Now that I have spent a week discussing energy and energy stocks, I will get back to business as usual. I finally gave up hope last week that an old friend would return my copy of Benjamin Graham's autobiography "The Memoirs of the Dean of Wall Street" and purchased a slightly used copy on Amazon. I am always amazed how Graham's simple ideas have stood the test of time and work as well today as they did when he first developed them decades ago.
Graham discussed one of his last concepts in an interview with Medical Economics magazine shortly before he died in 1976. He used two simple criteria -- a low price-to-earnings ratio and an equity-to-assets ratio over 50% -- to identify safe and cheap stocks. The P/E ratio used under this strategy was the inversion of an earnings yield more than two times the AAA bond rate, or 10, whichever was lower. He then suggested that the shares be held for two years or a 50% gain, whichever came first.
Wesley Gray and Tobias Carlisle tested this approach in their fantastic book "Quantitative Value" and found that it crushed the stock market, exceeding the return of the S&P 500 from 1976 through 2011 by more than 60%. The 17%+ compound return delivered by the model exceeded Graham's expectations for the strategy of 15% a year.
I ran this simple screen this morning and came up with some interesting stocks worth consideration by long-term investors. While the set of criteria is much more flexible than I usually use and produces some stocks that might not pass my more-stringent value screens, this approach has worked well so it's worth investigating. Given that two times the current AAA bond rate would produce a maximum P/E of 16, we will use 10 as our cut off.
It should come as no surprise that there are no large- or mega-cap names on this list of "Graham cheap stocks." We are flirting with all-time highs in the broader market, so the big names are just not cheap right now.
The largest non-energy company on the list, with a total market capitalization of $747 million, is Sturm Ruger (RGR), the firearms company. Firearms manufacturers are facing some difficult comparisons now that the gun-buying binge of a few years ago has settled down and Wall Street has turned negative on these companies. However, Sturm Ruger has no long-term debt and trades at 9.5x earnings so it qualifies as a Graham cheap stock and is worth considering.
REX American (REX) operates in alternative energy and real estate -- a strange combination of businesses. The alternative energy segment has seven ethanol production facilities, while real estate operations are focused on monetizing the company's former retail properties. Driven by ethanol gains, earnings have grown by about 75% a year over the past five years. The company has very low levels of long-term debt and the shares fetch less than 8x earnings, so REX appears to be a long-term bargain issue.
Immersion Corp. (IMMR) makes software that enables game developers and advertisers to add touch sensations, allowing gamers and others to experience the feel of car motors rumbling, gun recoils and the impact of a baseball hitting a bat. The software also has use in medical education and digital controls. I confess that I am intrigued by this company, as this would seem to have enormous potential, particularly in gaming. IMMR makes the list of Graham cheap stocks with a P/E ratio of 6.3 and an equity-to-assets ratio of 70%. In addition, the company has a current ratio of 4.4, showing financial strength.
There are 34 energy-related companies on the list of Graham cheap stocks, including some larger-cap stocks such as Hess (HES) and Marathon Oil (MRO). Two stocks that I am watching for an entry point right now -- Tidewater (TDW) and Gulfmark Offshore (GLF) -- are also on the list.
Graham suggested holding a portfolio of around 30 stocks and to stay fully invested. Although the initial screen produced 102 names, by the time I went through them and discarded one-off events that distorted earnings and energy trusts, I came up with fewer than 10 names with market caps over $100 million.
As with every top-performing value screen I have run of late, it is pretty much impossible to find enough names to get fully invested in what noted value investor James Montier recently called a "hideously expensive market."
