James Rea mailed a computer printout of his stock list to Ben Graham. Rea had never met Graham. He had no clue Graham existed. At least, not until clients said he should read an article by Graham.
It turns out Rea’s list was filled with the type of stocks Graham wrote about for years. His letter eventually led to a phone call from the legend, which led to a meeting, then a research collaboration, and finally a private investment fund.
After some debate, Rea and Graham agreed on 10 stock criteria to base their research around. The period covered was 1925 to 1975.
Graham’s goal was simple:
To try to buy groups of stocks that meet some simple criterion for being undervalued — regardless of the industry and with very little attention to the individual company.
He wanted to bypass time-consuming analysis for a more diversified “group” approach to stock selection using a few simple metrics. And their research backed up the idea.
The results were impressive enough that the two started a small private fund. The portfolio was initially broken down into three equal parts: U.S. government bonds, Graham’s NCAV strategy, and “performance companies” selected using the 10 criteria. (They later reduced their criteria down to the best performing three: low P/E ratio, high dividend yield, and a debt/equity ratio of less than one.)
Of course, the proportions weren’t set in stone. They allowed for flexibility but with limits. The bond allocation would never fall below 25% or exceed 75% (the same goes for the stock allocation). The stock allocation was largely dependent on the availability of stocks. As the market moved higher, the number of stocks meeting their criteria fell. So naturally, the size of the stock allocation moved opposite the market.
Then Graham asked an important question: What happens when there are not enough stocks to invest in? What’s the alternative? He suggested this:
What if we were to write options naked, in other words, to sell call options (or buy puts) in companies’ stock which we don’t own. But only for those companies that are on the bottom side of the print-out, which are the ones that are the most popular in that their price-to-earnings ratios are extremely high, they don’t pay much dividend yield, and they haven’t had that much growth recently, nor stability in that growth, and their balance sheet is highly leveraged where their net current asset value is negative, their debt is much greater than their equity, and, in other words, they don’t have much financial soundness. There are a lot of those companies, popular companies, that have the lowest reward-to-risk ratio and have the poorest rating using our ten criteria, so we wouldn’t want to own those stocks, but maybe we could write options on those stocks naked.”
(Graham liked arbitrage situations back in his Graham-Newman days, and was thinking of ways to use options via arbitrage.)
Unfortunately, Graham died not long after the fund was created. To my knowledge, the fund’s performance was never made public either.
Still, there are a few lessons to take away from their portfolio collaboration.
1. Each criterion serves a purpose. Rea and Graham divided their criteria into two goals. Rea described it as reward potential (profit) and risk potential (loss) — five criteria for each. They wanted stocks with a high reward-to-risk ratio.
The reward criteria looked for stocks that offered a high chance of profits. The risk criteria eliminated stocks with a high chance of loss.
The first step was to disqualify stocks using the risk criteria. That removed as many financially unsound companies as possible that would likely result in a loss. Then the reward criteria are run on the remaining pool. The result is a list of stocks that not only improve the chance of profit but (hopefully) increase the magnitude of profits too.
A few things can happen from here. For instance, if only a couple of reward metrics are used, like a valuation multiple, you can sort by cheapest. The same can be done with several metrics, but another option is a points system, which is what Graham and Rea used with their 10-criteria method (before simplifying things down to 3-criteria).
Of course, a system that uses dual criteria can prioritize loss avoidance over profits. That option is lost if reward criteria are the only focus.
2. Simple over Complex. The interesting thing about their strategy is they started with 10 criteria and an elaborate points system.
But when they dug into the data, they found three criteria, when combined, produced similar returns. So they ditched the 10 criteria for three.
Even Graham can be drawn to complex strategies, at first. It seems to be a consistent shortcoming for most investors. Simpler methods often work just as well, if not better.
3. Set the rules in advance. Patience and time were key to their strategy’s success. Graham knew human nature worked against that. So he created simple allocation rules that worked contrary to the market’s movements. Conveniently, it worked contrary to human nature too. But the portfolio was never totally out of stocks or bonds either. It always owned some of each, in case he was wrong.
He also pushed for set buy and sell rules for similar reasons. The rules protect against emotional decisions that lead to mistakes. But also, the rules fill in for the absence of valuation analysis. Graham chose a sell rule, so as not to be too greedy — sell after a 50% gain or 2 years, whichever comes first.
Now, this assumes investors stick to the rules. So it’s not foolproof. That said, the average investor is probably better off with rules than without.
4. Diversification is more important than in-depth analysis. Graham was skeptical that the average analyst could outperform his “groups.” His argument was: more information doesn’t always produce better results.
So often when I went to the trouble to get all this information on any one company, I found it was not always right. And even the presidents and vice presidents of the companies were not consistent in what they told me. I think we are doing really enough research if we make sure that these companies meet our criteria, so why don’t we just buy a little bit of each company? Don’t trust it. And diversify by buying just a little bit of another company that also meets our criteria. I think our performance will be much better if we do that rather than trying to do so much in-depth research.
Investing is about placing a bet before you know all the details. The risk is trying to collect every last scrap of information. If you collect long enough, you’ll eventually be certain of the outcome, but so will the market, and the opportunity for big profits will be lost.
Graham is essentially saying that with enough diversification, less information is more (profit). So how many stocks? Enough stocks need to be owned for the odds to work in your favor. For Graham, 30 was the minimum.
5. Never stop thinking about new ways to invest. No strategy is guaranteed to work forever. Graham knew this from experience. The market can eliminate opportunities — like his NCAV strategy — for long periods of time, sometimes permanently.
So what happens when the criteria produce no stocks? The risk is in moving the goalposts just to own something. Graham was thinking about that possibility when he suggested the options strategy.
But first, you must research it and then test it with a small portion of the portfolio. One of the last things Graham wrote Rea was:
Never stop your research, Jim. Keep your research up and keep looking for new areas of investment.
The one thing about Graham is he never stopped looking for new ways to apply his value principles.
This post was originally published on January 24, 2020.