When Ben Graham was developing his simple two-step approach to picking stocks he talked about it with several publication and interviewers. One interviewer, a CFA named Hartman Butler, published his discussion under the title, "An Hour with Ben Graham." In this March 1976 interview, Graham discussed the approach and said that although he used earnings and PE ratios in his studies, you could use other measurements. "One can also apply a dividend criterion or an asset value criterion and get good results." Naturally, this caught my attention as I am more of an asset than earnings investor. I decided this needed to be tested to see if the results were as favorable as the earnings measurement.
I have two ways to test stock-picking approaches. Method one is to spend hours and days torturing data in a spreadsheet and spend hours of frustrating effort to get the results. That's not the easiest way, so I used method two to test the asset-based approach. I jumped on Skype and reached out to Tobias Carlisle, the author of the books Quantitative Value and Deep Value, and exploited his expertise and good nature. In a relatively short period of time we had our answer. Substituting price to book value for low PE ratios works very well as part of two criteria approach to picking stocks.
Tobias used 15 years of data and found that a portfolio of stocks that have an equity-to-asset ratio of more than 50% and trade for less than 80% of book value returns a 12.49% compounded return compared to the S&P 500's 5.83. I can more than live with a return of more than twice the overall market!
I sat down and ran a screen looking for candidates today. We cut our universe to those stocks that traded in the bottom 40% of market cap which gave us a current cut off of stocks with a greater than $38 million total market cap. We ended up with a list of 82 stocks of which less than half have a market capitalization above $100 million.
The list looked a lot like the holding page of a natural resources fund. Oil and gas names dominate the list right now. WPX Energy, (WPX), Tidewater (TDW), Rowan (RDC), Patterson-UTI Energy (PTEN) and Gulfmark Offshore (GLF) are among the familiar names on the list. I own a lot of them already and expect I will own a lot more before the oil madness settles down.
Buying oil-related stocks right now implies making a call on oil, which is something I am not too good at. However, I expect that the head of the Kuwaiti oil company is pretty good at it since he is one of those controlling the price. Nizar Al-Adsani, the CEO of the Kuwait Petroleum Corp., told Bloomberg yesterday, "I think oil prices will stay around the current level of $65 for six or seven months until OPEC changes its production policy, or recovery in world economic growth become more clear, or a geopolitical tension arises." If he is right, then this is a good time to start buying the energy names.
Tropicana Entertainment (TPCA) is one of the more intriguing non energy related companies on the list. The company owns include two casinos in Nevada and one casino in each of Indiana, Louisiana, Mississippi, Missouri and New Jersey. Outside the U.S., the company has a property in Aruba. The stock has been hit of late as a result of the mess in Atlantic City -- that one-time gambling mecca has imploded. Carl Icahn is the chairman and controlling shareholder and I doubt that he is willing to flush his stake or the money he is putting up to bail out other casinos in the region. Trading at less than 70% of book value with an equity-to-assets ratio of 60%, this stock is a safe and cheap way to bet that Icahn can get full value out of his gambling interests over the next several years.
Another interesting stock is Sears Hometown and Outlets Stores (SHOS). The company sells home appliances, hardware, tools and lawn and garden equipment. The company was spun off from Sears (SHLD) back in 2012 and the stock is cheap: It trades at 60% of book value and has a reasonably safe equity-to-asset ratio of 60%. The Hometown stores are struggling a bit but the outlets showed almost 10% same-store sales growth and the commissions received from sales on Sears.com also grew year over year.
Substituting price-to-book value for price-to-earnings in the simple approach developed by Ben Graham back in the 1970s has worked pretty well over the past 15 years. I am pretty sure it will continue to do so for the next 15 years.