Think Like the Father of Value Investing

 | Apr 27, 2012 | 12:00 PM EDT  | Comments
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If the starting point of the world of analysts has an equivalent to the universe's Big Bang, it is found in Benjamin Graham. British-born and New York-raised, Graham is widely considered the forerunner of today's analysts. A public figure during this lifetime, today -- 35 years after his death -- he remains a touchstone for many analysts and investors. In fact, his most famous student is Warren Buffett, who continues to extol Graham's importance. Buffett attended graduate school at Columbia University specifically in order to study under Graham, and he worked for Graham before starting out on his own.

Graham approached stock buys as though he were buying the company itself, taking into account all of the company's profit, debt, assets and revenue streams. His rationale: In the short run, stocks are unpredictable, but over the longer term, a stock's price tends to move in ways that reflect the real value of its business. This, in turn, is indicated by such fundamentals as price-to-earnings ratio, price-to-book ratio, sales, profit and the debt-to-asset ratio.

But mistakes can be made and the unexpected can intervene, which is why Graham wanted the typical investor to buy stocks with a "margin of safety." That means buying stocks whose prices are below the company's underlying value.

If one can find a company with solid long-term prospects – and whose stock is selling at a discount to the company's real value (the margin of safety) – the investor will enjoy downside protection. Even if the company encounters unexpected difficulties, the stock could hold its value or even increase a bit because it was so undervalued to begin with. Further, if the stock declines, the drop will likely be minimal, since it has already been selling at a relatively low price. This is the essence of Graham's investment strategy.

When I started investing, my immediate strategy was to learn from the best and to use their proven strategies in order to find stocks worth buying. Based on the writings of Wall Street's gurus, I created automated strategies that allow me to instantly analyze any stock and find those favored by these winning strategies.

Needless to say, Graham was on my initial list of gurus whose strategies I would automate. Several weeks ago I started a series of columns about gurus whose stock picks are relatively few, meaning I rarely get to write about them. I am concluding the series with this column about Graham. I do not write about him often, but he is definitely worth your attention.

If you still wonder whether Graham's strategy works, even after Buffett's endorsement, look no further than the performance of my automated version of the strategy on my website, Validea.com. In the nearly nine years since I began following it in July 2003, the Graham strategy has produced an annual rate of return of 12.3%, more than 3x the S&P average of 3.8%. You would have to be a real curmudgeon to argue with results like these.

Currently, these three companies earn the Graham strategy's highest grades:

Forest Laboratories (FRX): This pharmaceutical company focuses on central nervous and cardiovascular systems drugs that address such illnesses as depression, Alzheimer's and hypertension.

United Stationers (USTR): This company distributes office equipment and supplies, office furniture, janitorial and break room supplies to 25,000 resellers in the U.S. and Mexico.

Ceradyne (CRDN): This is a manufacturer of advanced technical ceramic products used in defense, automotive, oil and gas, nuclear power, solar, industrial, medical and electronic industries.

All of these companies have strong current ratios, or current assets to current liabilities. They each have moderate amount of debt -- in fact, Forest Laboratories and Ceradyne have no debt -- as well as a strong long-term track record of growing earnings per share. They also share a moderate price-to-earnings ratio, which indicates a well-priced stock.

Investors have been following Graham for decades -- and with good reason: His approach to investing has proven itself time and again. These three stocks can provide a way for you to benefit from Graham's insights.

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