Investment Policies of Property-Liability Insurers and Pension Plans: A Lesson from Ben

Graham
Author(s): Henry R. Oppenheimer and Gary G. Schlarbaum
Source: The Journal of Risk and Insurance, Vol. 50, No. 4 (Dec., 1983), pp. 611-630
Published by: American Risk and Insurance Association
Stable URL: http://www.jstor.org/stable/252704
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Investment Policies of Property-Liability Insurers
and Pension Plans: A Lesson from Ben Graham
Henry R. Oppenheimerand Gary G. Schlarbaum
ABSTRACT
The investment returns of property-liabilityinsurers and pension plans are of
increasing importance to the American public. This article examines a publicly
available investmentstrategy,formulatedby BenjaminGraham,which, seemingly,
is ideally suited to the goals and constraintsfaced by property-liabilityinsurersand
pension plans. Simulationsof this strategyover the 1955-1976 periodrevealedboth
after-cost risk-adjustedperformance and average annual return greater than an
appropriatemarket benchmark. This strategy, therefore, provides a reasonable
alternative to both the active strategies utilized by many institutional portfolio
managersand to passive index funds.
Introduction
The investmentreturnsof property-liabilityinsurersand pension plans, as
well as those of manyotherinstitutionalinvestors, areof considerableinterest
and importanceto the Americanpublic. The success - or lack of success -
of institutionalinvestorsimpactsdirectlyon the wealthof what may now be a
majorityof the populationof this country:shareholdersof property-liability
insurers,' policyholders of property-liabilityinsurers,2shareholdersof cor-
porationswith employee pension plans (which have requiredemployer con-

Henry R. Oppenheimeris an Assistant Professorof Financeat Texas ChristianUniversity.

He earnedhis Ph.D. at PurdueUniversity.Dr. Oppenheimeris currentlythe FacultyAdvisorof
the EducationalInvestmentFundof Texas ChristianUniversity, the largest studentmanaged
fund in the United States.
Gary G. Schlarbaumis a Professor of Managementat Purdue University. He earned his
Ph.D. at the Universityof Pennsylvania. A CharteredFinancialAnalyst, Dr. Schlarbaumis a
frequentcontributorto leading financejournals. He is also an Associate Editorof theJournalof
Financial and Quantitative Analysis.
IThe returnsof shareholdersof property-liabilityinsurersare a directresult of two interde-
pendent activities: underwritingand investment. For the period considered in this study
(1955-1976) Best's [4] reportsa meancombinedratioof 100.2, reflectinga slight underwriting
loss. Therefore, shareholderreturns(dividends and price change) were largely a function of
investmentperformance.However, the insuranceactivitiesprovidedthe fundsfor the insurers'
investments.
2Traditionallypremiums of property-liabilityinsurers have been set by state regulatory
commissionsby determininga "fair" underwritingprofit,as a percentageof premiumsearned.

611
612 The Journal of Risk and Insurance

tributions),3and individualswho arepresentor futurebeneficiariesof pension

plans. With over one half of one trilliondollarsin theirinvestmentportfolios
the investment policies of these institutional investors can and do have a
significant impact on the capital markets.4
The purposeof this paperis to examine an investmentstrategy,formulated
and published by the late Benjamin Graham,that could be used by institu-
tional portfolio managers. This strategy has been publicly available and
widely disseminatedsince 1949 and is seemingly ideally suited to the con-
straintsand goals of both property-liabilityinsurerand pension fund mana-
gers. The available empirical evidence on institutionalinvestment perfor-
mance during the 1955-1976 period (e.g., [3], [13], [23], [29], [38], [41])
suggests thatthe performanceof manyinstitutionalinvestorscould have been
enhanced by following Graham's strategy over this period. This policy,
therefore, merits careful considerationby such portfolio managers.
The paper is organized as follows. Section II describesthe recommended
Grahaminvestmentpolicy andrelatesit to the uniqueconstraintsand goals of
property-liabilityinsurersand pension plans. Section III describes the data
used in implementingthe strategy. Methodology is described in Section IV
and the results are presentedin Section V. The conclusions are discussed in
the final section.

Graham's Recommended Portfolio Policy

In each of the five editions of his book, TheIntelligentInvestor [ 15], [16],
[17], [18], [19], Grahamprovideda complete portfolio policy for the defen-
sive investor. This policy included both an appropriatemix of fixed-income
securitiesand common stocks and criteriafor selecting the specific securities
to be included in the investor's portfolio. While this paper focuses on the
criteriafor common stock selection, Grahamprovidedvaluableadvice on the
problem of investment timing as well.5

At present at least 21 states consider investment income in this rate-settingprocess [14].

Thereforeit is possible thatpremiumswill be higher(lower) thanthey would otherwisebe if the
property-liabilityinsurer's investments performpoorly (well). For furtherdiscussion of the
regulatoryenvironmentand investment results see [9] [14] [22] [25].
3Employer contributionsaredeterminedby actuarialassumptions.To the extentthatpension
fund managers exceed the minimal rate of return assumption future contributionscan be
lowered, leaving greater earnings for distributionto shareholders. See [1] [6] for further
elaboration.
4Recent estimates of the size of these portfolios:property-liabilityinsurerportfolios, $100
billion [26]; corporatepensionfunds, $286 billion [21]; andstateandlocal governmentpension
plans, $225 billion [42].
1This paperdeals only with the investmentpolicy pertainingto funds designatedfor equity
investment. However, given the importance(in termsof both dollarmagnitudeandproportion
of discretionaryfundsinvested)of the commonstock componentsof theirinvestmentportfolios
of both property-liabilityinsurerand pension plans, such policy is very importantto overall
 Property-LiabilityInsurers and Pension Plans 613

