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July, 2003


Many savvy financial analysts, from Warren Buffett to Andrew Gluck (See "Master Harold's New Portfolios" in "Investment Advisor," July, 2003, pp. 39-46.) expect for various reasons that the equity premium, the traditional extra performance of stocks over bonds, will be much lower in the coming years than was the case for the past generation or so. After inflation, investment expenses, and taxes, some now say the average equity portfolio for quite some time is probably going to average zero to only about a 3% net annual total return. Under these conditions, investors need an edge!

One place to look for such an advantage is to Benchmark Investing (BI), a strategy for purchasing the stock of major companies when they are out of favor, and thus lower in price, and selling once they are again popular and showing healthy investor profits. Had you invested just $1000 in 1973 using the Benchmark Investing approach, later popularized by Kenneth Lee in the book, Trouncing the Dow, and then kept rebalancing according to the system's guidelines, you'd have $1,082,230 as of 7/4/03, excluding taxes, commissions, and any redemptions. (These results are based on the site's current figures and correspond with those [through 1996] published in the book.) That works out to a 26.72% compound annual total return!

Although it has the disadvantage of generally more frequent stock trading, that there are often greater tax consequences, but for this factor BI would have even beaten Warren Buffett's superb investing performance in the same period.

Ideal then for tax-deferred brokerage accounts, BI relies on a value investing technique for assessing when major companies' stocks are undervalued or overpriced, and hence when to buy or sell.

BI demands more homework by the investor than many approaches but, as is evident from the total returns, one's labors are well rewarded. This method also requires access to a current set of reports from "Value Line Investment Survey." They are usually available in large public or business school libraries. Alternately, one could elect to subscribe to the "Trouncing the Dow" web site. It currently costs about $200/year.

Here are the steps to take if, like us, you'd rather do the calculations yourself:

Ten Steps for Benchmark Investing
(Among Dow Jones Industrial Average - Dow 30 - Candidate Stocks)

  1. Screen out any companies with a year-over-year earnings increase of less than 10%. (Next year's projected earnings per share less this year's, divided by this year's must = 10% or more.)

  2. Screen out all remaining candidates with a projected 3-5 year return on shareholder equity of less than 15%.

  3. Among the still remaining candidates, if the "Value Line" report shows both the cash flow and capital spending per share, screen out any for which the price to value, based on Warren Buffett's "quick screen," is greater than .99.
    1. Find the company's cash flow per share.
    2. Subtract the current capital spending per share from this year's cash flow.
    3. Multiply the resulting "net" cash flow by the company's outstanding shares.
    4. Divide by the current U.S. government 30-year bond yield (your discount rate) to find the company's quick screen intrinsic value.
    5. Compare the present market-capitalization to the company's intrinsic value. (If P/V = one or above, reject that company from further current consideration.)

  4. Among the candidates left, next calculate the average return on shareholder equity (R.O.E.) for the previous 10 years (near the bottom of the financials in "Value Line").

  5. To find the adjusted R.O.E. ratio, divide the current year's return on equity by the company's previous 10-year average (step 4).

  6. Calculate the stock's average yearly book value for the previous 10 years.

  7. Calculate the stock's average yearly low price for the prior 10 years.

  8. Divide the average yearly low price by the average book value to calculate the stock's low market-to-book multiplier.

      Average yearly low price  
    Average book value

  9. Find the high market-to-book multiplier by repeating steps #7 & 8 using the average yearly high price.

      Average yearly high price  
    Average book value

  10. Find the stock's current upside and downside benchmarks. (Remember that every few months new benchmarks should be calculated before either a purchase or a sale.) To figure out where the stock's downside, or bargain, price should be, multiply the low market-to-book multiplier by the R.O.E. ratio and then by the current year's book value.

    Low market-to-book x Adjusted ROE ratio x Book Value This Year = Downside (or Bargain) Price Target.

    To find the stock's upside price, replace the low market-to-book multiplier with the high market-to-book multiplier and otherwise perform the same math.

    High market-to-book x Adjusted R.O.E. ratio x Current Year Book Value = Upside Price Target.
    (Sell assets which have reached or exceeded their currently calculated Upside Price Targets.)

If I have done the math properly, only one of the Dow 30 stocks now meets the indicated criteria, Home Depot (HD) (closing price 7/17/03: $33.10). Hopefully not coincidentally, it appears to be one of "Trouncing the Dow's" current recommended holdings. HD's downside price target or bargain level is $44.07 or below, with a current upside target of $84.39.

As is true with most mechanical investing approaches, BI is more effective as a total system than an assurance of performance by any single security. (It may not be appropriate to mortgage the farm to buy Home Depot.) However, we figured HD worth a modest recent share purchase.

With BI the results are a little lower if one waits a year between evaluations. The investor is encouraged to reevaluate each Dow stock more frequently for new buy or sell signals. Since "Value Line" publishes a new report on each of its 1700 survey companies (including of course those in the Dow 30) quarterly, that is the best interval also for redoing one's BI calculations.

We cannot recommend BI too highly for those with the extra hours and inclination to follow this means to financial success. In these times of likely lower overall equity returns, Benchmark Investing gives one at least a fighting chance of not only staying ahead of inflation but setting aside a significant nest egg to help meet his or her lifetime goals and cover eventual retirement expenses. You and I may not achieve returns of 26% a year by this method anymore, but Val and I think your odds of highly competitive profits are much greater with BI than with just about any other approach generally available to the small investor.

Happy investing!


Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)

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