Interview with J. Royden Ward, Editor of Cabot Benjamin Graham Value Letter
10/16/07

WSR:  Benjamin Graham Value Letter.  Now, Benjamin Graham is commonly known as the 'Father of Value Investing.'  How do you keep his legacy alive with your newsletter?

WARD:  The letter is based on the principles that Ben Graham has taught, and in the letter, at least every six months, I include an article about Ben Graham, value investing, and his principles.  I also do a lot of corresponding with our subscribers, and oftentimes they have questions about value investing and why I think differently than other investors.  I explain to them more about Ben Graham and the principles involved.

WSR:  What's the most frequent thing that you point to when you speak of the genius of Ben Graham's principles?

WARD:  I guess the thing I stress is that you need to buy quality companies at reasonable prices.  Also, a couple of other things, like avoiding losses by taking less risk.  That was one thing that Ben Graham really stressed.  He felt that you could get good returns if you could avoid losses.  More stress should be put on avoiding losses than trying to get big gains.

WSR:  It seems to have become a theme in some of my recent interviews, that emotion really gets in the way of good investing.  What were some of Ben Graham's selling principles to cut losses, if you will?

WARD:  He recommended, basically, that if a stock goes down, you should buy even more, because it's at a cheaper price, or else, if things have changed with the company, then we should sell it.

WSR:  You bought it for a reason, so if it goes lower, then hopefully that reason still holds?

WARD:  That's right.  If nothing has changed with the company and the stock gets caught up in a downdraft in the market, or whatever, take a look at it and, if nothing has changed, then you can buy more shares at the lower price, which is one thing that I've explained quite a bit to subscribers, because they are used through just bailing out of growth stocks when they go down.

WSR:  Now, your newsletter comes with two model portfolios, the first of which is the classic, the Benjamin Graham Value Model, and the second is the Wise Owl Model.  Take us through the metrics that you use for the Benjamin Graham Value Model?

WARD:  We call it the Classic Ben Graham Model, because it's taken right out of one of Ben Graham's books, the one entitled Intelligent Investor.  In the book, he spells out very clearly what one should look for in a stock.  The seven metrics include low P/E, or low price to earnings ratio, a low price to book value ratio, a low debt in relation to current assets, a high current ratio or high current assets compared to current liabilities, and no earnings deficits during the last five years.  That’s something I always adhere to.  If a company has lost money during the last five years, I avoid it, and that's one thing he suggested also.  I make sure, in the Ben Graham Model, not to invest in companies that haven't had positive earnings growth during the last four or five years.  Also, as a strict rule, the company must be paying dividends currently, and finally, Graham used Standard & Poor's quite a bit.  He suggested that investors stick with companies that are rated by Standard & Poor's at B or better, and that rating is based on the consistency of earnings and dividend.  So, those are the seven metrics that I follow that Ben Graham has spelled right out for me.  I just follow along what he suggested.

WSR:  It's really amazing how those principles that you just spelled out still adhere to today's market.

WARD:  Yes, it's been 75 years since he wrote the book and it still works, as well as Warren Buffet.

WSR:  That's really one of the kings of the value investing.  Of each of these seven metrics, correct me if I'm wrong, when he does place a minimum or maximum of these, which is the most important to follow with the minimums and maximums?

WARD:  I believe it's important that a company at least come real close to all of them.  I start out by looking at the price to earnings ratio and the price to book value ratio to screen out companies that are selling at high ratios.  I keep in mind I want low debt, and a dividend to be paid like everything else, too.

WSR:  Take us through one of the recent examples that this model has uncovered.   For example, Mylan Labs, why don't you take us through (?) fit perfectly into Benjamin Graham's Value Model?

WARD:  First, I'll have to admit, it doesn't fit perfectly, but it comes real close.  It's got a low P/E, it's got a low price to book value ratio.  It has a real low gap(?) and a good kind of ratio with lots of cash on hand.  That's going to change for the generic division of Merck and that's a big acquisition for them.  They are going to use $1 billion in cash.  So, they are going to put quite a bit of cash into it, but they are going to take on a lot of debt.  That will change their balance sheet.  I believe that even after the approaches, that will be reasonable, and management will be able to handle it.  They've also suspended the dividend, which was a bit of a surprise to me.  But, I can see their point, while they go through this transition of acquiring the division of Merck, they want to conserve as much cash as possible.  So, if anything unforeseen comes up, they are in good shape.  I kind of agree that suspension of the dividend is a good thing and I believe that, if everything goes reasonably well, they will resume the dividend in about two years.  That’s a long-term investment, which is another thing that Ben Graham stressed, in that we are probably looking at a two-year transition period here while they acquire the generic division of Merck.  I still like Mylan because I think Mylan is going to evolve as the world’s leading generic drug company in a couple of years, or within two years.