In general Graham advised the defensive investor to choose a set of

proportionsfor fixed-income securities and common stocks - for example
50-50 - and stick to them.6 In other words, he suggested that investors
should not attemptto time-themarket.By selecting a set of proportionsand
stickingto themthe investoris protectedagainstalways being wrongin timing
decisions. Given the fact thatmost institutionalportfolioshave cash flowing
into them on a regularbasis (that is, they normallyhave a net cash inflow),
they should be able to maintaina fixed set of proportionswithoutincurringan
undueamountof transactionscosts. The evidence on timingpresentedin [29]
suggests that the policy of fixed proportions would improve the overall
performanceof institutionalportfolios.
Graham'scommon stock selection advice remainedreasonablystablefrom
edition to edition: in each edition he suggested that the defensive investor
should purchase(and maintainwith yearly reevaluation)a portfolioof ten to
thirty securities, each meeting specified criteria. The specific criteria that
appearedin each edition are presentedin Table 1. Underlyingthese criteria
was Graham'sbelief thatin orderto assuresafety of principala securityhadto
meet certainminimal business standardsand also provide a certainvalue for
the purchaseprice. Thus certainconservativestandardshad to be met: each
firmhad to have paid some dividendeach year for many years;no firmcould
have excessive leverage; and each firm had to be "large and prominent."
Grahamfelt that only if each of these conservativecriteriawas met could the
investor be confidentthat a firm would be able to both survive recessionary
periods and also provide an adequatereturnduring such periods.
Grahamviewed the price-earningsratio criterionas of particularimpor-
tance. While the firstthreecriteriaallowed the investorto judge the operating
soundnessof a corporation,the price-earningsratio allowed measurementof
the price paid to value received. Grahamarguedthatthe price-earningsratio
was an indicationof currentmarketoptimism (or pessimism) about a firm's
futureearnings. He said that, historically,relativelyhigh ratioshave reflected
recent rapid growth rates of earnings and/or projected future high growth
rates; relatively low ratios have reflected the opposite. He then arguedthat
first, high growthrates have rarelybeen sustainedand, second, thatanalysts

total portfolio performance. Over the past twenty years, on average, common stocks have
accounted for over 50 percent of pension fund assets (see [10]) and about 50 percent of
discretionaryinvestment(thatinvestmentaftermeeting legal requirementsfor investing mini-
malcapital, unearnedpremiumreservesandrequiredreserves- none of which can be invested
in equities) of property-liabilityinsurers.
6Graham'sfundamentalguiding rule was that the investor should never have less than 25
percentnormore than75 percentof his or her fundsin common stocks, with actualproportions
being in inverseproportionto marketlevels. His preferredpolicy was a steady50-50 allocation.
He felt that this policy was simple and best suited to the needs of most defensive investors.
7The primaryconcernof the defensive investoris safety of principal;the secondaryconcern
is freedom of bother.
614 The Journal of Risk and Insurance

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 Property-Liability Insurers and Pension Plans 615

predictionsof growth of earnings have not been particularlyaccurate.8He

anticipatedgrowth rate impounded into security prices and prices will be
revised (downward). He providedsimilarargumentsfor firmswith relatively
low price-earningsratios (those firms neglected by the market), with such
firms having subsequentupwardrevisions in both price-earningsratios and
price.
In summary,Grahamadvisedthe defensive investorto make surethateach
securityin the portfolio was both a soundbusiness entity and did not have too
high a price as comparedto underlyingvalue.
This paperconsidersthe usefulness of this advice to the defensive investor
for portfolio managers of pension plans and of property-liabilityinsurers.
Unlike the individual investor who was the primary target of Graham's
advice, each of these individualsfaces specific constraintsand goals which
may, in a significantmanner,limit the rangeof investmentalternatives.Thus
before consideringresultsavailablefrom utilizationof this advice it is neces-
saryto examinethese constraintsandgoals to determineif the type of security
selected fromuse of Graham'sadvice is compatiblewith these constraintsand
goals.
Institutions (such as those considered in this paper) frequently manage
portfoliosof hundredsof millions (or even, in some cases, billions) of dollars.
As such, the portfoliomanagersmust consider several potentiallyconflicting
issues: economies of scale of managementcosts availablefrom dealing with
large sums of money, requireddiversification, and liquidity (the ability to
tradelargeblocks of stock withoutlargepricechanges). Reilly [32] andothers
assert that the need for compromise among these factors has resulted in a
"'multi-tier"market.Because institutionsdesire to have a limited numberof
securities in their portfolios, to hold a relatively large dollar amountof each
security, andto hold a relativelysmall percentageof the outstandingsharesof
any one corporation,they can only considerpurchaseof firmswith a substan-
tial marketvalue. Reilly suggests thatthreetiersexist. The firsttierconsists of
approximately400 firms;all institutionalinvestors can consider purchaseof
blocks of sufficientsize fromthis group. Reilly indicatesthat ""firsttier" firms
must each have, on average, a total marketvalue of equity of about $400
million. The second tier consists of a groupof about300 securitieswhich all
but the very largestinstitutionscan considerfor purchase.Reilly suggests an
averagemarketvalue of equity of such firmsof about$200 million. The third
tier consists of the vast majorityof public firms:those Reilly considers too
small to be considered by most institutions.
Any strategy suggested for the property-liabilityinsureror pension fund
portfolio managers must be viable; it should provide securities with an
aggregatemarketvalue largeenoughto meet theirconstraints.9The following
8Malkiel and Cragg [28] later provided empirical evidence that confirmed this second
assertion.
9 Reilly's argumentsare predicatedon a restrictionof 40-50 securitiesin a large institutional
portfolio($1 billion in assets) and no more than 5 percentof the sharesof a companyheld by
616 The Journal of Risk and Insurance

