Blog - Investing Notes

March 26, 2007 - Testing Benjamin Graham Out of Sample

Does old-fashioned value investing still work? In their recent paper entitled "Testing Benjamin Graham’s Net Current Asset Value Strategy", Ying Xiao and Glen Arnold test Benjamin Graham's approach to valuation based on net current asset value to market value (NCAV/MV) to see whether it outperforms in a modern market environment. NCAV is current assets minus all current and long-term liabilities, divided by the number of shares outstanding. The strategy assumes that a stock is substantially undervalued when NCAV/MV is 1.5 or greater. Using accounting and return data for stocks listed on the London Stock Exchange during 1980-2005, they find that:

• The average five-year buy-and-hold raw return for stocks with NCAV/MV > 1.5 is 254% (19.7% annualized) with equal weighting and 216% with value weighting, compared to 137% and 108% respectively for the overall market.
• NCAV/MV portfolios underperform the market index in only four or five out of 20 five-year holding periods. Based on equal weighting, the NCAV/MV strategy outperforms the market eight out of ten years in the 1980s, but less regularly in the 1990s.
• The average delisting rate for the NCAV/MV (market) portfolio is 27% (32%) for five-year holding periods. The average five-year failure rate for the NCAV/MV (market) portfolio is 2.6% (4.2%). NCAV/MV stocks are not riskier than the average stock based on this data.
• The standard deviations of monthly returns for the fairly small NCAV/MV portfolios are slightly higher than that of the overall market.
• The size effect accounts for a substantial part of NCAV/MV portfolio outperformance, most apparently for shorter holding periods. Over five-year holding periods, however, size and book-to-market ratio do not explain abnormal NCAV/MV stock returns well.

The following table, taken from the paper, shows average equal-weighted and value-weighted raw returns for NCAV/MV portfolios and a broad London Stock Exchange portfolio for holding periods of one to five years during 1980-2005. NCAV/MV portfolios consist of listed companies with NCAV/MV > 1.5 at the beginning of the preceding July. The table shows that the NCAV/MV strategy consistently outperforms the market.

In recent years, the number of companies satisfying the condition NCAV/MV > 1.5 is small (less than ten), greatly limiting the diversification of associated value portfolios.

In summary, Benjamin Graham-style value investing still works but is more difficult to execute than in the past because severe undervaluation has become rarer.

For related research, see Blog Synthesis: The Value Premium.