A stock portfolio based on Ben Graham’s Stock Selection Criteria for the Defensive Investor is a straightforward yet robust method to beat the market. The strategy selects 15 stocks listed in the S&P 500 and holds them for one year or more. Once a year, investors examine the portfolio and are instructed on replacing between two and three stocks.
I have rigorously tested my screener and strategy using the best-known methods to avoid curve-fitting and cognitive biases. Let’s see how it fared in the short-term (i.e., in 2019) and the long-term.
In chapter 14 of his book “The Intelligent Investor”, Graham provides his lists of stock selection criteria for the defensive investor. Following are the rules and how we applied them:
1. Adequate size of the enterprise
In our model, we defined our stock universe to be the S&P 500. All constituents are large and prominent companies.
2. A sufficiently strong financial position
Graham suggested to filter out companies whose current ratio (current assets divided by current liabilities) is less than 2, or whose long-term debt is less than the net current assets (current assets – current liabilities). We assume that the constituents of our universe, the S&P 500, possess a sufficiently strong financial position. Applying further rules are not necessary. Such rules would be too restrictive and will result in losing good opportunities rather than avoiding bad companies. Our testing confirms this choice.
3. Earnings Stability
Graham suggested a positive net earnings figure in any of the last ten years. We are less stringent and require only five years with some net earnings in every year.
4. Dividend record
Graham suggested uninterrupted payments for at least 20 years. Over the years, paying a dividend has become less popular and were substituted in part by repurchasing shares or re-investing in the firm. We require uninterrupted payments for only five years.
5. Earnings growth
Graham suggested a minimum increase of at least 33% during the last ten years, using three-year averages at the beginning and the end. We adopted the rule as stated.
6. Moderate Price/Earning Ratio
Graham required that the current stock price should not be more than 15 times the average earnings of the past three years. Given the much lower interest rates these days than in Graham’s day, we relaxed the rule to P/E <= 20.
7. Moderate Ratio of Price/Assets
Graham required that the multiple of P/E (using average earnings for the past three years) and P/B would be less than 22.5. This rule is interchangeable with the previous rule (OR function between them). We have relaxed it to P/E * P/B<= 30.
Applying these rules on the S&P 500 universe results in 40-150 stocks at any given time. Graham allows the defensive investor to apply his own discretionary judgment as to which stocks to select out of this group. We have performed backtesting with numerous criteria, and we have found that choosing the least volatile stocks (as measured by 3-y Beta) provides the best risk-adjusted returns. Selecting stocks on the merit of other momentum or value results in an excellent performance, yet the higher volatility may be uneasy to handle, especially for defensive investors.
“Defensive Investor” Screener Performance During 2019
The following chart presents the performance of a quantitatively-selected portfolio of 15 stocks selected according to Graham’s criteria, out of the S&P 500 universe.
All stocks were bought on January 1st, 2019, and held for exactly one year.
Unfortunately, Graham’s “Defensive Investor” strategy did not beat the market during 2019. It has returned 20.55% vs. the S&P 500’s 31.22%, including dividends. While a 20% annual return figure is a good result on an absolute basis, it is 11% lower than the benchmark’s return in 2019.
Does it mean that Graham’s criteria for the defensive investor have lost their charm and they are no longer a good investment strategy?
2019 was not a good year for value investors, regardless of their style and specific methodology. We shall elaborate on that below.
Long-Term Performance of Graham’s “Defensive Investor” Screener
The following chart presents the performance of my version of Graham’s strategy over a 5-years period, June 30th, 2014, to June 30th, 2019. The reason I perform all my long term backtests starting June 30th is two-fold: 1) to be consistent with academic research who uses such convention 2) to be consistent across all my other publications, enable readers to compare all my backtests, apples to apples.
We can see that the performance over a 5-years period was somewhat lower than the S&P 500’s performance.
Testing the strategy over 20 years starting June 30th, 1999, and ending on June 30th, 2019, tells a totally different story.
The strategy delivered great average annual returns of 9.68% vs. 5.82% for the S&P 500. Over the long term, the strategy beats the benchmark. Moreover, it has done so with lower volatility, as measured by the standard deviation of monthly returns. The standard deviation of the strategy came in 11.35% vs. 14.51% for the S&P 500, as can be seen in the following table. Sharpe ratio is at a super high level of 0.72x vs. 0.32x for the S&P 500. The correlation with the S&P 500 benchmark is a mere 61%. It means that only 61% of the months tested, the S&P 500 and the model both appreciated or both declined. In all other cases, when the market declined during a month, the model appreciated, and vice versa. Over the long term, Graham’s “Defensive Investor” strategy develops a healthy margin over the market and runs much higher.
It is also interesting to see, in the tables above, the contrast between the overperformance in the long term (table on the right) vs. the underperformance during the last three years (table on the left).
Looking at the yearly performance in the following table, we see that in most of the years during the last 20 years, the model delivers positive excess returns over the market.
What Does The Future Hold For the “Defensive Investor” Strategy?
The largest overperformance was achieved following the underperforming years. Following 1999, a disastrous year for Value Investing and a bad year for our model, lagging by more than 22%, came the year 2000-2002 with a fantastic excess of roughly 20% above the market each year. Following 2009, the strategy’s performance has degraded compared to the previous decade. That is comparable with most Value Investing strategies, which have lagged the market during most of the last decade.
The most telling graph I could find about the history of Value Investing a one taken from an article by Dr. Gray titled Alternative Facts About Formulaic Value Investing:
The chart shows the 10-year rolling returns (compounded annual growth rate, or CAGR) or Value vs. the S&P 500. Every point on the chart indicates the following: had you invested in a value portfolio (or the S&P 500) 10 years ago and held it until that date, what would have been your CAGR. We can see that during most 10-years periods starting the 1930’s, a Value portfolio had beaten the S&P 500. But there were four long periods where it was not the case. Those periods occurred in the late ’30s to early ’40s, during the late ’50s to early ’60s, during the late ’90s, and recently, since 2010. In those periods, Value Investing fell short of the benchmark, leading investors (different ones each time) to believe that Value Investing is dead. An important observation is that those periods of Value underperformance are long, prolonging for many years, even a decade.
Now, ask yourself, examining the historical trends for almost a century, do you believe that Value Investing will underperform forever? Where would you put your money? And if you, like I, believe that Value will re-emerge, as it always has, wouldn’t you want to be invested in the best-performing Value Investing strategy?