It's challenging, to say the least, to spend a portion of the week thinking about how Ben Graham might behave in the current era. In Graham's era, the market didn't have the institutional dominance that exists today. There were no futures or options markets for equity traders, and it was a much more lax operating environment in terms of regulation. There was no high-frequency trading, nor were there discount brokers. No financial television blared a wide range of thoughts and meaningless predictions at us all day. Could Graham's approach work in this new, much-more-complex version of the financial markets?
Obviously, I think it would. The caveat here is that, if you want to use Graham's methods in today's equity markets, you are not going to be the biggest kid on the block. If you want to be a billionaire fund manager who is on Page Six of the New York Post with executive jets, this is not the approach for you. Even the best value managers today -- the ones who are closest to the Graham methods -- apply his approach to markets beyond equities. Seth Klarman at Baupost reminds me most of Graham, and his portfolio is only about 20% equities; the rest is in asserts such as real estate and distressed debt.
I have spent some time worrying and chewing on this, and I figure that somewhere between $100 million and $200 million is the most you can manage using a pure deep-value asset-based approach. If you add earnings- and cash-flow-based techniques, you can probably ramp that up to between $400 million and $500 million. While you can make a very nice living at that asset level with today's fee structure, again, you will not be the biggest kid on the block.
In considering how Graham's approach might apply in today's world, I went back and revisited the "Margin of Safety" chapter in The Intelligent Investor. Here, Graham outlines the simple fact that margin of safety should be the central principle of a successful investment operation. Specifically applied to the search for bargain issues, this concept means that the business value is in excess of the market value, and that the business can withstand adverse conditions. He points out that you may not necessarily love the business, but that if a stock is cheap enough and has a margin of safety, it's generally best to own it anyway.
I sat down this morning and ran some quick screens to look for stocks that are cheap and have a fairly rigid margin of safety. The stocks had to trade below tangible book value, of course, and they had to have a current ratio of more than 1.5x; a Piotroski F Score of 5 or more; and, finally, an Altman Z score of greater than 3. The combination should give us a list of cheap stocks with a very high survivability factor.
As you can imagine, given the run in the market for the past couple of years, we did not get a huge list of stocks. In fact, among U.S.-based companies, we found just 67 that meet our strict criteria. As with almost every other screen we have run in the past few months, the results skew toward smaller companies. Just 15 stocks with market capitalization of above $100 million make the list. 46 of them have a market cap of less than $50 million. The deep-value stocks in today's world are smaller and trade far away from the valuation distortions caused by index traders and HFT gang.
So, while the rest of the value-investing world turns its attention toward Omaha, Neb., in the next few days (for the Berkshire Hathaway (BRK.A, BRK.B) annual meeting, of course), I will devote my attention to the three things that matter most in my version of the value universe: the Kentucky Derby, my birthday weekend and this list of cheap stocks.
The first name on the list is one I have owned for some time, and I have some fairly large gains in the position at the moment. Yet, in spite of the 21% year-to-date gain, Kelly Services (KELYA) still trades just below its tangible book value. The F score is 6, the lowest buy ranking, and the solid balance sheet generates a Z score of 4.9.
While I prefer to initiate new positions at a lower price, a recent report from S&P Capital IQ points out that Kelya usually tops out at more than 130% of tangible book value or higher, and I see no reason for this time to be any different. The company stands to see a huge pickup in demand as the global economy improves, and it could actually become a growth issue over the next few years. I am holding my shares and would happily become a buyer on any broad-market selloff or individual pullback in the stock.
Not all of the businesses on the list are ones I consider stellar, but they are safe and cheap. On Thursday I will begin working my way down the rest of the screen results of modern-day candidates for Graham-like bargain-issue equity investing.