Finding Undervalued Stocks 2 – Revisiting Graham’s Rules

In a previous article, we discussed Ben Graham’s Net Current Asset Value (NCAV) strategy and how it works. Here we will revisit Graham’s rules, which were fairly severe in their original form in that they required the price of the stocks under consideration to be trading at less than two-thirds of their NCAV or Graham’s Number. These he considered to be “Bargain Issues”, and to quote him: “Our purchases were made typically at two-thirds or less of such stripped-down asset value. In most years we carried a wide diversification here– at least 100 different issues.”

Such a wide diversification may seem excessive for most investors, but with such low-priced stock there were evidently going to be a few bankruptcy candidates. Graham considered this strategy to be suitable for what he called  “defensive” investors. He did acknowledge, however, that there were some “enterprising” investors who could afford to be more aggressive from the point of view of risk. To this end, he suggested a series of less onerous criteria for selecting stocks which is outlined below.

First, list all stocks with Price/Earnings ratios below 9. Note: Graham was  writing in 1970 when P/E’s as a whole were not as elevated by technology stocks as they are today. Readers who are less risk-averse or who just want to consider a wider range of stocks may wish to vary the P/E in order to see what comes up — perhaps up to 80 percent of the average P/E of the S&P 500 would be a good start. Currently the operating average is around 18 and 85 percent of that figure is just over 15. Graham did not state if he was using a Trailing or Forward P/E ratio, but most likely he was using Trailing P/Es. I personally prefer to use Forward P/E ratios, especially if they are significantly lower than the Trailing P/E as this implies expected earnings growth and therefore possible increase in the stock price.

Once we have a list of stocks meeting the P/E criterion, we consider the financial condition of each stock, referring to the most recent balance sheet: initially, Current Assets must be at least 1.5 times Current Liabilities. This can  also be gleaned via a stock screener by displaying stocks with “Current Ratio” >= 1.5. Total Debt must not be greater than 110% of Net Current Assets (i.e. the sum of Cash & Cash Equivalents, Inventory, Accounts Receivable).

Looking further back, we need to find evidence of Earnings Stability, with no deficit in the last five years, i.e. no evidence of an annual loss. Additionally, evidence of earnings growth over a five-year period is a must. This can simply be the consideration, for example, that 2004 earnings were greater than 2000 earnings.

There should be some current dividend payout. Finally, the current price of the stock should be less than 120% of the NCAV per share or Graham’s Number. Where to find this number? From the balance sheet, subtract Total Liabilities
from Current Assets, and divide the result by the number of shares outstanding. Assuming you have a positive number that is greater than zero, the stock’s price should not be greater than 120% of this number.

At grahaminvestor.com, we list stocks that are trading within 120% of the NCAV per share. Since this was an important measure for Graham, you can start there and work your way backwards through the other criteria.

Graham did not set any lower limit on market capitalization. “Small companies may afford enough safety if bought carefully and on a group basis.” He meant that a well diversified portfolio with a fair number of such companies stock would protect the enterprising investor from the bankruptcy of one or two companies.