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Benjamin Graham's Lost Magic Formula in 1976?

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gurufocus
Jul 10, 2007
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In my recent article titled “Warren Buffett’s Magic Formula in 1965?” I entertained the idea that Buffett employed a similar version of Joel Greenblatt’s Magic Formula (MF) found inThe Little Book That Beats the Market.


As a follow up, I re-read many of Benjamin Graham’s writings including his best selling books Security Analysis and The Intelligent Investor. After several days of investigation, I found a nugget of wisdom related to my previous article that I hope is worth sharing. I did not find it though in one of the five editions of Security Analysis nor did I find it in one of the four editions of The Intelligent Investor. Rather, I found it in interviews Graham graciously did just before he died September 21, 1976.


Benjamin Graham started his career on Wall Street in 1914 and was a millionaire by the age of 35. He retired from professional investing in 1956 but continued to follow the market while releasing updated versions of his masterpieces. Regarded as the father of value investing, Graham spent decades analyzing thousands of companies, practically inventing the security analyst profession, and documenting the value investment framework for many to follow today.


While reading these interviews he did between age 79 and 82, I got the feeling that Graham was enthusiastic as he described a new mechanical formula he had nearly finished testing. He believed his formula was the simplest way for both seasoned analysts and layman investors to find undervalued stocks and outperform the Dow (the performance metric used during his time). After 60 years of analyzing financial statements and managements, Graham said this about projecting earnings, evaluating market share, and analyzing individual companies:


“Those factors are significant in theory, but they turn out to be of little practical use in deciding what price to pay for particular stocks or when to sell them. My investigations have convinced me you can predetermine these logical “buy” and “sell” levels for a widely diversified portfolio without getting involved in weighing the fundamental factors affecting the prospects of specific companies or industries.”





This is not what you’d expect from the author of the bible of value investing and the original advocate of the Chartered Financial Analysts organization, renowned for their high analytical standards. Human nature would be to defend his 60 years of investment contributions which preached steadfast adherence to rigorous analysis. Instead, at 82 he was still open to new ideas while in search of the simplest method of selecting bargain stocks. 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.


Graham further recommended building a portfolio of 30 diversified stocks meeting such 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.


Graham back tested the period from 1926-1976 with his refined formula and concluded that such a program would have earned 15% or more, not including dividends, and would have beaten the Dow by twice as much. He was so excited by the study results that he contemplated including them in the 5 th edition of Security Analysis.


In the early 1970’s Graham was working on the 5 th and final edition of Security Analysis. My evidence suggests that he was virtually complete in 1976. Interestingly enough, while scrolling through the 5 th edition searching for any mention of his formula, I realized that the 5 th edition was not released until 1988. It was published a full 12 years after his death and 26 years since the 4 th edition. His death in late1976 certainly could have delayed publishing. However, a statement in one of his final interviews suggested that publishing the 5 th edition may no longer have been a priority. When asked about Security Analysis, his response was;


“They called it the “Bible of Graham and Dodd.” Yes, well now I have lost most of the interest I had in the details of security analysis which I devoted myself to so strenuously for many years. I feel that they are relatively unimportant, which, in a sense, has put me opposed to developments in the whole profession. I think we can do it successfully with a few techniques and simple principles. The main point is to have the right general principles and the character to stick to them.”





Wow! Did Graham feel so strongly about his newfound approach that he no longer had an interest in releasing the final edition? Even more disturbing, I have been unable to find evidence that he, nor any anyone else on his behalf, pursued his study any further. Not only was the book delayed by 12 years, more importantly, his study results were likely tossed aside. My guess is that had Graham lived longer it is likely he would have introduced the study in a new book dedicated solely to the formula. What a treat it would have been to see the father of value investing evolve to such simplicity. It would be nearly 30 years before a reputable investment manager introduced a similar formula.


Graham’s formula bears resemblance to Joel Greenblatt’s MF found in The Little Book That Beats the Market. While Graham used a “financial stability” metric (e.g. equity/assets) and Greenblatt used a profitability metric (e.g. Return on Invested Capital), both recommended buying the same number of cheap stocks. In addition, they recommended strict sale rules while both outperformed the market by more than 100%. Below is a comparison of Joel Greenblatt’s MF and Benjamin Graham’s prescribed formula in 1976.


(table here)


I found that by setting up a “Graham” screen with the above criteria (excluding financials, utilities, and ADR’s as prescribed in the MF) there is considerable overlap of potentially undervalued stocks when compared to Top 25-100 MF stocks at magicformulainvesting.com


Mohnish Pabrai, managing partner of Pabrai Investment Funds, has trounced the market since 1999. He has returned more than 28% after fees by operating a portfolio of approximately 10 stocks bought at 50% discounts to intrinsic value. Despite his enormous success, Pabrai in his best selling book The Dhandho Investor noted that investors would do quite well simply following Greenblatt’s MF. He went on to say;


“The Magic Formula is a very good place to go hunting for fifty-cent dollar bills. We could keep it very simple, only analyzing Magic Formula stocks day in and day out, and become quite wealthy over time. I strongly recommend this approach. It is simple. You’re shooting fish in a small barrel, and the results are likely to be vastly superior to the indexes.”





Benjamin Graham, Joel Greenblatt and Mohnish Pabrai combined represent more than 100 years of investment experience and annualized returns far superior to the market. And they all did it with in-depth, company-specific analysis. Yet, all three recommend a simple, mechanical approach for outperforming the market. I find it fascinating that this seemingly complex group of investors known for their stock picking abilities recommended a painfully simple approach that requires virtually no thinking or analysis.


So there you have it. Graham, the father of value investing, reduced intelligent investing to a mind-less formula a 10 year old could successfully implement. Buffett, as I suggested in my previous article, may have used a “relatively” undervalued approach in 1965 similar to Greenblatt’s Magic Formula. And lastly Pabrai, a modern day value investor that has handily outperformed the market, recommends the Magic Formula approach as a simple means to outperforming the market.


Simple and easy enough, right?


In the last of 3 articles on magic formulas titled “Magic Formula’s: Do As I Say, Not As I Do” I will argue that value investing is a mechanical formula and explore why most people are simply unable to follow a mechanical formula even after compelling evidence that such a technique outperforms the market.


Editor update (June 2013): Check out the Ben Graham Screener here.


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