Graham outlines 5 possible ways to outperform the market (but only recommends 2):

  1. Growth Stocks
  2. Relatively Unpopular Large Cap Stocks
  3. Market Timing
  4. Purchase Bargain Issues
  5. Secondary Stocks

1) The Growth Stock Approach

Every investor, myself included, has a respect for the Motley Fool. They do a great job identifying stocks and they are true investment professionals. They are also are exceptional marketers: “The hottest stocks this year!” “This stock could be like buying Amazon in 1997!”.

Graham concedes that buying growth stocks appears to be the easiest way to outperform the market. It is intuitive to believe that the fastest growing stocks will continue to sky rocket. So why not just get a list of the top 100 best performing stocks, pick out the 10-15 best companies, and let it ride?

There are three threats to the growth approach that Graham identifies:

  1. Stocks that have been successful and are believed to have bright futures already sell at high multiples. Even though an underlying company may have excellent growth prospects, if we overpay for the stock our eventual returns may be disappointing.
  2. At some point the growth curve flattens out, and the company’s slower earnings growth takes an axe to it’s optimistic P/E.
  3. Growth stocks are much more volatile, investors have to weather much larger price swings, and these expensive stocks carry considerably more risk

Graham defines growth stocks as companies with P/Es above 20, and he generally argues to ignore stocks with a P/E above 25 altogether.

But come on, what a buzz kill Graham is!! If only he was alive to see the Amazon, Netflix, and Teslas of the world; all the ten baggers, the hundred baggers he would have missed out on!

Well he did see similar growth stocks in his time and he offers a thoughtful caveat which you may have experienced if you’ve owned a soaring growth stock, When should I sell? After seeing the stock you’ve purchased double, triple, or more; your overall financial position grows in the stock, as well as the percentage of your portfolio in the position. The company you initially invested $10,000 in is now worth $75,000 and man are you checking it’s price everyday. It dips 3 or 5% and the dread sets in: the roller coaster ride is over; we freak out and we sell. Or we set arbitrary price ceilings on the stock, and we sell. While we know companies that have had exponential decade-long periods of growth, it’s a rare investor who was disciplined enough to hold those stocks from beginning to end against all temptations to sell.

I’ve done it myself. I purchased Facebook at $21.85 in 2012. As the price continued to rise it became like an insatiable itch to sell, I could picture the day when people would begin to finally lose interest in aimlessly perusing Facebook or Instagram and the stock would take a hit. Despite that, the earnings continued to rise, quarter after quarter FB returned amazing growth. As the stock surpassed $80, $90, and then $100 a share, I began to count down the days and hours to each earning call. Finally, I sold 65% of my position at $130 in Q1 2017 while Facebook continues to accelerate and is currently trading at $152.

Each decline – however temporary it proves in the sequel – will accentuate his problem; and internal and external pressures are likely to force him to take what seems to be a goodly profit, but one far less than the ultimate bonanza.
Benjamin Graham, The Intelligent Investor

2) Relatively Unpopular Large Cap Stocks

The Intelligent Investor may argue that if growth stocks attract a popularity that can overvalue them, then unattractive stocks become undervalued. Frequently these undervalued stocks are beset by temporary headwinds that create excellent investment opportunities.

While that explains Graham’s recommendation for unpopular stocks, why does he hone in on only large cap stocks? Large cap stocks offer two advantages over small and even mid-cap stocks:

  1. Large cap stocks have the finances, assets, and human capital to survive a downturn in their industry
  2. If an unpopular but well-known company begins to show an uptick in their earnings and future profitability, the market will reward the company and its shareholders with a nice bounce.

Today, the unpopular large cap strategy has become known as the Dogs of the Dow. The Dogs of the Dow strategy is to annually purchase the top 10 highest yielding dividend stocks on the Dow to identify the index’s most unpopular stocks. So how does this value strategy first developed by Graham in 1949 hold up in the modern “growth stock era”? AMAZINGLY well!

Here are the total returns (including reinvested dividends) for the Dogs of the Dow, entire Dow index, S&P 500, and the Vanguad Growth Fund ETF (VUG).

Strategy 2012 2013 2014 2015 2016
Dogs of the Dow 9.9% 34.9% 10.8% 2.6% 20.1%
Dow Jones 0.2% 29.7% 10.0% 0.2% 16.5%
S&P 500 16.0% 32.4% 13.7% 1.4% 12.0%
Vanguard Growth ETF 17.0% 32.5% 13.6% 3.3% 6.1%
5 Year Growth of $100,000 2012-2017
Dogs of the Dow, Dow Jones, S&P 500 and Vanguard Growth ETF

The Intelligent Investor Dogs of the Dow Strategy vs DJI vs S&P vs Growth

So at the end of the most recent 5 years the Dogs of the Dow strategy would have grown $100,000 into $202,413, $35.5k more than the Dow Jones, $4.1k more than the S&P, and $9.4k more than the Vanguard Growth ETF!

