Graham's Formula Still Works

 | Aug 29, 2012 | 2:30 PM EDT  | Comments
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Stock quotes in this article:

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tis

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csco

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I just started reading The Einstein of Money, the new biography of Benjamin Graham by Joe Carlen. It is an enjoyable read, since in addition to being the father of value investing, Graham was a fascinating individual. His autobiography is long out of print, so if you never read it, pick up this book as soon as you can.

In my reading I was reminded that shortly before his death, Graham told interviewers from Forbes and Medical Economics magazine that he had developed a set of 10 stock-selection criteria that handily beat the market.

The criteria include such metrics as price-to-book, debt levels, price-to-earnings ratios and balance-sheet strength. Only at the bottom of severe bear markets have I ever found a stock that met all criteria, but mixing and matching from the 10 can uncover undervalued, market-beating stocks. The selection criteria have been exhaustively tested by academics and practitioners, and a couple of combinations have proven most profitable.

One of the most successful combinations by far searches for stocks that have the following characteristics:

  • Earnings yield is twice the AAA bond rate.
  • Solid earnings growth.
  • A dividend yield of at least two-thirds of the AAA bond rate.
  • A solid balance sheet with a current ratio of more than 2 and debt less than the book value of assets.

While bond yields are as low as they are, the threshold for earnings and dividend yield is not that high. It works out to a P/E of less than 15 and a yield of more than 1.4%. You would think that there would be a cornucopia of companies that meet the criteria. Surprisingly, that simply is not the case. Just 45 U.S. companies meet the criteria to be included in the portfolio.

My favorite stock on the list is one that has shown up before on one of my lists of undiscovered growth stocks. Orchids Paper Products (TIS) makes private-label paper products including bathroom tissue, paper towels and napkins. The company distributes its products through discount stores, grocery stores and convenience stores in the Midwest and Texas.

The company has grown earnings at an average rate of more than 40% the past five years. So far this year, both sales and earnings have continued to grow at a double-digit rate. It is in the most basic of businesses, it is run efficiently and profitably, and its stock sells for a respectable price. As a bonus, Orchids doubled the dividend last year, and the shares now yield more than 4.5%. Orchids sits at the very top of my list of stocks with which to "load the boat" in a selloff.

Some big tech names make the list as old-school tech companies begin to understand the value of retuning actual cash to shareholders. Cisco's (CSCO) recent announcement of a dividend increase is something I had been suggesting for several years now. Although I am sure that I had no influence whatsoever, it was a great move by the networking giant. Trading at 12x earnings with a rock-solid balance sheet, a dominant position in its industry and a sparkling 2.91% dividend yield, this is now a stock worth considering for long-term value investors. The same can be said of Intel (INTC) at 10x earnings and a yield of 3.6%.

My favorite name among the big-cap techs that make the Graham list is Corning (GLW). Corning will play a leading role in the strongest growth areas of the tech economy. The substrate division makes glass that's used in flat-screen TVs and monitors, and the fiber-optics part of the company provides the fiber and cable needed to build out and improve high-speed networks. Corning also has a presence in the potentially high-growth environmental technology and life-sciences industries.

The company has more than $3 billion of net cash and no debt maturing until 2017. It has been using cash and cash flow to buy back stock, and it recently increased the dividend. The stock is one of the very few that fit almost all of the Graham criteria, and I believe it is a screaming buy at current level for long-term investors. The stock trades below tangible book value and has a price-to-earnings ratio of just 8.1. At the current price, the dividend yield is 2.57%. I believe long-term investors will experience some price volatility in the short term but will be rewarded with spectacular gains over the next five years.

Graham's stock selection methods have stood the test of time and still uncover bargains that can reward investors with gains of multiples, not percentages, over time.

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