What Would Graham Buy?

By Jeffrey Lange | October 16, 2008 AAA

Seventy-five years ago, following another market meltdown you may have heard of, McGraw-Hill published the classic investment book "Security Analysis" written by Benjamin Graham and David Dodd in 1934. Graham and Dodd advocated the concept of "intrinsic value" and the book became the bible of value investing.

Graham is considered the father of security analysis, advocating the position that securities have an intrinsic value that is not always necessarily reflected in the market prices of those securities. Graham and Dodd stated in their preface their hope was to write a book that "will stand the test of the ever enigmatic future". With the October 2008 market meltdown coincident with the book's 75-year anniversary, it may be interesting to look at some equity securities that Graham might be evaluating if he were alive today.

Graham's Gang
Warren Buffett, the chairman of Berkshire Hathaway (NYSE:BRK.A), is one of the most notable followers of Graham, but there are several other disciples that investors may recognize: John Bogle, the former head of the Vanguard Group, Mario Gabelli of Gamco Investors (NYSE:GBL), Gabelli Equity Trust (NYSE:GAB) and Gabelli Dividend & Income Trust (NYSE:GDV), as well as mutual fund managers Michael Price, John Neff and others. (For more on Graham's influence, read The Intelligent Investor: Benjamin Graham.)

Potential Deep Value Candidates
Graham would try to identify intrinsic value, a core value for a company within a relevant range. However, if a company's losses would continue for a protracted period of time, the margin of safety would eventually dissipate and intrinsic value of the company would decline. To provide a margin of safety beyond intrinsic value, he looked for companies whose stock was trading at less than net current assets per share or working capital per share. The margin of safety allows an investor to purchase stock no matter what the stock market is doing or whether the company was experiencing temporary difficulties.

Determining the reason why a company is trading at a discount to its net current assets or alternatively, its intrinsic value per share, was equally as important as finding companies trading at such discounts, allowing one to assess whether intrinsic value could ultimately decline over a long period of time.

The following table displays companies whose market-prices per share are trading below net current assets or working capital per share. As shown, many of these companies are also trading below book value per share.

Company Net Current Assets / Share Margin of Safety / Share Margin % of Market Price P/B Cash Dividend Yield
Ashland
(NYSE:ASH)
$33.71 $8.31 33% 51% 4%
Ampco-Pittsburgh
(NYSE:AP)
$13.45 -$6.91 -34% 112% 3%
Aracruz Celulose
(NYSE:ARA)
$8.97 -$6.70 -43% 83% 6%
Byth
(NYSE:BTH)
$8.01 $0.73 10% 102% 7%
CDI
(NYSE:CDI)
$12.11 -$1.24 -9% 82% 4%
Chicago Rivet & Machine
(AMEX:CVR)
$16.97 $2.72 19% 56% 5%
Carpenter Technology
(NYSE:CRS)
$14.39 -$5.79 -29% 119% 3%
Formula Sys.
(Nasdaq:FORTY)
$16.56 $8.56 107% 55% 7%
Overseas Shipholding
(NYSE:OSG)
$20.83 -$20.34 -49% 78% 4%
Note:
• Graham\'s "net current assets per share" equals working capital per share
• Graham\'s "margin of safety" is working capital per share less stock price
• Margin percent is the margin of safety per share as percent of market price
• Price to book is market price to book value per share
• Cash dividend yield is annual cash dividend as percent of market price per share

Example Analysis - Ashland Inc.
Ashland is a global diversified chemical company that manufactures specialty chemicals in the construction markets, packaging, transportation and other cyclical areas of the economy. With a dividend yield of 4%, debt equivalent to a meager 2% of equity, sales and earnings growth over the last five years of more than 11%, the company has a good track record and a solid balance sheet. As the table shows, an investor can buy the Graham net current asset value per share of this company and basically obtain the equipment, products, customers, management, future earnings, future cash flows and future growth for free.

Taking Advantage of Short-Term Adversity
If you find a stock trading at levels below working capital per share, short-term market fluctuations or temporary company operating difficulties need not be a concern. Graham followers should think long term and have a reasonable time horizon. And in the short-term, there is the Graham margin of safety as a gift from Mr. Market. The margin of safety is the amount of excess net current assets an investor can buy at today's market price while still obtaining the rest of the company for free.

Buy Value, Forget Short-Term Earnings Trends
This article provides a list of stocks that, based on preliminary analysis of the numbers, are possible candidates for a long-term portfolio. All of the companies above (with perhaps the exceptions of Blythe, Chicago Rivet, and Formula Systems - where intrinsic value could possibly be stagnant or eroding) may be good candidates under the Graham approach.

The Graham approach does not lend itself to short-term trading. These companies are trading at low valuations because their market price dynamics are surrounded by low expectations for short-term earnings trends or other possible negative factors. Poor market sentiment creates potential opportunity for followers of the Graham approach. Long-term investors should take a hard look at the companies listed here.

For more on Graham and other great investors, read Greatest Investors Tutorial.

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