concludedthat while it may be appropriateto pay some premiumfor growth,

the premium demanded for most growth stocks is too high. The market
focuses uponforecasts, biddingthe price (andprice-earningsratio)above that
level commensuratewith the projectedgrowth rate; in the future the actual
growth rates of high price-earningsratio securities will be less than that
sections fully describethe dataanddata selection used in this paper. It should
be noted here, however, that the size constraintis easily met by Graham's
criteria:the mean marketvalue of each security selected in each of the four
60-security portfolios were $225, $640, $333, and $770 million in 1954,
1959, 1965, 1973 respectively. Furthermore,in each year a significant
numberwere among the very largestfirmsin the United States. Forexample,
of the 60 firms in the 1973 sample, 34 were among Fortune's 500 largest
industrialfirms (an additionalten were among the second 500 largest firms),
three were among the largest 50 utilities, two were among the largest 50
retailers and one was among the largest non-U.S. firms.
In addition to a size constraintwhich both property-liabilityinsurerand
pension plan portfolio managers must deal with, each must consider con-
straintsspecific to their situations. Property-liabilityinsurerportfolio mana-
gers must purchaseportfolios with risk levels complementaryto insurance
risk levels. If, for example, an insurerderives most of its premiumincome
frompropertyratherthanliability insuranceit is usually consideredto have a
higher risk exposure (of net cash inflows) than if most premiumsemanated
from liability insurance. Similarly within each line of insurance(property,
liability, etc.) different risk levels may exist. In general, the riskier the
insurancebusiness the more conservative the investmentportfolio and vice
versa. By the very natureof their business, property-liabilityinsurershave
largeliquidityneeds (the cash outflow for claim paymentis not very predicta-
ble and has large variance), providing a furthersuggestion of the need for
reasonablesafety of principal. Graham'sstrategyfor the defensive investor
does seem ideally suited for such portfolios. It provides for selection of
securitiesof conservative, strongly financedcorporations,providingin most
instances a low risk exposure of the investmentportfolio. Further,with the
strategy's emphasis on safety of principaland large well-seasoned issues it
appearsto provide securitieswhich should not be greatlydepressed(in price)
during periods of unusual claim payment demand.
Traditionallypension fund managershave had to face two general sets of
constraints: 1) legal constraintsand 2) individual pension plan restrictions
imposed on managersby writtenstatementsof objectives and policies. The
majorlegal constraintsconstraintsimposed on pension plan managershave
been the "prudentman" rule and the Employee RetirementIncome Security
Act (ERISA) of 1974.

such an institution.To the extent that institutionsdesire more diversificationthan that (which
many do) the average marketvalue in his firstand second tier can be lowered and more firms
will be eligible.
 Property-Liability Insurers and Pension Plans 617

Priorto ERISA the "prudentman" rule, as frequentlyinterpretedby the

courts,providedthateach securityin a portfoliohadto meet a prudenttest and
that the overall total value (or increase in value) of the total portfolio would
not excuse a single imprudentinvestment. Further,most state courts have
distinguishedbetween investmentand speculationwith emphasis on conser-
vation of capital. Graham's advice was predicatedon similar constraints.
Eachsecurityincludedin the portfoliois requiredto meet specific standardsof
investment merit. In addition he also emphasized the difference between
investment and speculation, specifying ". . . an investment operation is one
which, upon thoroughanalysis promises safety of principaland an adequate
return. Operationsnot meeting these requirementsare speculative."" The
advice to the defensive investor, therefore,is ideally suitedto the prudentman
rule.
Withthe adventof ERISA, some feel pensionplan managementchangedin
important ways. First, now assets were judged within the portfolio plan
context. Second, Cohen, Zinbargand Zeikel [8] speculate that ERISA pro-
vided a need for purchaseof larger more well-establishedcompanies at the
expense of small less seasoned ones. Third, Cummins et al. [10] indicate
ERISA may have caused a greateremphasis on diversifiedportfolios, use of
index funds, a greateremphasison liquidityandon currentreturn.They found
that a substantialmajority of surveyed plan administratorsand investment
managersshifted investmentobjectives away from maximizationof returnto
minimizationof risk. The strategyof the defensive investorseems congruent
with ERISA: it provides for selection of large, conservatively financed,
seasoned companies, each of which must provide currentreturn.
Most pension plans provide specific investmentconstraintswhich mana-
gers must follow. While some constraintswould precludeGraham'sstrategy
from serious consideraton,the most common constraintswould not. Two of
the most common constraints concern stock selection vis-a-vis expected
performanceduring recessions and dividend policy. Frequentlyit is argued
thatsecuritiesshould be chosen with emphasison theirexpectedperformance
during recessionary periods. The reasoning is that employer contributions
duringsuch periods may be limited, currentretireepaymentsmust continue,
and employees may take early retirementratherthan accept indefinite (or
permanent)layoff. Each of these factors places a large currentdemand on
pension plan assets, providing impetus for emphasis on recessionaryperiod
performance being better than the market performanceas a whole. The
Grahamstrategy provides such an emphasis: he advocates purchaseof sec-
urities which he feels, throughtheir size, and their operatingand financial
soundness, will be best able to survive such periods and provide adequate
returnsduring these periods.

