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Thursday, September 06, 2012

Einsteinian Investing






 I just started reading the new book, The Einstein of Money, a biography on Benjamin Graham by Joe Carlen. It is enjoyable read as in addition to being the father of value investing graham was a fascinating individual. His autobiography is long out of print so if you never read it, pick up this book as soon as you can. In my reading I was reminded that shortly before his death graham told interviewers from Forbes and Medical Economic magazine that he had developed a set of ten stock selection criteria that handily beat the market. 

The criteria include such metric as price to book, debt levels, price to earnings ratios, and balance sheet strength. Only at the bottom of sever bear markets have I ever found a stock that met all criteria but mixing and matching from the ten has also been proven to uncover undervalued market beating stocks. The selection criteria have been exhaustively tested by academics and practitioners and a couple of combinations have proven most profitable.

One of the most successful by far searches for stock whose:

 Earnings yield is twice the AAA bond rate

 Have solid earnings growth

Have a dividend yield of at least two thirds of the AAA bond rate

Have solid balance sheets with a current ratio of more than 2 and debt less than the book value of assets.

With bond yields as low as they are the threshold for earnings and dividend yield is not that high. It works out to a PE of less than 15 and a yield of more than 1.4%. You would think that there would be a cornucopia of companies that meet the criteria. Surprisingly that simply is not the case. Just 45 US companies meet the criteria to be included in the portfolio.

My favorite stock on the list is one that has shown up before on one of my undiscovered growth stock lists. Orchard Tissue (TIS) makes private label paper products including bathroom tissue, paper towels and napkins. They distribute their products though discount stores grocery stores and convenience stores in the Midwest and Texas. The company has grown earnings at an average rate of more than 40% the past five years. SO far this year both sales and earnings have continued to grow at a double digit rate. It is the most basic of businesses that is run efficiently and profitable selling for a respectable price. As a bonus they doubled the dividend last year and the shares now yield more than 4.5%. This stock sits at the very top of my “ load the boat” in a selloff stock list.

Some big tech names make t heist as old school tech companies begin got understand the value of retuning actual cash to shareholders. The recent dividend announcement by Cisco is something I have been suggesting for several years now. Although I am sure that I H ad no influence whatsoever it was a great move by the networking giant. Trading at 12 times earnings with a rock solid balance sheets, dominate position in its industry and a sparkling 2.91% dividend yield this is now a stock worth considering for long term value investors. The same can be said of Intel (INTC) at ten times earnings and a yield of 3.6%.

My favorite name among the big cap techs that make the Graham list is Corning (GLW). They will play a leading role in the strongest growth areas of the tech economy. The substrate division makes glass used in flat screen TVs and monitors and the fiber optics part of the company provides the fiber and cable needed to build out and improve high speed networks. Corning also has a presence in the potentially high growth environmental technology and life sciences industries. The company has more than $3 billion of net cash and no debt maturing until 2017. The have been using cash and cash flow to buy back stock and recently increased the dividend. The stock is one of the every few that fits almost all of the Graham criteria and I think it is a screaming buy at current level for long term investors. The stock trades below tangible book value and has a PE ratio of just 8.1.  At the current price the dividend yield is 2.57%. I think long term investors will experience some price volatility in the short term but be rewarded with spectacular gains over the next five year.

Grahams stock selection methods have stood the test of time and still uncover bargains that can reward investors with gains of multiple snot percentages over time.Before we move on from the Graham stock selection criteria, I want to look at another recombination of his criteria that has provided solid results over the past 25 years or so that I have been around the markets. Instead of earnings yield this time we will focus on my favorite tool, price to book value. We then look for those that are profitable and pay dividends to assemble our list of stocks. This has been part of my approach for many years now and it works as well for me as it did for Graham many years ago.

Curiosity got the best of me this morning so I ran a quick and dirty back test of the approach.. Over the past 25 years this approach has yield an average annual return of 40% more than the broad market.  Only four years staying of fully invested and using this approach showed a loss and in the year following a loss the asset based approach outperformed the market by an average factor 3 to 1.  It requires a great deal of patience and discipline but it works extraordinarily well.

My first observation upon looking at the current list is that is it absolutely dominated by small banks. Of the 81 names returned by screen 34 of them were small community and regional banks. Most of them are my tiny banks but a few are large enough to be familiar to readers. Republic Bancorp (RBCAA) has risen in price since I first talked about the Kentucky based bank but it is still statistically cheap. Fox Chase Bancorp (FXCB) is not the most exciting stock I have ever owned but it has moved steadily higher and is still very cheap.  The nest bargain issues however are the smaller institutions. The industry faces short term headwinds but many of the stock are too cheap not to own.

One of the cheapest non-financial stocks on a book value basis is Kelly Services (KELYA). The staffing company currently trades at just 70% of tangible book value as a weak global economy weighs on the business and stock price. Not only has the company been profitable since the end of 2009 in a very weak global economy, Kelly has reported a full year loss just twice in the past 10 years and that was in the near depression years of 2008 and 2009. There is a slow recovery starting in job in the US although Europe remains weak. Much of the hiring is temporary and that favors Kelly Services. This is a too cheap not to own stock and one of my top picks for a tough market.

American Greeting (AM) is also a very cheap stock with the stock at 70% of tangible book value. The entire greeting card industry has suffered as much of the communication world has gone on line, However there will always be birthdays, anniversaries and other occasion where online simply will not do and eventually American Greetings should see its business recover. They are the second largest global and only publicly traded greeting card manufacturer. It is not a sexy or exciting business but it is a cheap stock with a solid balance sheet as evidenced by it Altman Z score of over 3. Greeting card sales will grow in line with the economy and when this happens the cost reductions and structural changes implemented over the past few years will turn the company into a steady growth stock with an increased valuation.

The stock selection techniques outlined by Benjamin Graham back in the 1970s still work today. Although many talk about the Graham approach to picking stocks almost no one actually uses his approach and that suits me just fine. Buying cheap stocks requires a great deal of fortitude and patience. As an Orioles fan and value investor I have perfected both traits. 


1 comment:

Thomas Cal said...

Tim,
Is it possible you can share the details of the criteria you back-tested and mentioned in your Sept. 6, 2012 post?
Thanks,
Tom