I Found 5 Stocks With The “Ben Graham Method”
One of my kids recently stumbled across my brokerage statement and asked if the balance was enough for me to retire.
I assured him it wasn’t. But it was a good learning opportunity, so I further explained that bank accounts, 401(K)s and other assets were only half the picture. You need to deduct car loans, credit card debt and other liabilities to determine net worth.
Of course, the same is true for any business.
Ignoring This Event Could Cost You A 6-Figure Payday.
Take Coca-Cola (NYSE: KO). The beverage giant currently owns $8.8 billion in property and equipment, $7.2 billion in cash and equivalents and $3.2 billion in inventory, among other assets. In total, it adds up to $88.3 billion. But it owes $10.9 billion in accounts payable and $29.4 billion in long-term debt.
If the company liquidated its assets and used the proceeds to satisfy its liabilities, there would be $17.7 billion in cash left over. That’s what we refer to as shareholders equity or book value. Spreading that money among the 4.3 billion shares outstanding works out to $4.12 per share.
KO is currently trading near $48, representing a Price/Book ratio of 12.
It’s not uncommon for a stock to trade at a premium to its book value. After all, this figure is simply a snapshot of today’s assets (some of which have appreciated and are worth more than what is on the books). It says nothing about a company’s future earnings potential.
All things equal, the faster a business is expected to grow, the higher it might be valued in relation to today’s book value. The average stock in the S&P 500 currently trades at a little more than three times book value. That essentially means you are paying $3 for every $1 of book value.
But what if you could buy a stock for just 80 cents or 90 cents on the dollar?
The Ben Graham Method
#-ad_banner-#Ben Graham, the father of value investing (and Warren Buffett’s personal mentor), was an early practitioner of using book value to pinpoint such stock-market bargains. He took it a step further, isolating current assets such as cash and receivables and eliminating everything else. He assigned no value to intangible assets (like goodwill) and long-term assets that couldn’t easily be converted to cash.
Under this more restrictive approach, he even valued inventory at just fifty cents on the dollar (assuming it would be sold at fire-sale prices). If what was left could be sold off piecemeal and used to pay off all obligations, then there was very little risk. Even in the event of bankruptcy, stockholders would be able to recoup their investment.
This basic approach was codified in Graham’s seminal book, “The Intelligent Investor.” It’s still considered the Bible among value investors. Warren Buffett (a student of Graham’s at Columbia) claims to have read it more than half a dozen times and refers to it as life-changing. He put the theory into practice, raking in huge gains from Graham-worthy companies in the early days of his career.
According to Forbes, one study found that stocks meeting Graham’s criteria delivered average annual returns of 29.4% over a 13-year period, versus 11.5% for the S&P 500.
Let’s Screen For Deep Discounts In Today’s Market
Unfortunately, we seldom see businesses trading for less than their liquidation value anymore — except in extreme market downturns. And even then, they might be distressed companies facing potential asset write-downs that are losing money and burning through their cash.
Nevertheless, the market is known to be irrational at times, driving stocks well below their true value. So it can be worthwhile to find quality companies temporarily trading close to book value. As an added measure of security, it can be smart to weed out unprofitable candidates by screening for stocks with above-average dividends and a return on equity (ROE) of 10% or better.
Here’s what I found…
As always, the stocks in the table above haven’t been fully researched and shouldn’t necessarily be considered portfolio recommendations. They simply meet certain screening criteria that make them worthy of a closer look.
With that said, let’s take a closer look at two standouts…
I’ve come to Macy’s (NYSE: M) defense in recent months. The venerable department store owner has suffered from the general malaise in brick-and-mortar retail, as well as a self-inflicted wound from raising earnings guidance last November only to reset it back down shortly after.
Still, this is not Sears. Macy’s is a high-end retailer operating 680 stores that haul in more than $2 billion in revenues each month. And sales are expanding, not shrinking. In fact, Macy’s has reported six consecutive quarters of positive same-store sales growth, or “comps.”
Market pessimism has driven the stock down from the upper $60s to the low-$20s, not far from the book value of $20.47 per share. And management is monetizing those holdings, raking in $43 million in asset sales last quarter alone.
While there are operating headwinds, the stock is appealing at this level.
I’ve also got my eye on Seaspan (NYSE: SSW), which rents containerships to third-party shippers under long-term charter contracts. I like the transparent cash flows in this industry, which are partially insulated from volatile day-to-day shipping rates. Seaspan is trading at just 60 cents on the dollar relative to its book value (versus a historical average of 80 cents) and boasts a compelling yield of 4.9%.
Action to Take
As with any metric, price/book ratios shouldn’t be used on a standalone basis but in conjunction with other financial measures. Book value tells us nothing about a company’s earnings or cash flows and can be misleading when the balance sheet reflects a large proportion of intangible assets.
That being said, this can be a useful valuation tool. There is a reason why Warren Buffett has measured his own job performance by the growth in Berkshire Hathaway’s per-share book value over the years. And the fact that these companies are paying regular dividends suggests that they are generating surplus profits.
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