"' See Cohen, Zinbargand Ziekel ([8] p. 626 ff) for a more detaileddiscussion of the courts'
interpretationof the prudentman rule.
"11[ 91 p. 1. Other similar statementsappear in each of the earlier editions.
618 The Journal of Risk and Insurance

Finally many plans requirethat securitiespurchasedbe currentlypaying a

dividend and that when a securityceases to pay a dividend it be sold within a
year.12Graham'ssecurities must meet constraintsconsistent with (but more
restrictivethan) such rules.
In sum Grahamprovides advice for security selection and such advice,
consideringthe constraintsandgoals of property-liabilityinsurerandpension
plan managers, seems ideally suited to them.
Data
The analysis presented below simulates the investment experience of
hypotheticalproperty-liabilityinsurerand pension fund portfolio managers
who utilized Graham'scriteriafor selection andretentionof specific common
stock issues. Two sets of datawere requiredto performthe analysis. The first
set includes the data used to select securities for the hypotheticalportfolio
managers.The second set encompassesthe datarequiredto computereturns
and measure portfolio performances.
Two readilyavailablesourcesof informationwere used to select portfolios
of common stocks which satisfiedall the criterialisted in Table 1. The firstof
these is Moody's Handbook of Widely Held Common Stocks (later renamed
Handbookof CommonStocks). This quarterlypublicationprovides financial
datafor the largestpublicly-heldcompaniestradedin the UnitedStates.13 The
second data source is Standard and Poor's Security Owner's Stock Guide.
This monthly publicationprovides one line of financialinformationfor over
4,000 publicly tradedfirms. These two sourcesof informationwere available
to and likely to have been used by portfolio managers making portfolio
decisions during the period of the analysis.
In orderto calculate monthlyratesof returnon securitiesandportfoliosit is
necessary to have monthly closing prices, dividends, and capitalization
changes. These data were obtainedfrom the CRSP monthlyfiles for all firms
listed on the New York Stock Exchange. For those firms not listed on the
NYSE (a very small percentage of the firms actually selected for the
portfolios)the necessarydatawere obtainedfromthe WallStreetJournal and
the Security Owner's Guide.

Methodology
Generation and Maintenance of Defensive Portfolio Manager Portfolios
The initial step in stimulating the investment experience of a portfolio
managerusing Graham'sadvice for the defensive investorfor common stock
selection was the creation of appropriateportfolios containing 60 securities

12See [8], p. 633 for an example.

13The numberof companiesincludedin Moody's Handbookvariedfrom 576 to 1010 during
the period included in the analysis. The number varied from year to year while gradually
increasing over time.
 Property-LiabilityInsurers and Pension Plans 619

that satisfied the relevant criteria.'4The method chosen involves selecting

portfolios in July 1955 and December of 1959, 1965, and 1973, using the
most recent edition of The Intelligent Investor, the last quarteredition of
Moody's Handbook, and the Standardand Poor'sStock Guide. This method
enabledthe authorsto simulatethe investmentexperienceof portfoliomana-
gers who purchasedthe text in any of its last fourcopyrightyears andadopted
its advice as a portfoliostrategyat thattime.15All sourcesof informationwere
publicly available at the times the decisions were made.
Securitiesinitially includedin each portfoliowere selected in the following
manner.Firsta randomnumberRi was chosen from a randomnumbertable.
The Rist security in the July 1955 Moody's was located. The relevant
financialfiguresfor this securityandeach subsequentsecuritywere compared
to the 1954 criteriain Table 1 until 60 securitiesmeeting all the criteriawere
selected. In a similar manner using random numbers R2, R3, and R4 60
securities were selected for the December 1959, 1965 and 1973 portfolios,
using the criteriagiven in those editions in conjunctionwith the last Moody's
Handbookand Standardand Poor'sStockGuide for each of those years. This
procedureprovided for four 60-security initial portfolios.
Grahamadvised yearly review of each security in an investor's portfolio.
Accordinglyeach year the portfoliomanageris assumedto have used the last
Moody's of the calendaryear, the Standardand Poor's Stock Guide and the
most recent edition of The IntelligentInvestor to determineif each security
still met all the relevant criteria. Those meeting the relevant criteria were
retained while those not meeting all the relevant criteria were replaced by
suitable securities on the last business day of December.
The selection procedurefor the replacementsecuritieswas identicalto that
used to createeach portfolio. A randomnumberwas used to providea starting
pointin Moody's Handbook.Then this securityand each subsequentsecurity
were compared to the appropriatecriteria until the necessary number of
replacement securities were located. No security was allowed to enter a
specific portfolio more thanonce at any given time. Thus each portfoliohad
60 unique securities at all times.
At times firmswhose securitieswere in a portfolio were acquiredby other
firms. If all or a part of the proceeds from acquisitionconsisted of common
stock of the acquirer,the acquirerwas not in the portfolio, and the acquirer
satisfied all the relevant selection criteria, the authorsassumed the portfolio
managerused all the proceedsto obtain sharesof the acquirer.Otherwisethe

