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Benjamin
Graham
Graham's
Net Current Asset Value Strategy
Finding
low-risk stocks should be priority number one in this market. Benjamin
Graham, considered by many to be the architect of fundamental analysis,
described a strategy for identifying deep value stocks, which in his
view are low-risk candidates, in his book, “The Intelligent
Investor,” published in 1949.
Graham’s
strategy, dubbed the “net current asset value” approach, apparently
works very well. One research study, covering the years 1970 through
1983 showed that portfolios picked at the beginning of each year, and
held for one year, returned 29.4 percent, on average, over the 13-year
period, compared to 11.5 percent for the S&P 500 Index. Other
studies of Graham’s strategy produced similar results.
Despite the
impressive results, Graham’s net current asset value (NCAV) approach
is relatively unknown to individual investors. That’s probably because
finding stocks meeting Graham’s requirements requires some digging. No
Web site provides tools to screen for NCAV stocks.
However,
it’s not hard, and anyone willing to devote a couple of hours to the
task should be able to come up with a few candidates. Here are my ideas
for finding NCAV stocks.
Graham's Value Strategy
Graham’s NCAV strategy calls for buying stocks trading below their
calculated value. Many value stock selection strategies can be described
similarly. What’s different is how Graham determines value.
Book value,
the usual value measure, is a firm’s assets minus its liabilities.
Graham does the same calculation, but only includes current assets
(cash, inventories, and accounts receivables) in the computation. He
ignores long-term assets such as buildings, equipment, patents, and the
like. However, he still counts all liabilities including short- and
long-term debt, and everything else that appears in the liabilities
column of the balance sheet.
Thus, net
current asset value is current assets minus total liabilities.
Graham’s NCAV strategy calls for buying stocks trading at two-thirds
or less of their net current asset value.
That’s a
stringent requirement, since most companies have negative NCAVs. But
Graham was looking for firms trading so cheap that there was little
danger of falling further. His strategy calls for selling when a
firm’s share price trades up to its NCAV.
Finding Graham's Value
Stocks
According to Graham, some of the companies meeting his NCAV criteria
could end up failing, so he recommended buying a large number of stocks
to diversify the risk. Since that’s not practical for individual
investors, I’ve come up with additional qualifying criteria to
minimize the insolvency risk. I’ll describe these additions as I
describe how to screen for prospective NCAV stocks.
Screen for Value
While you can’t search directly for NCAV stocks, you can set up a
screen that will hone down the list to a reasonable number of
candidates.
You can use a
variety of Web screeners, but I’ll demonstrate the process using
BusinessWeek Online’s Quick Stock Search (www.businessweek.com).
Note: the Business Week screener is no longer
available. However, you can run the same screen using MSN Money's Deluxe
Screener (http://moneycentral.msn.com).
Enter the
following search parameters into the
screening program.
Stock Price
Real cheap stocks signal problems, and the lower the price, the higher
the risk. Start with a $2 minimum price. I picked that number
arbitrarily, so you can adjust the level to increase or decrease the
number of candidates.
Price/Book Ratio
Most NCAV candidates have P/B ratios well below 1. Specify a maximum P/B
of 0.8 to screen out unlikely candidates.
Price/Cash Flow Ratio
Cash flow, the amount of cash that moved into, or out of, a firm’s
bank accounts due to its operations is a reliable profitability measure.
Requiring positive cash flow eliminates many high-risk companies. You
can limit your search to positive cash flow companies by specifying a
minimum 0.1 P/CF.
Price/Sales Ratio
Most NCAV stocks show very low P/S ratios, usually below 0.2. Require a
0.3 maximum P/S ratio to rule out stocks unlikely to meet Graham’s
requirements.
Debt/Equity Ratio
The lower the debt/equity ratio, the more likely that a stock will meet
NCAV criteria. You can’t require zero D/E, however, since most NCAV
stocks do have some debt. Stipulating a maximum D/E of 0.1 should pick
up most NCAV stocks. However some do have higher D/E ratios, so try
higher values if you don’t come up with enough NCAV stocks.
Use the
dropdown menu to select a maximum of 50 stocks to list before running
the screen. I found 30 candidates when I ran it last week.
Your next
step is to determine which of the stocks turned up by your screen meet
Graham’s requirements.
Evaluate Candidates
Hoover’s (www.hoovers.com) is the
best site to do the analysis because it displays the balance sheet
information in a user-friendly format.
Enter a
ticker symbol, and then click on
Financials
to see Hoover’s combined income statement and balance sheet for each
stock.
Liabilities vs. Current
Assets
Save yourself time by first visually determining if current assets
exceed total liabilities. Both figures are shown near the bottom of the
page. Most stocks won’t meet this test, so eliminate them here.
Otherwise,
compute the net current asset value by subtracting the total liabilities
from the current assets. Then, convert the NCAV to a per-share figure by
dividing by the number of shares outstanding listed on the bottom line
of the balance sheet.
Finally,
compare the per-share NCAV to the recent stock price shown on your
screen results. The stock passes if the current share price is no more
than 67 percent of the NCAV.
Goody’s
For instance, Goody’s
Family Clothing turned up on my screen. Goody’s current assets
totaled $273 million compared to $196 million total liabilities. So
Goody’s NCAV was $77 million ($273 minus $196).
Hoover’s
listed 32.5 million shares outstanding for Goody’s, so its per-share
NCAV was $2.37 ($77 divided by 32.5).
Goody’s
share price, at $10.60, exceeded its NCAV, so it didn’t qualify as a
NCAV stock.
Two Passed
Only two of the 30 stocks turned up by my screen, Manchester
Technologies, and Gentiva
Health Services, qualified as NCAV stocks. (Since this column was
published, several readers pointed out that Gentiva had sold a major
product line to another firm in June, so Hoover's March quarter data may
no longer apply.)
It sounds
like a lot of work to analyze 30 candidates to come up with only one or
two NCAV stocks, but it goes quickly once you get the hang of it.
Run the
screen around once a month. You should pick up a five to 10 qualifying
stocks in a year’s time.
published 6/30/02 |
