as top American firms such as Amazon, Apple, and Google steam ahead pulling up the indexes. Value investors have struggled to keep pace, so it’s important to put Graham’s Simple Way strategy into context.

Ben Graham’s Simple Way: How To Outperform Graham’s Last Investment Strategy

Looking at the above graph, it’s pretty clear that Graham was able to put together a great investment strategy that stood the test of time. What’s surprising is just how well Graham’s radically simplified investment philosophy works – not just over his 50 year test period but also throughout the last two decades.

If you’re an investor who is satisfied with a long term 15% return, then it’s tough to go wrong with Graham’s Simple Way strategy. But, for investors who want to boost returns while lowering risk even further, well… you can do a lot better.

We fall into the second camp here at The Broken Leg. We’re never satisfied and have sought out the best performing deep value strategies available. But, we also recognized the exceptional foundation that Graham laid out for investors in his Simple Way strategy. Rather than stick with the original formula, we tweaked a few things to come up with our own Simple Way 2.0 strategy. Take a look:

Graham's Simple Way 2.0

Ben Graham’s Simple Way 2.0 1999 to 2016 Performance

Building on Graham’s original strategy, our returns improved dramatically. Our adjustments produced a CAGR jump of 12% over the same period, from about 11 to 23%. Even better, the performance didn’t lag the market post-2009 like it did for our Simple Way backtest.

In our Simple Way backtest, the maximum drawdown (the largest portfolio value drop our strategy saw) was -64%. In our updated Simple Way 2.0 strategy, the maximum drawdown was right inline with the market. Remember, the S&P 500 is comprised of America’s top companies!

How did we get these returns? We implemented the following:

  1. A Forward PE less than 10x
  2. An equity to assets ratio of 50% or more
  3. A price to book value of less than 1.5x
  4. A dividend yield greater than the market’s

This defining set of criteria was enough for this astounding 23% CAGR.

We look for additional sweetners when selecting stocks for our investment letter subscribers, however. A sweetner is just a criterion that we look for which boosts returns and lowers risk. By incorporating these criteria into our Simple Way 2.0 scorecard, we’re targeting a 25% CAGR with much less risk. Click here to learn more about our Simple Way 2.0 strategy and other high performance deep value strategies we focus on.

That is the essence of Grahams Simple Way approach. Not every stock is going to produce a 50% return and having the objectivity to sell is important. Practiced with dedication over a long enough period provided Graham with returns averaging 15%. Compared with the general market, Graham’s Simple Way investment strategy provides a large boost to the money you’re able to save by retirement. An extra 5% per year over the market return adds a massive amount of money to your retirement funds. 

As the name implies the beauty of Ben Grahams Simple Way strategy is taking the guesswork out of investing. No more forecasting the future, predicting interest and cap rates, trying to nail down EPS, none of that, and investors can avoid needing to dive deeply into a firm’s financial statements. 

It’s ironic that the father of security analysis through most of his tactics away just before his death, but exceptionally skilled practitioners often radically simplify their approach over time. Most importantly, Benjamin Graham’s Simple Way Investment Strategy opens the door to a level playing field we can all share.

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