WSR:  Now, part of their model offers a maximum buy price and a minimum sell price.  How are these numbers determined?

WARD:  They are determined primarily from historic ratios.  I estimate the price and the target sale price for each company using ratios such as the historic P/E for each company, going back 10 years, historic price to book value for 10 years, and also price to sales, price to cash flow, and actually price to dividends, which of course is the inverse of the yield.  We've got software that projects what the trends are for each of these ratios to project (?) from those projections.  I can put the numbers together and figure out what our reasonable price to pay for each company is.

WSR:  Just for our listeners' knowledge, what were those numbers for Mylan Labs?

WARD:   Mylan closed yesterday at $15.83.  My maximum buy price is $20.12 and minimum sell price is $26.07, so that means, currently, Mylan is selling about 20% below what I consider a reasonable buy price. It is selling at a real good discount and a good margin of safety there.

WSR:  This could be an attractive opportunity at this price?

WARD:  Right, I believe so.

WSR:  Now, take us through the Wise Owl Model.

WARD:  Okay.

WSR:  You created this yourself?

WARD:  Yes, I did, but it's based on, again, the teachings of Ben Graham.  It’s more from his book, Security Analysis, and his other books.  It's also from what I learned in college.  I had a professor who was an interesting guy.  He sat down with Ben Graham in 1946, and they devised a system to estimate what reasonable value for a company should be, and they are the ones really (?) maximum buy and minimum sell prices.

WSR:  I believe that the Owl Model has Owl Ratings for different types and then there is an overall total (?) take us through those ratings and how they are determined?

WARD:  The ratings are devised to figure out whether a company is reasonably priced, with good quality and a good outlook, so that hopefully we'll come up with companies that are priced reasonably that have good appreciation potential with low risk.  The total ratings are the industry ratings, which are simply relevant price ratings of the industry that the company is in.  A quality rating, which, again, rates the quality of the company, whether it's overloaded with debt or whether it has sufficient cash, etc. Also in that quality rating is the consistency of earnings and dividends.  Is it a cyclical company, or has it had consistent growth over the years?

WSR:  If you take us through an example, it may be easier to spell out the individual ratings, one of your recent Wise Owl picks was Noble Corp.

WARD:  Noble Corp. is an oil and natural gas driller, so it's in a good, strong industry.  We feel that oil prices are going to stay high, unfortunately, so it's in a strong industry trend.  The company's quality is a little bit low because oil drillers tend to be cyclical.  But, Noble has a strong balance sheet and a good current ratio for a company in that industry.  Noble's value rating shows that it's well undervalued.  Growth has been really strong recently, of course, and the technical ratings, the Street is treating the stock well, and the relative performance is very good.  So, that leads to a high total rating of 9 out of 10, approximately.

WSR:  The technical rating, how is that determined?  What goes into that rating?

WARD:  What goes into that is the relative strength of the stock during the last three to six months, and actually it's one-month, three-month, and six-month ratings to figure out whether the company is doing better than the market during those periods.  If it is doing better than the market, then it's going to get a high technical rating.

WSR:  I see another side, the CEO resigned here recently.  Does Ben Graham assess management, or does he just look at the performance of the company to indicate quality management?

WARD:  He stressed management.  He was kind of a numbers person, I guess I'm kind of numbers-oriented too, but he also stressed management.  He believed that you need to have faith in management.  If they don't seem to be performing the way you think they should perform, then sell the company.  I have a rule of thumb that if management doesn't meet expectations for three quarters in a row, which is more than enough time for management to perform well, I'm happy to sell, or recommend selling, the company.

WSR:  You give management nine months.  I've seen some CEOs only get 100 days.

WARD:  That's right, I think long term.

WSR:  What were your max buy and minimum sell prices for Noble?

WARD:  Noble is currently selling at $48.70 and my max value is $54.12.  So, it's selling at about 10%, what I think is a reasonable buy price and I have a minimum sell price of $68.37.  So, during the next one to two years, I expect the stock to go up about 40%.

WSR:  Do you know how weighted Noble is in natural gas?  I know the Street doesn't seem to like natural gas.

WARD:  I don't have actual percentages in front of me, but I believe they are weighted quite a bit towards international offshore drilling.  80% of their drilling is offshore, international, and 20% is on this continent.

WSR:  That means they get a lot of the weak dollar.  They are going to be a getting a lot of foreign exchange benefits.

WARD:  That's right. If the dollar keeps declining, they'll get a little kicker there, too.

 

Wall Street Reporter, established in 1843, helps smart investors connect with exciting companies, through its website, magazines and conferences. They are probably best known for their exclusive interviews with industry leading CEOs and the worlds top investment experts.

More information on Cabot Benjamin Graham Value Letter
More Cabot in the News
Cabot Home
Sign up for free Cabot Wealth Advisory e-newsletter