'4Grahamsuggested a portfolioof 10-30 securities. The authorsused 60 becauseinstitutions

require(desire) greaterdiversificationthanis availablefrom a portfolioof 10-30 securities. In
separateanalyses the authorsdid consider20-securityportfolios. Those resultsaresubstantially
identical to those reportedhere, with slightly lower significance levels.
"5Moody'sHandbook was first published in 1955. Because it was not possible to find a
suitablesubstitutefor this data source priorto 1955, the authorscould not use the 1949 edition
of The Intelligent Investor to select portfolios.
620 The Journal of Risk and Insurance

managerwas assumedto have used the proceedsto purchase,at the end of the
month of acquisition, a new firm meeting the relevant criteria.
Ev aluation of' Performacie
In analyzing portfolio performancethis paper will focus on the monthly
returns generated by the four portfolios corresponding to the last four
copyright years of The Intelligent Investor. Initially month-end portfolio
values areestablishedfor each of these portfoliosand for the marketportfolio
for periods startingin October 1955, December 1959, December 1965, and
December 1973.16Each periodends in October 1976. These portfolio values
are used to compute monthly rates of returnfor the hypotheticalportfolio
managers. Monthly rates of return are then used to obtain risk-adjusted
performancemeasures. Eachof these steps is detailedin the remainderof this
section.
The end of month portfolio value for an m-securityportfolio is given by
m
(1) Wt - E NitPit for t=O,...,T
ill

where:

Wt = the value of the portfolio at the end of month t

Nit - the number of shares of security i in the portfolio at the end of

month t (after adjustments for capitalization changes and costless

reinvestment of after-tax dividends)

Pit - the closing price of security i in month t

t-0 - December 1955, December 1959, December 1965 or December 1973

t-T - October 1976

The monthly returnof the portfolio, Rpt3,is computed as
-
(2) Rpt = Wt Wt-1

Wt-1
Risk-adjusted performance measures for a portfolio manager using
Graham'sadvice to the defensive investorareobtainedby comparingthe rates
of returnof these portfolios with those provided concurrentlyby naively-
selected equityportfoliosof identicalrisk. Two sets of risk-adjustedmeasures
are estimated. The first set relies on the equilibriummodel of Sharpe [40],
Lintner [27] and Mossin [31] to generaterequiredbenchmarkreturns. Per-
formance measures are estimated by using equation (3):
(3) Rpt - Rft -
apf + apf(Rmt -
Rft) + ept
where
Rpt - the month t return of a portfolio held by a portfolio manager using
Graham's criteria

'6In all cases the initial investment was assumed to be $1,000,000.

 Property-Liability Insurers and Pension Plans 621

Rft = the 'risk-free' (Treasury Bill) rate of return in month t

Rmt the rate of return of the market portfolio (a value-weighted port-

folio of NYSE common stocks) in month t

ept = an error term assumed to have expected value of zero, a constant

variance and not be serially correlated
cpf = the measure of performance for the hypothetical portfolio manager17
apf I cov(Rpt, Rmt)/Gc7(Rmt)

A second set of performancemeasures, based on the Black [5] version of

the asset-pricing model was estimated by use of equation (4):
-
(4) Rpt Rzt a +
apz Bpz (Rmt Rzt) + Upt

where Rzt is the rate of returnin montht of a "zero beta" portfolio, one
whose returnsare uncorrelatedwith a marketportfolio.18
Recent evidence [7] [12] suggests that the second model is probablymore
appropriatethan the first. However, the next section reports both sets of
estimates for the sake of completeness and because it is possible to compute
after-taxreturnsusing equation(3) but not using equation(4). In those cases
where both estimates can be compared the results are similar, as the next
section shows.
This methodof estimatingperformancemeasuresis now "standardproce-
dure" in the finance literature. However, recently it has been attacked in
several ways. Roll [35] correctly argues that it is impossible to observe the
"true" marketportfolio of risky assets the theoreticalconstructof most
existing asset pricing models.19Roll [36] shows that use of differentmarket
proxies can affect conclusions about portfolio manager performance
changing proxies may change "superior" performersto inferiorperformers
and vice versa. As a response to Roll, Mayers and Rice [30] argue that the
"standard"methods, used in this study, are not withoutmeritand thatRoll's
criticisms are "vastly overstated."
To date this issue remains unresolved. It is unlikely that it will ever be
resolved to everyone's satisfaction. This paper offers empirical results be-
lieved to be most relevantfor the hypotheticalportfoliomanagerswho arethe
focus of this study. It is clear that one viable alternativeis for a portfolio
managerto purchasea "market"portfolioof common stocks. One appropri-
ate index for measuringperformanceof a portfoliomightbe a value-weighted
(or even an equal-weighted) index of all available equity securities. The

17This measure of performancewas introducedby Jensen in [23].

18 The methodused to calculatethe estimatesof R;t is identicalto thatused by Famaand
MacBeth [ 12] except that a value-weighted marketindex is used in the computations.
19Thisinability to observe the "true" marketportfolio is the basis of both Roll's [35] and
Fama's [II] conclusion that there has not yet been a meaningful test of the Sharpe-Lintner-
Mossin version of the asset-pricing model.
622 The Journal of Risk and Insurance

