What Would Ben Graham Do?

 | Apr 30, 2013 | 1:00 PM EDT  | Comments
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ktos

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cvu

Investors should pay far more attention to the teacher than to the teacher's most successful student. Billionaire investor Warren Buffett's investing philosophy has deviated from the original methods taught by Ben Graham, as his enterprise has grown to a size that makes true cigar-butt, asset-based value investing less practical. Much is made of Buffett learning more of a Phil Fischer-like approach from partner Charlie Munger, but the truth is Buffett would have had to develop along that path even if he never met Munger. He had too much money under management for a hardcore value approach to be practical.

That is a problem I do not have, thankfully. I can still focus on the approach learned in the Columbia University classroom that gave birth to what we now know as value investing. Different practitioners of the art have taken it different directions over the decades, but I still prefer the basic buying of assets and, secondarily, earnings at a very low price. I also heed Graham's advice to benefit from price rather than try to predict market movements. Market movements are important in that they change the relationship between the business value of an enterprise and the current market quotation. It is the price of the individual securities rather than the current level of the averages that matters most.

The collapse of the averages can and does create a plethora of buying opportunities. Periods like 2002 to 2003 and 2009 to 2010 are fun for long-term asset-based investors as bargains are everywhere. Stocks and bonds alike trade for far less than they are worth as an operating business and many sell for a discount to their liquidation value. Periods like the late 1990s, and to a lesser degree the current market, are not as much fun. Bargain issues are difficult to find and one may begin to question the wisdom of avoiding the high-priced, high-valued market darlings. Cash levels in portfolios rise as former cheap stocks become expensive and are sold.

As I thought about the lessons of Graham, I wondered what a classic asset-based investor like him would be doing today. The market has been rising on a steady basis since the 2009 lows and is up double digits already this year. The value screens I run show fewer names worth considering most every week, and there are few opportunities to get money to work.

Notice that I said few, not none. I think if Graham were alive today, he'd have a team working on a few sectors of the market that have not done well. Fear of sequester and defense cuts have weighed heavily on many names in the defense sector. No one expects much from them and Wall Street could care less about most names. This makes me want to dig deeper into small companies such as Kratos Defense and Security Solutions (KTOS). Most of its business comes from defense and homeland security contracts, and one expects conditions to be awful. The truth is actually opposite that as the company works on secure programs such as drones, cyber warfare and defense as well as transportation infrastructure protection. Funding for these projects is not going away and the company should prosper as it now wins new contracts almost weekly.

CPI Aerostructures (CVU) also appears vulnerable to cuts in defense spending, but dig deeper and you'll see its key military projects include a new helicopter and drone surveillance system that won't see any sharp spending cuts. It also has a growing business providing aircraft components to commercial aircraft manufacturers. The company had a record year in 2012, and business should be stable this year and begin growing at a healthy rate again in 2014.

The stock trades at a discount to tangible book value and at about the value of its net current assets. The fascinating part is that the bulk of its current assets are cash, receivables and money earned on contracts not yet billed. The money is owed by large defense and commercial aircraft manufacturers, so there is little chance of non-collection; it's as good as money in the bank. The stock trades for about 7x earnings and is a bargain by almost any measure.

There are not a lot of cheap stocks around, and I think Ben Graham would be as frustrated as those of us who utilize his approach are today. But there are bargains worth buying in sectors of the market that are out of favor and ignored.

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