Hulbert on Why Graham Is Relevant Again

 |  Includes: AEO, AMN, CKP, JAKK, KMT
by: John P. Reese

In his latest MarketWatch column, Mark Hulbert wonders whether the recent market plunge has shown that “maybe Ben Graham isn’t old-fashioned after all”.

Over the past couple decades, Hulbert says, the strict, conservative approach used by Graham — who is known as both the “Father of Value Investing” and the mentor of Warren Buffett — had fallen out of favor on Wall Street. But as the current downturn has dragged on, Graham’s approach seems quite relevant again, Hulbert says.

The reason: Graham defined “value” in absolute terms — not relative terms. And, as asset prices in general became overinflated in recent years due to the use of massive amounts of leverage, even many stocks that looked relatively cheap — i.e., those that were trading at low price/book and price/earnings ratios compared to other stocks — were overpriced. They were simply less overpriced than other stocks.

Graham, on the other hand, didn’t just compare stocks to each other to determine value. He compared their prices to absolutes. The most notable of these absolutes, Hulbert notes, was “net current asset value” (NCAV), which is equal to total current assets minus total current liabilities, long-term debt, and the redemption value of preferred stock. If a stock’s price was less than two-thirds of its net current asset value per share, Graham approved. That was one way that Graham identified stocks that had a “margin of safety”, meaning that they were so undervalued compared to their hard assets that even poor performance wouldn’t drag them down much further.

The net current asset value criterion was part of the “Enterprising Investor” strategy Graham outlined in his classic, The Intelligent Investor. The Guru Strategy I base on Graham’s writings is focused on the “Defensive Investor” strategy Graham lays out in the same book. While the Defensive Investor approach differs from the NCAV/Enterprising Investor strategy, it also includes some absolute value criteria.

For example, my Graham model requires that a firm’s long-term debt be no greater than the value of its net current assets. And it requires that the company’s current ratio — the ratio of its current assets to its current liabilities — be at least 2.0.

It appears that both Graham’s Enterprising Investor approach and Defensive Investor approach have indeed provided a margin of safety while the market has tumbled. According to Hulbert, the reason the enterprising approach fell out of favor was that few, if any, stocks passed the NCAV test in the 1980s and 1990s — not surprising when you consider that that was when the overleveraging of corporate America began to build, skewing relative value assessments (just ask Jeremy Grantham). “In response, value managers simply relaxed their definition of value,” Hulbert writes. “No doubt the bear market that began in October 2007 has led many of those advisers to wish that they had not done so.”

My Graham-based Defensive Investor approach, meanwhile, has been hit far less than the rest of the market in the downturn. It lost 14.1 percent in 2008, while the S&P 500 plunged 38.5 percent. The model is on top of the index again this year.

And while Hulbert says Graham’s enterprising approach may be making a comeback, his Defensive Investor approach seems to have never left. Since its July 2003 inception, my ten-stock Graham-based portfolio has gained 90 percent, while the S&P 500 has dropped 13 percent.

As for the enterprising method, Hulbert says the bear market is “causing more and more companies to come at least within shouting distance of satisfying Graham’s [Enterprising Investor] value criteria.” Four stocks currently meet the two-thirds of NCAV requirement, according to Hulbert: Ashland Inc. New (NYSE:ASH), ION Geophysical Corp. (NYSE:IO), Skechers USA Inc. (NYSE:SKX), and Technitrol Inc. (TNL).

My Graham-based Defensive Investor strategy is finding a number of values in the market right now. Here are five picks that currently get strong interest from the model:

  • American Eagle Outfitters (NYSE:AEO) — no long-term debt and current ratio of 2.15
  • Checkpoint Systems (NYSE:CKP) — long-term debt ($130.8 million) is less than half of net current assets ($285.9 million); current ratio of 2.49.
  • JAKKS Pacific (NASDAQ:JAKK) — current ratio of 3.09; long-term debt is about one-quarter of net current assets; and the product of its P/E (7.5, based on three-year earnings) and P/B of 0.68 is less than 22, passing another Graham-based defensive criterion.
  • Kennametal Inc. (NYSE:KMT) — current ratio of 2.43; long-term debt of $479.6 million vs. net current assets of $590.9 million.
  • Ameron International Corporation (NYSE:AMN) – long-term debt of just $36 million compared to almost $300 million in net current assets; current ratio of 2.87.

Disclosure: At the time of publication, John Reese and his private clients at Validea Capital are long all five stocks mentioned in this article.