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Empirical Finance just released a detailed research study that backtested a simple Ben Graham strategy for investing in stocks.

Backtesting Ben Graham

The backtest is based on a 1976 article in Medical Economics magazine, where Graham was interviewed and provided some tips on stock selection.

From the article,

“Graham believes that a doctor handling his own investments should be able to utilize those same principles to achieve an average return of 15 percent a year or better”

According to Graham, investors should look for two defining characteristics when picking stocks:

  • P/E ratio of 7 or less
  • Shareholder Equity ratio of > .50

Graham also goes on to recommend a portfolio of roughly 30 stocks and a holding period of two to three years.

Empirical Finance has done an amazing job of running the study based on these criteria. Here is the explanation:

“We decided to keep it simple and backtest the low P/E (<10), shareholder equity > .5 strategy from 1965–2010. We also backtested the results in accordance with the “trading rules” alluded to by Graham: stocks entering the portfolio are held for 2 years, or if they appreciate >50%. For robustness, we tested a variety of P/E and shareholder equity combinations–all results are very similar.”

It turns out that Graham was spot on with his return estimates:

Both the small and mid-cap backtests eclipsed the 15% CAGR metric for the study period.

It looks like the large-cap portfolio did not fare as well.

The study is great confirmation that Graham’s methods work, especially for the smaller stocks that are the focus of this blog.

And probably proof that many investors badly over-complicate their stock picking strategies – myself included!

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3 Responses so far

  1. Ranajit says:

    Interesting, another Magic formula like screen with a longer holding period. Great.

    Although I wonder how much will the real returns be when considering spreads, slippage and commissions, given that it is a basket of 30 stocks. I wonder if the backtest takes those factors into consideration. In any case, I guess it is still better performance than a lot of mutual funds :-)

  2. Ranajit says:

    Btw, on a different note..what do you think about the federal govt shutting down poker sites. Pretty unfortunate that a game of skill has been branded as gambling. I am glad I stopped playing and didn’t have much money in my poker accounts.

    • asues says:

      Ranajit,

      That’s why I’m interested in the full academic study – to see if some of those factors were taken into consideration with the return calculations. Even if they didn’t, the returns are certainly impressive considering how simple the analysis is. The problem is that most investors will deviate from the strategy during the inevitable rough periods.

      As far as poker, I’m glad I got out as well. The games had already gotten significantly tougher (since only pros and competent grinders were left still playing for the most part). I didn’t delve into all of the details of the recent shutdown, but I am hoping for the day when poker is finally controlled and regulated – I can’t believe the government would pass up the chance for billions of dollars in tax revenue.

      We’ll see how it plays out, but I think it is very likely it gets legalized in the near future.

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