The Curious Case of a Milk Giving Cow and 462% Gains in One Year

Jul 20, 2020

Rahul Shah, Editor, Profit Hunter

If not for some bovine inspiration, James Rea would have been just another investor.

But Rea not only got his name etched in the annals of investment history, he also had the good fortune of teaming up with Benjamin Graham, the father of value investing.

Yes, you read that right.

Impressed with his ability to explain stock picking without any mathematics, Graham agreed to partner Rea for developing a market beating investment strategy back in the 1970s.

Did they succeed?

Yes, of course they did...and I show you their investing strategy.

But before I do that, here's Rea's colourful analogy that won Graham over.

Rea drew interesting parallels between stock selection and buying and maintaining a cow for its milk.

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Just as a stock had earnings, the cow had a certain yield.

And like earnings, he preferred the yield to be stable and growing for few years at least, if not for its entire lifetime.

He also likened the cheese from the milk to the dividends that the company pays out to its shareholders.

Last but not the least, he was wary of falling into the trap of overpaying for the cow.

He asked for the purchase price of the cow to be compared with the price at which it would be sold once it stops giving milk, thus squaring it well with the liquidation value of a stock.

Now, as cold hearted as this last sentence sounds, the analogy does tick most of the boxes.

At least it did in the mind of Graham. He partnered Rea to give shape to a new investment strategy.

In its final form - achieved after an intense brain storming and lots of give and take - the strategy came down to following 10 key rules. Ten important rules for zeroing in on a group of market beating stocks.

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The first five had mostly to do with valuations. The other five involved segregating stocks based on leverage as well as earnings quality and growth.

Now, I would have shared with you all the 10 rules.

However, after a thorough back-testing going back 50 years, both Rea and Graham rejected most of them and pruned the list down to just three rules.

They concluded that a stock need not meet most of their 10 rules. Even if it fulfilled the shortlisted three, it had a strong chance of doing well over the next 2-3 years.

These are the three rules of market beating investment strategy:

  • Earnings yield of a stock (earnings per share divided by the stock price) should be at least twice the AAA bond yield.
  • Dividend yield should be at least two-thirds of the AAA bond yield.
  • Debt to equity ratio of less than one.

Now I will show you how this strategy worked in the Indian stock market.

2014 was a very good year for smallcaps. The BSE Small cap index went up almost 70% in that year.

However, using the three rules of Rea and Graham, you would have outperformed the index by a whopping 70%.

That's better than what most money managers can achieve.

I came across 38 stocks with a revenue of at least Rs 1 bn that would have fulfilled all three criteria back in 2014.

They had an earnings yield of at least 14%, almost twice the bond yield of 8%. Their dividend yield was at least 5% and their debt to equity ratio was less than 1.

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Cumulatively, these stocks were up 116% for the entire year. This is almost 70% better than the returns achieved by the small cap index.

Some of the notable gainers were:

  • Ador Fontech, up 74%
  • Narmada Gelatines, up 101%
  • Manali Petrochemicals, up 96%
  • Gujarat Sidhee Cement, up 99%
  • And Vinyl Chemicals, up a massive 462%

There aren't many simpler ways of beating the market.

Of course, these stocks can go down faster in a bear market compared to the index.

But overall, a group of 25-30 such stocks should beat the market over the medium to long term. In fact, my Microcap Millionaires service has been heavily inspired by very similar rules.

Since inception in 2014, it has beaten the benchmark by more than 2x. The strategy is up 167% versus 79% achieved by the Sensex.

I won't be surprised if others who followed these very simple rules got similar results.

It's worth highlighting, this strategy was formulated during Graham's last years. It's a testament to how much Graham wanted to make investing simpler and accessible to the common man.

If strategies such as these and others are anything to go by, he did succeed in his mission.

And it is my mission too!

Good Investing,

Rahul Shah
Rahul Shah
Editor, Profit Hunter
Equitymaster Agora Research Private Limited (Research Analyst)

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1 Responses to "The Curious Case of a Milk Giving Cow and 462% Gains in One Year"

N vivekanandaswamy

Jul 20, 2020

The mails from Equity Master are repeats from repeated quotes, earlier year results, with vexing same content, finally giving you an option to pay Rs.1.00 lakh per one year instead of Rs.10.00 lakhs.

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