So writes Norman Rothery (www.stingyinvestor.com) in edited excerpts from his original article entitled 6 Graham Stocks for 2013.

Rothery goes on to say in further edited excerpts:

You can see the full performance record for my take on Graham’s strategy in the accompanying table. I’m happy to report that it has outperformed the S&P500 (as represented by the SPY exchange-traded fund) in 9 of the last 12 years and often by a large margin.

If you had bought equal dollar amounts of the Graham stocks and replaced them with the new crop of stocks each year, you would have gained 681% (19% annualized) over the full period. On the other hand, the unfortunate index investor who bought and held the S&P500 ETF (NYSE:SPY) would be up only 28% (2% annualized) over the same period. (These results are in U.S. dollars, do not include taxes, but do include dividends reinvested each year when the new stocks are selected.) As you might imagine, I’m very pleased with the returns so far.

You can read all about Graham’s original method for defensive investors in his book The Intelligent Investor. While he passed away in 1976, an updated edition of The Intelligent Investor (ISBN 0060555661), with modern commentary from veteran columnist Jason Zweig, was published in 2003 and it is definitely worth picking up. I hasten to add that serious Graham buffs should also get a copy of the sixth edition of Security Analysis (ISBN 0071592539) which includes additional commentary from some of today’s most famous value investors. Just be warned, it’s a thick volume that can be daunting.

The Graham Rules

Graham’s original rules for defensive investors were very strict. So strict that you’d have been hard pressed to find any North American stocks with it for much of the last decade. As a result, I took a slightly more lenient approach. The factors I look for are shown in the accompanying list.

To highlight one way that I differ from Graham, consider the dividend test. I require some dividend growth over the last five years whereas Graham demanded a twenty-year record of uninterrupted dividend payments. However, there are very few firms with good 20-year dividend records and requiring them narrows the universe of stocks under consideration dramatically.

Despite the different rules, very few U.S. stocks usually pass my version of Graham’s test. The annual list peaked at ten stocks in 2002 and quickly bottomed out at two stocks in 2003. (As an aside, I track the list more frequently and found over forty stocks that passed the test when the market hit its lows in the spring of 2009.) This year, the list slipped down to six stocks as the U.S. markets moved higher.

I hasten to add that a well-diversified portfolio should hold more than 10 stocks and in most cases much more. As a result, Graham’s list should be supplemented with other stocks to avoid under-diversification.

You can review the current crop of Graham stocks in the accompanying table but before buying any of them, be sure to examine each stock in great detail. After all, the method is based entirely on the numbers and less tangible aspects of each company are also worth considering. Look for issues that might not be reflected in a company’s latest numbers and get up to speed by reading news stories, press releases, and regulatory filings.

Take your time to get comfortable with Graham’s defensive method, and value investing more generally, before starting out. It might look easy, but it can be harder than you might expect to hold on as value stocks go through their ups and downs.

While Graham’s defensive method has avoided serious trouble so far, it can’t be expected to outperform all of the time. After all, it has trailed the markets in three of the last twelve years so don’t get lured into it based on past performance alone.

Related Articles From the munKNEE Vault:

1. Value Investing: The Practical Application of Benjamin Graham and Warren Buffett’s Principles

2. Which Stocks Trade at a Discount to the Graham Number?

Benjamin Graham, the godfather of value investing created an equation to calculate the maximum fair value for a stock, referred to as the Graham Number and any stock trading at a significant discount to this number would appear undervalued. [Here are the names of 18 such stocks.] Words: 1707

3. How the Dow 30 Stocks Compare According to Their Margins of Safety

Benjamin Graham, known as the father of value investment, is famous for his simple, yet powerful, valuation method as first explained in his 1973 book, Intelligent Investor, and later updated in his book entitled Renaissance of Value. His Graham Number approach has been adapted and applied to all 30 stocks listed on the Dow Jones Industrial Index to determine which of the stocks have above average safety factors of which only 10 do. Below is an explanation of the approach, the formula and the results for all 30 stocks.