resultingcomparisonwould be between the performanceof portfolioschosen

from utilizationof the criteriaof Table I and the entireequity securities.The
resultingcomparisonwould be betweenthe performanceof portfolioschosen
from utilization of the criteria of Table 1 and the entire equity market.
Unfortunatelysuch a comprehensiveindex was not readilyavailable. Instead,
the authorsused a value-weightedNYSE index. Given the NYSE dominance,
in dollar value terms, of the equity marketin this country (and to a certain
extent the world), the returnson this portfoliomustbe quite similarto those of
the unobservedcomprehensiveindex. Further,for the hypotheticalportfolio
managersin this study such an index is more comprehensivethan(but highly
correlatedwith) the benchmarksthey frequentlyuse: the Standardand Poor
500 and the Dow Jones IndustrialAverage. To the extent that most index
funds are value-weightedsubsetsof the equity marketsthe index used here is
also an excellent proxy for the passive index funds that many portfolio
managershave adopted.
Recently Banz and Reinganumhave suggested that the equilibriumasset-
pricing model is misspecified in that there are additionalfactors which are
omittedfromthe model but which affectprices andreturns.Both Banz [2] and
Reinganum [33] find that there has been a significant consistent negative
relationshipbetween the marketvalue of the equity of firmsand the returnon
their shares. Further,Reinganum[34] finds a negative relationshipbetween
the price-earningsratios of shares and their returns. However, Reinganum
also finds that there is a positive relationshipbetween firm size and its P/E
ratio, and, after adjustmentfor size the relationshipbetween P/E ratio and
returnlargelydisappears.Banz concludesthatthe size effect andP/E effect are
the same phenomenon, but the true underlyingfactor is unknown.20
These criticisms of asset-pricingmodels and their performancemeasures
are of particularimportanceto this study. The concern here must be that an
omittedvariablein the model may explain the superiorperformancereported
in the next section as being availablefromutilizationof Graham'sadvice. The
criteria include a P/E screen: securities with high price-earningsratios are
excluded from tested portfolios. However, size is also used as a screen:
smallerfirmsare also excluded fromtestedportfolios. Therefore,the superior
performance measures reported in the next section are not the result of
choosing small firmswhichtended, over the yearsof this study,to have higher
returns. Indeed, unless there is a P/E effect which is distinct from the size
effect the estimatesof superiorperformanceare likely to be downwardbiased
in view of the interrelationshipbetween size and P/E for the sample.2'

20Elsewhere, Roll and Ross [37] present tests of the more recent arbitragemodel. They
conclude thatat least threefactorsarepresentin the expected returnsof securitiestradedon the
NYSE and AMEX. They speculate that there may be a fourth as well.
21 For the four portfolios created the price-earningsratio was on average 10 percent lower
than that of the Standardand Poor 500. The average size of these firms was on average 50
percentlargerthanthe size of the averagefirmlisted on the NYSE. If thereare separateP/E and
size effects the size effect is probably more importanthere.
 Property-LiabilityInsurers and Pension Plans 623

Portfolio Performance
Risk-Adjusted Performance
The analysis described in Section IV is performed under two sets of
assumptions. In the first set, taxes and transactionscosts are ignored
assumed to be zero. The second assumes a marginal tax rate on dividend
income of 7.5 percent, a tax rateon capital gains of 25 percent, and transac-
tions costs identicalto the minimum"standard"ratesof the NYSE at the time
of the transaction.
These two sets of assumptionsareused to allow roughsimulationof the two
situations of interest:pension plan and property-liabilityinsurerportfolios
respectively. The "frictionless" world of capital asset pricingtheoryis quite
analogousto thatfaced by pensionfundmanagers.In these portfoliostaxes on
interest,dividends andcapitalgains are not imposedon funds undermanage-
ment. Normally, both managementand transactionscosts arerelevant.How-
ever, as developed more fully later, the attributablemanagementcosts of a
portfoliocreatedfromutilizationof the criteraof Table 1 are, at best, nominal
(relative to portfolio size) consisting of the cost of time for selection and
monitoring and comparableto the attributablecosts of an index which
consist largelyof the cost of time for makingrebalancingdecisions.22 Further,
transactionscosts of both portfolios are similar consisting of infrequent
requiredtradesin one case andrebalancingtradesin the other. Whenthereare
no significant differences in these costs between alternativesit is best to
completely ignore them, ratherthanattemptingto incorporatethem into both
the portfolio managerand marketreturns.
Under the second set of assumptions, normally 85 percent of received
dividendincome is exempt from taxationfor property-liabilityinsurers.Thus
the effective tax rate on dividends is 7.5 percent (15 percent x .5). While
transactionsratesfaced by individualinvestorsareused in calculatingreturns
for Graham'sstrategytransactionscosts arenot used in calculatingreturnsfor
the marketindex. This biases the results in two ways. First, duringmuch of
this period institutionalinvestors could obtain rates more favorablethanthe
ones used here. Use of such institutionalrates would increasereturnsof the
portfolios created throughuse of Graham'scriteria. Second, purchaseof a
market index does not completely eliminate transactionscosts of such a
portfolio. Since some rebalancingis invariablynecessaryit would be reason-
able to decrease monthlyreturnsof the marketindex by some small amount.
Correctionof each of these biases would undoubtablyincrease the reported
excess returnsin the property-liabilityinsurercase.
Ordinaryleast squaresestimatesof equations(3) and(4) for each of the four
portfolios from month of creationto October 1976 are presentedin Table 2.
The results obtained assuming no taxes or transactionscosts paid at NYSE

22A discussion of these costs follows later in the section.

