When you start taking an interest in shares, you quickly realise there are many different approaches to investing. No one style is “the best”.
Rather, different approaches suit different people, and it can take some time to discover the style that most suits you.
Over this series, I’m going to introduce you to five investors, each of whom has been extremely successful with his particular way of going about making money from shares. We’ll look at one of these master investors each day, examining their approach and running a “stock screen” to unearth examples of the type of company his approach produces.
First up is Benjamin Graham (1894-1976), often called the Father of Value Investing, whose ideas remain hugely influential today.
Ben Graham pioneered the concept of investing in “undervalued” shares. His first book Security Analysis, written with David Dodd and published in 1934, is an epic tome, describing in detail how to analyse a company’s financial statements – since known as “fundamental analysis”.
Graham’s second book, The Intelligent Investor, first published in 1949, is more accessible, and is said by many – including Warren Buffett – to be the best book about investing ever written.
In the final years of his life, Graham devoted himself to distilling 50 years of experience and research into a few easy-to-follow principles for selecting shares. He set these out in their most stripped-down form in an interview published in Medical Economics in 1976, titled “The Simplest Way to Select Bargain Stocks”.
Buying and selling
Graham famously said: “In the short run, the market is a voting machine, but in the long run it is a weighing machine.” The essence of his philosophy was to invest when the fickle and impatient “Mr Market” offered him financially sound companies at fundamental valuations that were “little short of silly”, giving him a “margin of safety” on his investment.
In the interview with Medical Economics, Graham boiled share selection down to just one undervaluation measure and one measure of financial robustness.
Now, focusing only on this pair of measures skips over the full richness of Graham’s investment oeuvre, but it does encapsulate where he was coming from with his approach for the lay investor.
Graham’s measure of an undervalued company was one whose earnings-to-price ratio (also known as earnings yield) — the inverse of the price-to-earnings (P/E) ratio – was at least twice the yield of top-quality (AAA) corporate bonds.
At the time he was talking, the bond yield was 7%. Thus, Graham required an earnings yield of at least 14. Converting that to a P/E ratio, 14 goes into 100 roughly 7 times, so he wouldn’t buy a share on a P/E of above 7.
Graham had a proviso: Never buy a share with a P/E of above 10 no matter how low bond yields get; conversely, a P/E of up to 7 is always acceptable no matter how high bond yields get.
Graham’s measure of a company in a sound financial condition was one whose balance sheet showed stockholders’ equity — in Australia, shareholders’ equity (also called shareholders’ funds or shareholders’ capital) — to be at least 50% of total assets. We’ve reversed this formula and selected companies with a total assets to equity ratio of less than 2.
Graham said his research showed that a holding period for shares of two to three years worked out best. He recommended selling a share if it made a 50% profit, but: “If a stock hasn’t met your objective by the end of the second calendar year from the time of purchase, sell it regardless of price.”
A Graham screen
Before embarking on our Graham screen, here are three general warnings about stock screeners:
- There may be errors in the data provided, so always check numbers in the companies’ financial reports.
- Screeners tend to take their data from companies’ annual results, so there may be more up-to-date information in half- or quarter-year results.
- A screener is only a starting point for further investigation.
I screened for companies satisfying Graham’s measures of undervaluation and financial health. When yields on corporate bonds are less than 5%, the acceptable P/E is always Graham’s maximum of 10, so I set the filter accordingly. in my screen, the P/E ratio was calculated using adjusted, diluted earnings per share that may differ from the reported earnings.
For a manageable list of companies for this article, I selected companies with a market cap greater than 100m and added a third measure that Graham also rated highly: A dividend yield of at least two-thirds of the bond yield — in our case, a dividend yield of 5% plus.
My initial screen returned more than 58 companies, so I’ve listed the top 10 by market cap in the table below.
|Company||Market Cap ($m)||Share Price ($)||P/E||Assets / Total Equity||Dividend Yield (%)|
|OZ Minerals Limited (ASX: OZL)||2,591||8.25||9.8||1.1||7.4|
|Harvey Norman Holdings Ltd (ASX: HVN)||2,093||1.97||8.2||1.9||5.2|
|Investa Office Fund (ASX: IOF)||1,633||2.66||9.4||1.3||5.9|
|Australand Property Group (ASX: ALZ)||1,482||2.57||8.9||1.7||8.6|
|OneSteel Limited (ASX: OST)||1,259||0.9425||7.7||1.97||6.4|
|David Jones Limited (ASX: DJS)||1,190||2.28||7.8||1.5||11.6|
|Southern Cross Media Group (ASX: SXL)||861||1.2225||6.7||1.6||6.6|
|Grange Resources Limited (ASX: GRR)||554||0.48||2.5||1.3||12.8|
|Emeco Holdings Limited (ASX: EHL)||532||0.87||9.6||1.7||7.1|
|United Overseas Australia Limited (ASX: UOS)||387||0.38||4.1||1.2||5.3|
Source: Capital IQ and Google Finance
Despite being a limited list, you get a good idea of the sort of ‘value’ opportunities Graham’s approach tosses up.
As the market frets about the state of the global economy, we find two resources companies (OZL & GRR) plus Emeco Holdings, which sells and rents heavy mining equipment, three property companies (ALZ, UOS & IOF), two retailers (DJS and HVN) and one media company (SXL). In addition to companies in unloved sectors, OneSteel has been spurned for business specific reasons. The company is migrating from a steel producer into an iron ore miner, which the market suspects may not turnaround the company’s fortunes.
Other notable companies that appeared on my initial screen include Cash Converters International Ltd (ASX: CCV), Thorn Group Limited (ASX: TGA), IMF (Australia) Limited (ASX: IMF), Jetset Travelworld Limited (ASX: JET) and Retail Food Group Limited (ASX: RFG).
Importantly, Graham invested in a ‘basket’ of many stocks that met his criteria. Some boomed, some busted – as with any mechanical approach, you need to spread your investment.
Foolish bottom line
I’ve only scratched the surface of Ben Graham’s approach by focusing on his interview in Medical Economics. I’d recommend anyone, who hasn’t already done so, to buy, beg, or borrow a copy of The Intelligent Investor.
In the next article in the series, I’ll be looking at one of Graham’s contemporaries, who had a very different approach to investing.
If you’re in the market for some less risky, high yielding ASX shares, look no further than “Secure Your Future with 3 Rock-Solid Dividend Stocks”. In this free report, we’ve put together our best ideas for investors who are looking for solid companies with high dividends and good growth potential. Click here now to find out the names of our three favourite income ideas. But hurry – the report is free for only a limited time.
Motley Fool contributor Mike King owns shares in IMF Australia. The Motley Fool‘s purpose is to help the world invest, better. Take Stock is The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it’s still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
A version of this article, written by G A Chester, originally appeared on fool.co.uk. It has been updated by Mike King.
5 stocks under $5
We hear it over and over from investors, "I wish I had bought Altium or Afterpay when they were first recommended by The Motley Fool. I'd be sitting on a gold mine!" And it's true.
And while Altium and Afterpay have had a good run, we think these 5 other stocks are screaming buys. And you can buy them now for less than $5 a share!
*Extreme Opportunities returns as of June 5th 2020
- Why PWR Holdings Ltd could see its share price rise from here – July 21, 2017 12:11pm
- Fortescue Metals Group Limited share price sinks on native title decision – July 20, 2017 4:23pm
- 5 overlooked finance shares to add to your watchlist – July 20, 2017 2:33pm