I was reviewing some articles on Graham's "value" investment rules and how they might be impacted in a rising interest rate environment. If the Fed plans to raise interest rates from historical low levels, what should the value investor expect from his recent value purchases? What is his selling methodology for exiting positions?
Benjamin Graham’s Lost Magic Formula in 1976?
gurufocus.com
From the article:"... His formula went through two iterations. He introduced the first formula at age 79 and concluded from his results that one would have performed quite well from 1961-1976 by buying stocks with the lowest values of these three criteria:
* A low multiple (e.g.,10) of the preceding year’s earnings;
* A price equal to half the previous market high (“to indicate that there has been considerable shrinkage”);
* Net Asset Value. (I presume this is the lowest price relative to book value)
In his next interview published in Medical Economics, September 20, 1976 titled “The Simplest Way to Select Bargain Stocks” Graham, then 82, proposed a simpler, more refined formula that consisted of:
* PE Ratio of 7x-10x or less (Based on 2x current AAA bond rates)*;
* Equity/Asset Ration of .5 or more (e.g. Debt/Equity >1).
* Calculate the maximum PE by dividing (2 x AAA bond rate) by 100. Example: 7% AAA bond would equate to PE of 7x (100/ (2x7)). If rates are below 5%, then use 10x PE max. Graham said always buy at PE 7x or less regardless of AAA rates...."
Grahams selling criteria
"...His study employed strict sale rules that required selling the stocks after a 50% gain or after a two year holding period, whichever came first. Graham noted that in the market downturn of 1973-1974 investors using the formula would have shown paper losses but would have been rewarded soon thereafter for sticking with the formula. Thus, to allow time for the program to work he recommended a minimum of five years. In other words, patience was a requirement for success...."
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It appears to me that we should see PE expansion in our value picks as higher LT interest rates get factored into the current stock price. Also, Graham's two year "strict" sales rule should come into play at the end of 2010 or the beginning 2011.
Perhaps it time to make my list of possible sales starting with peeling off shares of those 50% gainers bought in late 2008 and early 2009.
Is it going to be different this time?
EKS |
