Benjamin Graham (1894-1976) is widely recognized as the father of Fundamental Analysis and Value Investing. Graham's approach involved seeking out discrepancies between a stock's market price and its intrinsic value. He would buy large portfolios of undervalued stocks and hold them until their prices reflected their true worth.
His 1949 book, The Intelligent Investor, details a stock selection technique that focuses on identifying stocks trading at a substantial discount to a calculated value known as the Net Current Asset Value (NCAV).
Understanding NCAV: A Key to Finding Undervalued Stocks
Calculating a stock's NCAV is relatively straightforward but differs from the calculation of Book Value. While Book Value simply measures assets minus liabilities per share, NCAV requires a more nuanced approach. Graham’s method involved:
- Current Assets: Cash, cash equivalents, accounts receivable, and inventories.
- Subtracting Total Liabilities: From the current assets.
- Dividing by Shares Outstanding: To get the NCAV per share.
This NCAV per share represents Graham’s estimate of a stock's fair value.
Practical Application: G-III Apparel Group Ltd
Let’s apply this to a real example: G-III Apparel Group Ltd, ticker symbol GIII.
- Current Assets: $130.25M
- Total Liabilities: $68.3M
- Shares Outstanding: 7.22M
Calculation of NCAV:
- NCAV = (130.25 - 68.3) / 7.22 = $8.58
- Two-thirds of NCAV = $5.66
As of March 7, 2005, GIII was trading at $7.67. Since this is above the two-thirds NCAV threshold of $5.66, it may not be a buy candidate at this time.
Beyond NCAV: The Next Steps in Analysis
Graham viewed NCAV as a starting point. Further analysis was crucial to ensure the stock’s overall quality. Key factors to consider include:
- Earnings: Robust earnings growth.
- Revenue Growth: Consistent increases over time.
- Debt-to-Equity Ratio: Low levels of debt.
- Operational Cash Flow: Strong cash flow per share.
Stocks trading at significant discounts are rare and often result from negative news and market overreactions. Graham's strategy was to buy when others were selling and to sell when others were buying.
His approach would have guided him to avoid overvalued stocks before the dot-com bubble burst and to seek bargains afterward. Warren Buffett, a notable disciple of Graham, has consistently outperformed the market using similar principles.
Evidence of Effectiveness
Studies show that Graham’s NCAV strategy can be highly effective. For example, portfolios selected using this strategy from 1970 to 1983 yielded an average annual gain of over 29% when held for the duration of each year.
In Safe Strategies for Financial Freedom, Van Tharp describes an investing strategy based on Graham’s NCAV, also known as Graham’s Number. The approach involves:
- Buying Stocks: At two-thirds of their NCAV.
- Selling Strategy: Sell one-third of your holding when a 50% profit is achieved. If the price doubles, sell enough shares to recover half your original investment, leaving you with "free" shares.
This method can be applied in an IRA with a diversified portfolio of around 30 undervalued stocks. While finding such stocks is easier in a declining market, diligent investors in an up-trending market can still uncover valuable opportunities. Here is factors controlling market volatility as a reference.
Diversification and Risk Management
Graham's strategy involves significant diversification, which might seem excessive but helps mitigate risk. He recommended a diversified portfolio of smaller companies to shield against individual stock failures.
This approach is suitable for "defensive" investors, but Graham also provided criteria for more "enterprising" investors willing to take on higher risks.
Advanced Stock Selection Criteria
For a more refined approach, Graham suggested:
- Price/Earnings Ratios: Focus on stocks with P/E ratios below 9. Adjust based on current market conditions.
- Financial Health: Ensure Current Assets are at least 1.5 times Current Liabilities. Total Debt should not exceed 110% of Net Current Assets.
- Earnings Stability: Look for consistent earnings over the past five years and growth over that period.
- Dividend Payout: Prefer stocks with current dividend payouts.
- Price Relative to NCAV: The stock price should be less than 120% of the NCAV per share.
Graham did not set a minimum market capitalization limit, suggesting that small companies could still be safe investments if bought carefully and in a diversified manner.
By following these principles, investors can effectively apply Graham’s approach to find undervalued stocks and build a well-balanced portfolio.