624 The Journal of Risk and Insurance

standardratesarereportedunderthe heading "pensionplan. " Those obtained

assuming taxes on dividends at 7.5 percent, taxes on capital gains at 25
percent,andtransactionscosts paid at NYSE standardratesarereportedunder
the heading "corporateinvestor.'"23
The results contained in Table 2 show that positive risk-adjustedreturns
were available to the portfolio manager who purchasedan edition of The
Intelligent Investor in any of its last four copyright years, incorporatedits
advice into the portfolio strategy, and held the portfolio, with appropriate
Table 2

Regression Estimates for the Four Portfolios

(Monthly Rates of Return)

One-Factor Model
Parameters of:

Rjt - Rft = ajf + 8jf (Rmt-Rft) + fit

a t(a) 8 t(8) R2

1955-1976

Pension Plan .241% 2.62 .942 51.09 .812

Corporate Investor .133% 1.68 .918 48.37 .754

1959-1976

Pension Plan .239% 2.62 .919 42.95 .753

Corporate Investor .177% 2.02 .911 45.03 .771

1965-1976

Pension Plan .210% 1.83 .923 37.40 .783

Corporate Investor .186Z 1.63 .923 37.40 .783

1973-1976

Pension Plan .736% 2.84 .910 20.92 .814

Corporate Investor .630Z 2.34 .923 20.46 .807

Two-Factor Model
Parameters of:

Rjt - RZt - ajz + $jz (Rmt-Rzt) + f it

a t(a) 8 t(8) R2

Pension Plan

1955-1976 .164% 2.08 .927 55.62 .802

1959-1976 .241Z 2.62 .942 51.09 .812
1965-1976 .230% 2.07 .880 43.60 .831
1973-1976 .753% 2.84 .962 25.28 .865

23The "'corporateinvestor" results could not be computed using the two-factor model
because it was not possible to compute after-taxreturnson the zero-beta portfolio.
 Property-LiabilityInsurers and Pension Plans 625

revisions, until 1976.24Consideringfirst those simulationsmost relevantto

pension plan managers, for each period the estimate of alpha is positive and
significantlydifferentfrom zero (at atleast the 5 percentsignificance level).
These excess returnsrange from .21 percent per month to .73 percent per
month. The incorporationof taxes andtransactionscosts into the simulations
most appropriatefor property-liabilityinsurers does reduce the estimated
risk-adjustedreturn(by an averageof approximately.075 percentper month)
andthe significanceof these alphas.Nonethelessthe estimatesof alphafor the
property-liabilityinsurersimulationsare statisticallydifferentfrom zero (or
nearly so) at the 5 percent level.25
These results provide strong supportfor the conclusion that a portfolio
manager using Graham's selection rules could have earned positive risk-
adjustedreturnsover periodsof considerablelength. Dependingon when the
investmentprogramstarteda pensionplanmanagercould have earned21/2to 9
percentmore per year thanhe or she could have by purchasingand holding a
marketportfolio of equivalent risk. When taxes and transactionscosts are
incorporated into the analysis to approximate the world as faced by a
property-liabilityinsurer (and in a way that biases the results against the
selection rules), the annualrisk-adjustedexcess returnsrangefrom 1.6 to 7.8
percent.
Raw Returns
As stated above, either a pension plan or a property-liabilityinsurer
portfolio managercould have earned significantrisk-adjustedexcess returns
by purchasingany of the last four editions of The Intelligent Investor and
simply utilizing its advice. For some, however, comparisons of the last
section may be irrelevant. Some may feel that the appropriatecomparison
may simply be of raw returnsof the portfolio createdfrom use of Graham's
criteria with the marketportfolio, adjustingeach for appropriatetaxes and
transactionscosts. Such comparisons have two virtues. First, during the
earlier years considered here the raw returncomparisonswere the relevant

24
Clearlythe fourperiodsportrayedin Table 2 arenot independentin thatall fourcontainthe
1973-1976 period, three contain 1965-1973, and two contain 1959-1965. The purposein this
analysis is to portraythe experience of a hypotheticalportfolio managerwho upon publication
of an edition of Graham'stext, immediatelyincorporatedit as a long-termstrategy.In separate
analysesthe authorsfirstdividedthe returndatainto two contiguous 10-yearperiodsandthenin
a furtheranalysis into four contiguous 5-year periods. Using the Chow test ([24], p. 207) the
authorswere unableto rejectthe null hypothesis of homogeneous interceptsfor eitherthe two
ten-year periods or the four five-year periods. Thus these positive risk-adjustedreturns
apparentlywere stable over this period. These results, for example, indicate a portfolio
managerusing the strategyfor a period not presentedin Table 2, say 1965-1970, would have
earnedpositive risk-adjustedreturnsof the orderof magnitudeof those of Table 2, thoughthe
significance level would be reduced because of reduced sample size.
25 Choosing various ten or five year periods ending in years other than 1976 does not alter
these findings.
626 The Journal of Risk and Insurance

comparisons risk-adjustedmeasuresdid not exist in the 1950's and early

1960's. Second the betas of the simulatedportfolios are invariablyless than
1.0 during a period of largely positive market performance. A pensioner
might findlittle solace in observingthe pensionplanportfolioachieve positive
risk-adjustedperformancewhile its raw return(and its consequent market
value) lagged behindthe relevantbenchmark a scenarioquitepossible with
positive alphas, low betas and a rising market.
Table 3 presents mean monthly (and annual)rates of returnfor both the
simulated portfolios and the marketportfolios for each of the four periods
considered. In each case mean yearly return is greater for the simulated
portfolio than for the marketindex. The advantagevaries by period consid-
ered, but for the comparisonsrelevantfor a pension plan portfolio manager
the advantagerangesfromabout 13/4to 9/2 percentannually.Sucn advantages
are not trivial. An original $1,000,000 investment in 1955 (in a simulated
portfolio) would have grown to $7,500,000 in 1976. The comparableinvest-
ment in the market index would have grown to only $5,000,000. For the
simulationsrelevantfor the managerof a property-liabilityinsurerinvestment
fund the comparisonsare similar, though, as in the risk-adjustedmeasures,
the advantageis smaller. On a mean annualbasis the advantagefrom utiliza-
tion of Graham's advice ranges from 1 to 73/4 percent. Again, in terms of
market value of portfolio measures, these differences are large. Assuming
initial $ 1,000,000 purchases in 1955 the terminal values would be
$5,500,000 and $4,500,000 respectively for the simulated and market
portfolios.26
Table 3

