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Suresh Krishnamurthy

Over the last 12 months, the pay off for employing a Ben Graham-inspired technique has been exceptionally high. Its success suggests that this strategy can be tapped once more now to identify probable investment candidates. However, there are risks that need to be suitably factored when employing the strategy in the market place.

IT is incredible but true. There is an investment strategy that out performed equity mutual funds that have delivered returns of nearly 100 per cent over the last 12 months. Stocks picked in October 2002 using a filtering technique pioneered by the legendary US investor, Benjamin Graham, co-author of the book `Security Analysis', which is considered a bible for investors, have produced attractive returns. They are, on an average, higher than what equity mutual funds have delivered during the same period.

Can the strategy perform an encore now? The odds may be against it. Formula-based approaches to stock picking tend to miss out on some factors that are determinants of stock price trends, which, in any case, keep changing. For example, this strategy relies heavily on past performance. The performance of formula-based approaches may, therefore, be inconsistent.

Still, the underlying strength of this strategy needs to be considered. Its emphasis is on picking stocks of fundamentally sound companies with a reasonable profit growth record. The valuations of these stocks should be lower than that of their peers. In addition, its performance in 2003 also needs to be reckoned. This suggests that the strategy can be tried once more.

Unearthing value

Given that markets were under the grip of bears in October 2002, the filtering technique did unearth some valuable stocks that have since delivered attractive returns.

The technique picked out stocks such as TNPL, UTI Bank, JB Chemicals, FDC, Hindalco, Bank of Baroda, J&K Bank, Ucal Fuel Systems, Vesuvius India, Corporation Bank, Berger Paints and Pidilite Industries.

These stocks delivered average returns of about 120 per cent over the last year.

In October 2002, the price-to-earnings multiple of these stocks was lower than 10. Their financial performance over the previous five years was also good; they registered compounded annual growth of more than 10 per cent. Their solvency as measured by the current ratio was good. The proportion of long-term borrowings to net current assets of these stocks indicates that these firms were adequately capitalised.

Similar filters were employed now to the S&P 500 list of stocks to identify probable investment candidates. The technique produced a list of 28 stocks. This list was pruned using subjective judgment to the following set of ten stocks: South Indian Bank, PNB Gilts, Jammu & Kashmir Bank, Kochi Refineries, Canara Bank, Tube Investments, Apollo Tyres, FAG Bearings, Bayer ABS and Graphite India. Once again, the average price-to-earnings multiple of this set of 10 stocks is less than 5. Their price to book value ranges between 0.5 and 1.5. The long-term borrowing of these companies, as a proportion of net current assets, is substantially less than one. Their profit record is moderate, if not impressive.

Caveats apply

In the present list of 28 stocks, 15 are Banks. This is not surprising, as the valuation of bank stocks suggests that the downside is relatively lower compared with the market. On the other hand, it also suggests that the valuation of most other stocks have now risen appreciably over the past 12 months. Prices of other stocks now factor in earnings growth rates that may be higher than what was achieved in the past. In that context, this set of stocks may under perform in a rising market.

Importantly, the top of a bull market is not the right time to evaluate the efficacy of any investment strategy. As such, any investment strategy that relies solely on this technique runs a high risk. What would be more appropriate is to use this strategy among many other worthwhile strategies to identify stocks to build a portfolio. In addition, the risks involved in an investment in this set of stocks can be considered as high. Stocks such as South Indian Bank, PNB Gilts, FAG Bearings, Bayer ABS and Graphite India are relatively less liquid. If their financial performance worsens, then their liquidity may decline considerably. These risks need to be factored in while employing this strategy in the market place.

These risks however do not reduce the utility of this strategy considerably. In fact, these stocks are likely to out perform in a stable market. In addition, if stock prices decline, these stocks may even decline less than their peers.

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