Finding Your Intrinsic Value

by David Jenyns on November 5, 2007

The category of variable-ratio plans generally known as “intrinsic value” formulas are without doubt the most sophisticated of all the formula investing techniques. For this reason they are also the most complicated, some of them so much so that they offer little practical guidance to the investor who manages his own portfolio.

Perhaps the simplest of all the intrinsic value formulas is one based on the “central value” method devised by Benjamin Graham, beyond all doubt the most brilliant security analyst in the U.S. The method is presented in his book, The Intelligent Investor. It calls for dividing the average earnings on the Dow-Jones Industrials for the past 10 years by twice the current interest rate on Moody’s high-grade (Aaa) bonds, and multiplying the resulting figure by 100.

Mr. Graham does not actually recommend using the central value as the foundation of a variable ratio formula, but simply as a practice of selling all stocks when the DJIA reaches 120 percent of the central value, and buying back when it dips to 80 percent of the central value. Tests of this technique’s practicality have produced excellent results, although, as Mr. Graham points out, “the intervals between signals have at times been so long as to try the investor’s patience.”

A test of the method over the 1924-1953 period showed only seven points at which action is to be taken. The investor who followed the technique would have been out of the market completely from October 1925, to September 1931, and after a buy signal indicated in March, 1942, no further action was dictated up to the end of 1953.

It is relatively easy to develop a formula with the Graham central value principle. The central value itself would, of course, be the median, and buying and selling points up and down the scale would indicate varying proportions of stocks and bonds, to avoid the all-or-nothing procedure outlined by Mr. Graham. Such a formula has been worked out, specifying a 50-50 stock-bond ratio at the median, with a 5 percent reduction in stocks at every 10 percent rise above the median and a 5 percent increase in stocks at every 10 percent drop below the median. Maximum percentage of stocks is set at 65, and the minimum at 35. Excellent results were shown in the test, which covered the 1926-50 period. Value of the original portfolio nearly doubled, despite the fact that the Dow-Jones Industrial Average increased only about 40 percent.

Although Mr. Graham states the calculations of the central value from 1881 to 1936 “fall quite consistently within the actual price fluctuations during the period,” the method has not worked so well recently. At this writing, the central value has for some years been considerably below the actual market level. This has been because stock prices have risen far faster than corporate earnings, and interest rates have also soared.

However, it would be foolish to predict dogmatically that the historical soundness of the theory will never hold true again. The spread between the central value and the Dow-Jones corrected itself in 1929, and it may do so again. At any rate, a formula based on the central value is sound in its basic principles, easy to operate and in the past profitable.

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