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  1. Home
  2. / Investing
  3. / U.S. Equity

Bargains With the Modified Graham Number

Diversify with energy and retail stocks.
By TIM MELVIN Sep 30, 2014 | 03:00 PM EDT
Stocks quotes in this article: GIFI, DWSN, TPCA, SUP, TLYS, SCVL, BGFV, HGG, SSI

There is a lot of news and noise around the markets today. The Chicago PMI came in light this morning, there is civil unrest in Hong Kong, the numbers from Japan and Europe were horrible, China reported disappointing stable growth and consumer confidence.

The constant news flow is enough to make you dizzy . I have no idea how anyone can trade the short-term gyrations of such a news-heavy market. I have tried to keep my head down and look for potential bargain issues in the stock market. I have spent the past few days playing with my modified version of the Graham number and it is turning up some interesting stocks worth consideration by long-term investors.

Yesterday, I modified the classic graham number and have found it useful to identify bargain stocks. Instead of the product of the P/E ratio and price-to-book-value measure being 22.5, I use the more reliable enterprise value by using ebitda and tangible book value. If the product of these numbers is less than 8, you have a potential bargain issue. I have played around with this since the weekend, and it has been very promising so far. I have to unleash some quants who are more skillful than I am, but early results show a large premium over market returns.

Yesterday, I used this screen to look for dividend growth stocks with interesting results. Today, I used this screen to look for stocks across a broader swath of the market. As is the case with every screen I run these days, the list is short, but there are some good companies on the list that should provide solid long-term rewards.

As was the case yesterday, energy stocks make up a significant portion of the list. If we do not enter a long-lasting and steep global recession of Armageddon proportions in the next several months, and no new magic energy source is discovered in the fourth quarter, energy stocks are very cheap. I suspect I am not the only one whose deep value portfolio is starting to resemble a natural resources fund. Two of the cheaper names that made yesterday's dividend growth list are Gulf Island Fabrication (GIFI) and Dawson Geophysical (DWSN).

The Atlantic City casino market is a hot mess with three recent closings. The future does not appear that bright. Casinos are popping up all over the country, and it is no longer necessary to travel to gamble. Atlantic City has never succeeded in becoming a Vegas-like destination, and many observers expect conditions to get worse. In spite of the dim outlook, I cannot imagine Carl Icahn just writing off his stake in Tropicana Entertainment (TPCA). In addition to the fact that the company owns nine casinos outside Atlantic City, I expect Tropicana to emerge as one of the survivors of the Atlantic City shakeout. Based on my modified Graham formula, the stock is very cheap at current prices, with a ratio of just 4.6.

Superior Industries International (SUP) may not be a flashy stock, but it is a cheap one, with a modified ratio of just 5.6. The company has been around since 1957, and it is a really basic business. The company provides aluminum wheels to all of the major auto manufacturers around the world, and it is the market leader in its niche. The stock yields 3.99%, so you collect a decent dividend while you wait for the price to move higher.

There are more than a few retailers on the list as well. I am a little skeptical about the near-term future of retail, but I am a lousy forecaster, so let's just stick with the numbers . Tilly's (TLYS), Shoe Carnival (SCVL), Big Five Sporting Goods (BGFV), hhgregg (HGG) and Stage Stores (SSI) all make the cut as cheap stocks, using the modified Graham formula. In theory, the retail-oriented names should be inversely correlated with energy stocks, so adding a few of these to an energy rich portfolio might help provide additional diversification, as well as long term return potential.

This modification of the original Graham formula appears to have great potential as a stock-picking tool. I will continue to report back on the results, as I continue to test and refine it.

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At the time of publication, Melvin had no positions in any of the securities mentioned.

TAGS: Investing | U.S. Equity

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