Low Valuation Ratios Lead to Strong Portfolio Returns

Backtesting Ben Graham's Lost Formula strategy

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Sep 13, 2016
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Known as the “Father of Value Investing,” Benjamin Graham intelligently invested money in the stock market.

Throughout his investing career, Graham explored several investing strategies to search for company stocks trading at deep prices and discussed the principles of safe investing in his financial books and teachings. During his final three years, the intelligent investor introduced a simple formula for searching bargain stocks: a trailing 12-month price-earnings (P/E) ratio between 7 and 10 and an equity-asset ratio at least 0.5.

Backtesting feature identifies top investing strategies

As discussed in the new feature announcement, the Backtesting feature allows users to model an investing strategy’s performance relative to the Standard & Poor’s 500 index. Users can access Backtesting within the All-in-One Guru Screener and set up the following parameters: screen date, rebalance frequency, the maximum number of company stocks in the model portfolio and how to order those stocks. Each of the parameters can affect the test portfolio and its performance relative to the S&P 500 exchange-traded fund including the “rank by” parameter.

The following backtesting of Graham’s lost formula considers the effect of changing the following two parameters: rank by and rebalance frequency. To remain consistent, we have set the screen date to January 2006 and limited the test portfolio to 30 stocks. As of Sept. 12, the backtesting resulted in the following portfolio returns.

Rank By Order Rebalance Frequency Overall Performance Rank
P/E ttm ASC 12 months 93.22% 2
P/E ttm ASC Six months 70.30% 5
P/E ttm ASC Three months 81.56% 4
P/E ttm ASC None 159.68% 1
P/E ttm DESC 12 months 13.99% 13
P/E ttm DESC Six months -16.41% 15
P/E ttm DESC Three months -24.45% 16
P/E ttm DESC None 41.00% 8
E/A ASC 12 months 46.77% 7
E/A ASC Six months 25.88% 11
E/A ASC Three months 15.55% 12
E/A ASC None 56.38% 6
E/A DESC 12 months 35.25% 10
E/A DESC Six months 35.70% 9
E/A DESC Three months 5.10% 14
E/A DESC None 87.78% 3
S&P 500 exchange-traded fund 71.65% Â

Based on the above table, the Ben Graham Lost Formula strategy outperforms the S&P 500 ETF in regard to low P/E ratios, suggesting that investing in companies with low valuations results in strong portfolio returns.

Biotech companies offer good returns

The test portfolio held Biomarin Pharmaceutical Inc. (BMRN, Financial) from 2012 to 2016 and Alnylam Pharmaceuticals Inc. (ALNY, Financial) from 2014 to 2016. Both biotechnology companies contributed to the portfolio return: Biomarin had net gains from 2012 to 2015 while Alnylam gained 51.89% during 2014.

With a modest financial strength rating of 5, Biomarin has a slightly weakened business operation. The pharmaceutical company has a Piotroski F-score of just 2, and its operating margin outperforms just 53% of global biotech companies. Despite the poor F-score and return on capital, Biomarin has a strong Altman Z-score of 7.10, implying almost no distress.

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Biomarin’s Z-scores have increased from -2 to a 10-year high of 8.78 in 2015, suggesting that the medical company strengthened its business operations during the past 10 years. Even though the company’s profitability rank is a modest 4 out of 10, Biomarin’s three-year revenue growth and three-year EPS growth both outperform 60% of global biotech companies.

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Based on its profitability rank of 1, Alnylam Pharmaceuticals has struggled to make a profit. The company’s operating margin underperforms 78% of global biotech companies, and its three-year revenue growth rate is -28.30%. Despite the low profit margins, Alnylam has a higher Altman Z-score than does Biomarin, suggesting Alnylam is less likely to go bankrupt.

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Conclusions and see also

One of the value screeners that GuruFocus offers is the Net-Net Working Capital Screener, which highlights Graham’s investing strategy that looks for bargain companies based on net current asset value (NCAV). Additionally, the intelligent investor conservatively values companies with the Graham number, which is the square root of the following product: 22.5 times the company’s tangible book value per share and earnings per share without nonrecurring items.

Although premium members have access to all value screeners, including the All-in-One Guru Screener, the membership only offers up to three years of backtesting. Users need to upgrade to Premium Plus membership to backtest up to 10 years. Additionally, premium plus members have access to more than 4,000Â guru portfolios, the Manual of Stocks for all U.S. companies and 20,000 monthly queries in the Excel Add-in and API.

Disclosure: The author has no position in the stocks mentioned in the article.

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