While surfing the Web Tuesday I ran across an article from a 1976 edition of The Financial Analysts Journal titled "A Conversation with Ben Graham." I have read the article before but it has been some time. I re-read it and found it as fascinating and useful as always.
Graham did several interviews before he died, laying out more simplified approaches to investing. In this one he really simplifies the approach he thinks individuals should use to profit in the stock market.
One point that Graham makes for individuals is that Wall Street is not your friend. When asked his opinion of Wall Street, he says:
"A highly unfavorable, even a cynical, one. The Stock Exchanges appear to me chiefly as a John Bunyan type of Vanity Fair, or a Falstaffian joke, that frequently degenerates into a madhouse -- a tale full of sound and fury, signifying nothing. The stock market resembles a huge laundry in which institutions take in large blocks of each other's washing."
Graham adds that most financial professionals take themselves and the market too seriously and spend too much time trying to do things such as predicting market levels and making economic forecasts that simply cannot be done.
He suggested that investors focus on two approaches. One is his net current asset approach in which investors simply buy companies when they trade for less than net current asset value. He acknowledges that this approach can be limiting because opportunities dry up as the market advances. Today, for example, only a handful of stocks trade below net current asset value after six years of steadily rising prices. In 2008-2009 there were dozens of super cheap stock from which to choose.
The second method is one that is more readily available most of the time and is ridiculously simple. Graham told the Journal: "This is similar to the first in its underlying philosophy. It consists of buying groups of stocks at less than their current or intrinsic value as indicated by one or more simple criteria. The criterion I prefer is seven times the reported earnings for the past 12 months."
He said that he had studied the results of this simple approach over the prior 50 years and it had produced average annual returns of about 15% or so during that time period. That's a decent return from such a simple strategy so I had to back-test it myself. It does beat the market rather handily over the past 15 years. It outperforms in both up and down market cycles with a huge advantage in down markets.
I ran this simple screen on U.S. stocks and there are some interesting companies on the list, even in today's extended stock market. Unlike many value screens today, it is not dominated by energy companies. It seems that most energy-related stocks are showing a loss over the past 12 months, and we limited our universe to only those companies with positive earnings the past 12 months. Valero (VLO) and Anterra (AR) are the only two energy companies among the 20 largest companies that pass the screen.
Goodyear Tire and Rubber (GT) makes the list of cheap stocks to consider in today's market. The company has had revenues decline as the strong dollar has hurt results outside the U.S., but cost controls and a focus on higher-margin products are bolstering the bottom line. Goodyear has done such a good job marketing its high-value-added replacement and OEM tires that it has had to build a new plant to meet demand. The stock is trading at less than 5x earnings and is an intriguing long-term selection.
LB Foster (FSTR) is another interesting company that makes the list. This company is primarily in the railcar infrastructure business, supplying rail, track components and railcar repair. It also has divisions that supply products to the bridge-building and repair industry, the vertical well industry that serves the water industry, and pre-cast concrete building.
As the price of oil has fallen this year, LB Foster has made two oil services acquisitions to take advantage of low valuations. Most of its business lines are facing short-term difficulties. But an improving economy that boosts infrastructure spending and lifts oil prices could drive this stock a lot higher than the current depressed quote.
I do not have room to review all the companies on the list of stocks trading below 7x earnings but it is a simple screen to run. While not all the stocks are great candidates for purchase, it is thought-provoking list and can be a solid starting point for the research process.
I will leave you with one final thought. One industry most represented on the list was community banks. They are cheap not just on book value, but on earnings as well. If you are not heavily invested in community banks, you are making a mistake of omission that will be costly.