Mean Monthly and Annual Rates of Return for the Defensive Investor:
Simulated Purchase Dates in 1955, 1959, 1965, and 1973

Market Returns Investor Returns

Monthly Annual Monthly Annual
Pension Plan

1955-1976 .647Z 8.044% .783% 9.812%

1959-1976 .556 6.679 .768 9.616
1965-1976 .380 4.662 .587 7.275
1973-1976 .541 6.688 1.263 16.257

Corporate Investor

1955-1976 .582% 7.214% .665% 8.284%

1959-1976 .494 6.091 .585 7.249
1965-1976 .338 4.134 .500 6.163
1973-1976 .462 5.683 1.055 13.421

26Similaranalyses were performedfor ten-yearand five-year periods. For each the results
were similar to those presented in Table 3 - higher returns(and terminal wealth) for the
simulated portfolios.
 Property-LiabilityInsurers and Pension Plans 627

As indicatedearlier, a furtherissue, for both pension plan managersand

property-liabilityinsurerportfolio managers,is thatof portfolioperformance
during periods of poor marketperformance.In the three periods of poorest
protractedmarketperformanceduring the 1955-1976 period - December
1961 to June 1962, December 1968 to May 1970, and January 1973 to
December 1974 -using month-endfigures,the DJIAdeclined, respectively,
22.7 percent, 30.6 percentand 39.3 percent. Using actualhigh to low figures
does increase these percentagesslightly. The value-weightedindex declined
22.3 percent, 31.8 percent, and 38.2 percent, roughlythe same as the DJIA.
The simulatedpensionplanportfoliosdeclined20.6 percent,29.9 percentand
29.6 percent. These declines providesome evidence thatthe portfoliocreated
throughutilizationof Graham'sadvice performsat least as well as the market
during such periods.
Management Costs
On the basis of the evidence providedthis far, in termsof bothrisk-adjusted
and raw returnmeasuresGraham'scriteriaoffer the potentialof outstanding
performance. Of some interest, however, is the issue of whether these
potentiallylucrativereturnsare largely eliminatedby the explicitly excluded
(to this point) managementcosts.
The authors'experiencewith Graham'sapproachindicatedthatcreationof
one 60-securityportfoliotook less thanthreehours. Only two calculationsper
security are required:average earnings per share over the last n years and
comparison of this average with the currentprice of the security.27Yearly
maintenance took approximatelyone hour. Thus the cost of the Graham
system must be nominal when comparedto the costs of other implemented
systems. Indeedeven passive index funds probablyrequiremore time annu-
ally for monitoring and revision of the portfolio.
Partof the reasonthatmanagementcosts were so low was the relativelylow
turnoverin the portfolios. Duringthe 21 years of the 1955 portfolioonly 102
replacementsecurities were needed, or approximatelyfive per year. In the
60-security portfolio the annual turnoverwas approximately8 percent. In-
deed, of the original 1955 selections 16 (or 27 percent) were still in the
portfolioin 1976. Of the 60 original 1965 selections fully half were still in the
portfolio over ten years later. Thus transactionscosts were not particularly
significant in computing portfolio return.28

27
Equity as a percentageof capital is also needed. This measurewas usually calculated in
Moody's. In many othercases just looking at the componentsof capitalallowed determination
if this criterion was met.
28
Actually turnoverdue to securities no longer meeting the criteriawas even lower than
indicated above. Considering the 1955 portfolio, 21 of the 102 necessary replacements
occurredbecause included firms were acquiredby other firms. Slightly over 70 replacements
occurredbecause of excessive P/E ratios. Thus the vast majorityof portfolio revisions were
made for what a portfolio managermight view as the "right" reasons.
628 The Journal of Risk and Insurance

Conclusions
This paperhas examined an investmentstrategythathas been availablefor
use by portfolio managers(andothers)since 1949. Such a strategyis a viable
alternativefor both pension plan and property-liabilityinsurerportfolioman-
agers. Over the period studied the strategy could have provided for annual
risk-adjustedexcess returns, depending on the year of selection and the
investor tax situation, ranging from 1.6 to 9 percent greater than that of
purchasing a market portfolio of equivalent risk. The resulting portfolio
would have been a relatively conservative one - with a beta less than 1.0.
Despite this below-marketbeta raw returnsfrom this strategy were consis-
tently greaterthan those of the market.
The strategy is comparatively easy to implement, does not require
significantlygreatermanagementcosts than does a passive index fund, and
does not requiremuchtrading.Securitiesselected fromuse of this strategyare
large enough for institutionalconsiderationand meet common constraintsof
the institutionalinvestors considered here.
The strategyconsideredhere, therefore,is a reasonablealternativeto both
the active strategiesof currentportfolio managersand the increasinglypopu-
lar passive index funds and merits careful consideration by institutional
portfolio managers.

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