The best website I found to implement the Dogs of the Dow Strategy is dogsofthedow.com, they show you the list of stocks each year and track the returns of the strategy at http://www.dogsofthedow.com/ddogytd.htm and I used their performance tracker for this post.

3) Market Timing

Conceptually, market timing is simple, buy during bear market lows and sell in bull market highs. In practice, as we have all experienced, market timing is much more difficult. Making matters worse, in a CFA Institute study, Professors Chua and Woodward found that for a market timing strategy to be successful, an investor would have to make accurate calls over 70% of the time.

Furthermore, I believe market timing can be the greatest detractor to our long-term returns whether we become overly pessimistic and sell into bear markets, catch the irrational exuberance bug and buy into the end of bull market rallies, or sell out too early in bull markets and miss some of the best years in the market. In sum, the stock market is way too unpredictable to employ a market timing strategy.

4) Purchase Bargain Issues

Graham defines Bargain Issues as companies whose value exceeds 50% of their stock price, by using one of two methods:

  1. Income Statement – Estimating a stock’s future earnings and dividends, and then using that information to appraise the firm’s true value. A potential formula you might use is the dividend discount model which we explained in an earlier post.
  2. Balance Sheet – Reviewing a firm’s net assets to derive the value of a company to a private owner; for example if the company was bought out.

Companies that become bargain issues have usually gone through a period of poor earnings and/or general unpopularity. Graham warns that only companies of a certain caliber should be considered for this strategy: 10+ years of strong earnings under their belt, with no negative annual earnings, and they must have cash to survive a continued downturn.

I’m not going to waste too much of your time on this strategy because Warren Buffet, the living Intelligent Investor, has tried and failed repeatedly to profit from bargain issues and since 1989 has publicly denounced what he nicknamed the “cigar-butt” strategy.

“If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns.”
– Warren Buffet in his 1989 Berkshire Hathaway Shareholder Letter

5) Secondary Stocks

During every Olympic Games, we all want to know, “How many gold medals have we won?” Although the difference between gold and silver in the Olympics can be a split second, a single pound, or a few inches; we put the gold medalist on a much higher pedestal than the second place finisher.

The Intelligent Investor recognizes that a similar premium is awarded to each industry’s leader (gold), and a related discount is offered to secondary stocks (silver) in each industry; giving us tremendous value investing opportunities. While in the Olympics you either win it all or not; the stock market is constantly in flux and often times secondary stocks can deliver exceptional long-term profits.

Secondary Companies when silver investments are gold

Secondary stocks may deliver a higher total return for a combination of reasons:

  1. Better dividend yield – since secondary stocks trade at a discount compared to industry leaders, their dividend yield is often considerably higher.
  2. Reinvested dividends compound – reinvesting the higher dividends compound to dramatically increase the total return after 5 or 6 years.
  3. Lower P/Es stocks are exceptionally rewarded during bull market runs as investors become less picky in their investment choices and expand their investment horizons beyond best-in-class stocks (as an extreme example picture the low quality stocks which received crazy valuations in the dot-com bubble).
  4. More room for growth – because secondary stocks by definition have a smaller market share, a positive change in management and strategy (or hubris infecting the industry leader) gives secondary stocks a higher ceiling for growth.

A good example of the dividend yield disparity of secondary stocks are Exxon Mobile (XOM) vs. Shell (RDS.A). While Exxon has an industry leading market cap of $344 billion to Shell’s $227 billion, Shell offers a 6.98% yield compared to Exxon’s 3.78% yield. That’s a 3.2% higher annual dividend for Shell, a company with a very similar future outlook as Exxon. The premium/discount in price between both companies is also reflected in their P/E ratios – Exxon trades at a 34x multiple while Shell trades at 29x.

In Summary

In The Intelligent Investor, Benjamin Graham analyzes 5 ways an enterprising investor can outperform the market.

Recommended strategies to outperform the market:

  1. Relatively Unpopular Large Cap Stocks
  2. Secondary Stocks

Strategies less likely to outperform the market:

  1. Market Timing
  2. Growth Stocks
  3. Purchase Bargain Issues

Posted by Max Asciutto

Hi I'm Max Asciutto! The Intelligent Investor blog is dedicated to blending Benjamin Graham's time-testing investment advice with a modern flair to write contemporary investment articles and stock reports to help you make better investment decisions. If you'd like to stay in touch, you can subscribe to the monthly newsletter or follow @aValueInvestor on Twitter.

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