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Wednesday, June 26, 2013

Graham Income Stocks

There were three very important conversations around Chez Melvin. One had to do with the woeful status of the Baltimore Orioles starting pitching while the other two focused on more market related topics. A 1976 interview with Ben Graham floated around the interwebs this weekend that focused on the more mechanical value formula he developed after he retired. Graham said that a simple quantitative measure of picking stock using low PEs and low debt to equity ratios had outperformed the market in the 60 years leading up to 1976. Tobias Carlisle and Wesley Gray updated the study in their excellent book Quantitative Value and found that since 1976 the strategy has continued to work with a compound annual return of more than 17%.

The third conversation has to do with the almost desperate need for income investors to find suitable securities. Intense buying has lifted many of the traditional alternatives to unsustainable levels. The Wall Street commission machine is in overdrive creating products, many of them potentially toxic, to feed the need for income. I am frankly surprised that retirees in need of income are not staging furious rallies at the Federal Reserve and Capital building as government policies have destroyed their retirement plans.

It occurred to me that while I can do nothing about the Orioles pitching problems I might be able to combine Graham’s formula for successful investing with the need for equity income ideas. I added an income component to Graham’s basic screen and came up with some ideas worth including in an income portfolio.  It looks to me like this could be a very fertile and productive approach for income investors.
Universal Insurance Holdings (UVE) is an insurance company based in Jacksonville Florida that primarily underwrites homeowners insurance. In addition to its home staet the company has recently expanded operations into six additional states. They also have a specialty division, American Platinum Property and Casualty Insurance Company, which writes multi-peril homeowner coverage on homes in Florida worth more than $1 million. There is nothing overly exciting about the company but they show solid results and pay a dividend yield of 4.5%. The shares trade at just 8.7 times earnings and have cash balances in excess of their market cap and more than 10 times the debt they have outstanding. They recently purchased 4 million shares from the former CEO at a discount to the market price, reducing the overall share count by 16%.

Sterling Financial Corporation (STSA) is the holding company for Sterling Savings bank in the Northwestern United States. The Spokane based bank has 174 branches in Washington, Oregon, Idaho, and California and total assets of $2.96 billion. Sterling has chosen to be a buyer in the current depressed market for bank stocks and has made several acquisitions this year including the Puget Sound operations of Boston Private Bank and Trust. They are also the leading Small Business Administration lender in Washington and Oregon so far in 2013. Once again this not an very exciting stock but a sound institution with a decent dividend yield.
The company did a private equity led recapitalization back in 2010 and Warburg Pincus and Thomas Lee Partners still each own 20% of the shares outstanding. Since then they have sold problem assets and cleaned up the balance sheet. Right now total nonperforming assets are just 1.58% of total assets and the equity to assets ratio is over 15. The bank is in good shape and should be able to grow both organically and by acquisition for the next decade. The stock trades at less than 5 times trailing earnings and yields 3.7%.

Building an income portfolio using the techniques developed by Ben Graham is a worthwhile exercise in todays complicated markets. I will note that there were several additional stocks that were cheap with decent yields that seemed to have an adequate margin of safety for individual investors but are too small to write about here on Real Money. I am going to continue exploring the possibilities of solving the dire need for investment income using basic time tested value techniques as develop by Graham and practiced by folks like Walter Schloss, Irving Khan and the folks at Tweedy Browne. I suspect this approach to income investing will work a lot better than whatever high yield product of the week is turned out by Wall Street.

In addition to using simplified price to earnings and debt metrics to pick stocks in the 60 year study he completed in the mid-1970s Ben Graham also noted that you could substitute asset to price measures and achieve similar results. This is something of a relief to me as I have found that over the past 40 years the reliability of earnings measures has become somewhat suspect. Using the generous accounting standards, strategic buybacks and other financial engineering shenanigans most CFOs can make the earnings number come out where they want each quarter. Not everyone does this but enough do that earnings, and therefore price to earnings ratios are a bit trickier to use when searching for stocks. It will come as no shock that I prefer to use book value in my search for stocks.

During last night’s extensive rain delay in Baltimore I sat down and ran a screen for income stocks substituting a low price to book value for earnings for low price to earnings. I think investors looking for a decent income from their portfolio in these yield starved times should do both in order to find as many stocks as possible. The trick to making a cheap stock income portfolio to work over the long run is to own a bunch of them and let time and value work for you while you cash the quarterly checks.

I found some names that are worth of inclusion in a long term income portfolio that should also have long term upside appreciation potential. I have been a long term fan of California First National (CFNB) for several years now. The stock has not had any spectacular appreciation but it has steadily cranked out dividends and the shares currently yield 13%. The fiancĂ© company takes in deposits via telephone, the internet and mail and uses the funds for their leasing business that specializes in high technology assets. Like every other lending or leasing institution in the US the form is seeing some compression in net interest margins and this is keeping earnings in check for now. The actual leasing business is starting to see some strength as the economy slowly recovers and this should continue as we move from better to good over the next few years in terms of economic activity. The stock trades at 95% of book value right now. Insiders own 82% of the shares and have a vested interested in seeing the stock move higher over the next several years.  I think it will and in the interim we get paid to wait.

Old Republic Insurance (ORI) is probably not going to be the most exciting stock you ever own in your lifetime. The company sells insurance such as aviation, marine, commercial auto and general liability policies. They also sell extended auto warranties policies and title insurance. However it is a classic high yield value stock trading at 93% of book value with a yield over 5.4%. Insiders like the long term prospects of the company as several of them have been buying the shares this year. It may not be exciting but is should be enriching over the next several years. The insurance business should grow a little faster than the economy and as growth picks up so should earnings and revenues.

Ampco Pittsburgh (AP) is another stock that is not likely to make the most exciting list any time soon. The company makes custom engineered equipment and business has basically been flat for some time now. Bothe forged hardened steel and air processing equipment divisions need to see the economy move from the somewhat better to pretty good before business can really pick up. Until then the stock is trading right around book value, the balance sheet is strong and the share yield almost 4% at the current quotation.
The search for income stocks is one of the most frustrating endeavors for investors right now. The market has moved straight up without a significant correction for over a year now. Interest rates are low and in spite of recent gyrations in the long term bond prices are likely to remain so for an extended period of time. It is critical that investors avoid the product push of Wall Street and use common sense in assembling a portfolio of income securities. Adding an income component to the stock selection techniques developed by Ben Graham makes a lot of sense to me.

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