The
Graham-and-Buffettsville Smart Alpha Framework
First
Criteria: Reduce Business Risk
Graham
mentioned that when one buys a stock one is investing in the business. So one
faces business risk, i.e the risk of the business losing customers and sales.
Hence investing in fairly stable businesses with large revenue streams and a
big customer base is crucial. This reduces the business risk. To sort through
the more than 4000 companies available in the Indian stock markets we apply the
first criteria: Select companies greater than INR 1000 crores in sales.
Second
Criteria: Reduce Financial Risk
Graham
was an investor in bonds, stocks as well as all forms of hybrids. So his eye
for safety in stocks was very keen. The bonds of an over-leveraged company are
risky. And if bonds are risky then the stock of that company is even more
riskier! So the company could face financial risk and go bankrupt falling into
the hands of the bondholders, leaving nothing for stockholders. To reduce the
chances of bankruptcy, we apply the second criteria: Select companies with
Debt/Equity < 30%.
Third
Criteria: Focus on Value Creators
Buffett
has mentioned that companies which earn below their cost of capital are value destroyers.
He prefers to invest in companies with a Return on Equity of more than 15%, the
value creators. This helps us stick to companies which are adding value to
their equity holders: Select companies with ROE>15%
Fourth
Criteria: Don’t Lose Capital
Buffett
says there are only two rules to investing:
• Rule
#1: Don’t lose capital
• Rule
#2: Don’t forget Rule #1
Given
that we don’t want to lose our investment capital, we should not overpay.
Further, is there a criteria which can help us not only not overpay but in
addition help reduce the chances of the portfolio value falling too much? One
such criterion, in our opinion, is Dividend Yield. Dividend Yield is the
inverse of Price-to-Dividend ratio. If Price to Dividend is low then we are
probably not overpaying. This translates to the Dividend Yield being high. A
high Dividend Yield also guards against a big fall. Assuming a company sports a
2% yield and the market falls by 50%, if the company falls with it, it will now
be sporting 4% dividends and will become very attractive to income-oriented
investors in high tax brackets. To reduce price risk and preserve your capital
better: Select companies with Dividend Yield >2%
Now lets
see how many companies pass these filters?
Start
with 4000+ companies
• Apply
First Criterion: Sales > INR 1000 crores
609 companies are left, more than 3000 removed
609 companies are left, more than 3000 removed
• Apply
Second Criterion: Debt-to-Equity <30%
187 companies left, more than 400 removed
187 companies left, more than 400 removed
• Apply
Third Criterion: ROE>15%
99 companies left, nearly half removed
99 companies left, nearly half removed
• Apply
Fourth Criterion: Dividend Yield >2%
25 companies left, more than 70 removed
25 companies left, more than 70 removed