The simplest way to select bargain stocks
Posted on February 23, 2009 by Richard Beddard
Filed Under Editor's choice, Investing |
Three statistics and a newspaper
Much of the analysis on this blog is devoted to finding cheap companies with little financial risk. That’s because paying too much for companies, or buying companies that are financially insecure, is likely to affect return, adversely. Investing only in cheap, safe companies, on the other hand, boosts returns.
I favour the long-term price earnings ratio as a measure of value, and the F_Score as a measure of financial strength, but the problem with these measures is the data is not freely available.
It’s easy enough to calculate them for one company, it takes about twenty minutes from the annual report, but if you wanted to find all the companies on the stock market that have, say, a long-term PE under 16 and an F_Score higher than 3, that’s a thousand man hours or more.
There are a couple of ways around this problem: automate the calculations, or chose simpler criteria.
I’m working on the first solution. Benjamin Graham, the granddaddy of value investing, solved the second.
Graham retired with an unrivalled reputation in 1956. After a career that spanned the roaring twenties, the Wall St Crash, the Great Depression and the Second World War, he was bored, saying in an interview first published in Financial Analysts Journal1:
I felt I had established a way of doing business to a point where it no longer presented any basic problems to be solved.
He spent his retirement jettisoning the complexities of financial analysis he’d laid down in his textbook ‘Security Analysis’, saying:
I feel they are relatively unimportant, which, in a sense, has put me opposed to developments in the whole profession. I think we can do it successfully with a few techniques and simple principles. The main point is to have the right general principles and the character to stick to them.
“Imagine”, he said:
There seems to be practically a foolproof way of getting good results out of common stock investment with a minimum of work.
He’d outlined his method, the result of a 50-year study of all the stocks In Moody’s Industrial Stock Group, in an interview in Medical Economics a few months earlier. His system was simple enough, he expected even a doctor would be able to follow it J, and it had gained 15% a year, twice as much as the Dow over the preceding fifty years.
It required just three financial statistics, the one-year historic price earnings ratio widely quoted in the press and now all over the internet, the yield on AAA-rated corporate bonds and a test of the company’s financial position. “There are various tests you could apply,” he said but:
… I favour this simple rule: A company should own at least twice what it owes. An easy way to check on that is to look at the ratio of stockholder’s equity to total assets; if the ratio is at least 50%, the company’s financial condition can be considered sound.
The PE ratio tested value, and the corporate bond yield determined what level of PE the investor should apply between a minimum of seven and a maximum of ten. Graham was looking for twice the return on stocks as bonds to compensate him for the hassle of running his system.
Moody’s tell me the current Sterling AAA bond yield is 4.61%2 so Graham would be looking for an earnings yield (earnings per share divided by price multiplied by 100) of about 9.2%, which is a PE ratio (price divided by earnings per share) of just under eleven (to work out it out, just divide the earnings yield into 100).
Because of Graham’s maximum though, while bond yields are below 5% we should look no higher than a PE of 10.
He proposed an investor would start with a list of low PE stocks from The Wall Street Journal and calculate the ratio of stockholders’ equity (shareholders’ funds in the UK) to total assets from the company’s balance sheet in the annual report. The investor would buy a portfolio of 30 or more shares and sell any share that rose in price by 50% or remained in the portfolio at the end of the second calendar year from the time of purchase. In other words, he had a maximum holding period of between two and three years.
With the amount of financial data and number of stock screening tools on the Internet these days, I thought it would be even easier to screen the market for UK bargain stocks than it would have been in Graham’s time. In fact, it was more difficult than I thought.
I’ll publish the spreadsheet, and some observations tomorrow.
Footnotes:
- These interviews are collected in one of my favourite books of last year, The Rediscovered Benjamin Graham.
- Intermediate bonds with maturities between five and eleven years.
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6 Responses to “The simplest way to select bargain stocks”
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Dear sir,
I am a man that is just getting into the stokemarket i have just got my frist lot of shares at the age of 50.
It would be relly nice if you could let me have some common sense a round this field.
Thank you Paul.
Hi Paul. I’ll do my best, if you keep following this blog!
I try and understand how companies make money and consider the risks of owning the shares. If the shares are cheap and the company has a viable business then it’s probably a good investment. Owning twenty or thirty companies like that shields the investor from the occasional blow-up or disappointment.
Richard.
I am now going to be using this technique and following your thrifty 30 experiment - goog luck sir!