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Finding Undervalued Stocks. The Graham's Number Technique.
Benjamin Graham (1894-1976) is considered by many to be the
architect of Fundamental Analysis and Value Investing.
Graham liked to find discrepancies between a stock's price
and its value and would buy large portfolios of undervalued
stocks, holding them until they became fully valued. In his
1949 book "The Intelligent Investor, Graham describes a
stock selection technique that identifies stocks that are
trading at a deep discount to a calculated value termed the
Net Current Asset Value or NCAV.
Calculation of a stock's NCAV is a fairly simple endeavor
and is somewhat different from the calculation of Book Value.
Whereas Book Value is purely a per share measure of Assets -
Liabilities, the NCAV is a little more rigorous.
In calculating NCAV, Graham only considered Current Assets,
i.e. cash, cash equivalents, accounts receivable, inventories.
However, from this value he still subtracted Total Assets.
The result he then divided by the number of shares outstanding
to give the NCAV per share. This value would be considered by
Graham to be a fair value for the stock.
You might think he would buy at this price, but no. Graham only
bought stocks that were trading under two-thirds or 66% of
their NCAV. Consider as an example G-III Apparel Group Ltd,
ticker symbol GIII.
Current Assets are $130.25M, Total Liabilities are $68.3M,
and there are 7.22M shares outstanding.
NCAV = (130.25 - 68.3) / 7.22 = $8.58.
Two-thirds of this price would be $5.66. At the time of writing
(03/07/05), GIII is trading at $7.67, so may not be a buy
candidate at present. It is important to note that Graham would
consider the NCAV to be a first step in further analysis of the
stock. A sensible investor would investigate the balance sheet
further to check for a sound business with other desirable
factors such as good earnings,revenue growth, low debt-to-equity,
and good operational cash flow per share.
Stocks trading at such a deep discount are few and far between,
and have usually been beaten down by a combination of bad news
and emotional reactions from the investing public. These stocks
were Graham's bread and butter. He repeatedly insisted that
the time to buy stocks was when everyone else was selling
and the time to sell was when everyone else was buying. Had
he been alive, he certainly would have been out of stocks
before the dot com bubble burst and would surely have been
picking up bargains soon after. It is no secret that one of
Graham's most famous disciples is Warren Buffett who has
consistently beaten the market by a large margin with his
investments.
One study has shown that Graham's NCAV strategy works well;
in this particular study, portfolios picked using the strategy
at the beginning of each year between 1970 and 1983 would have
returned an average annual gain of over 29% when held for only
the duration of each year in this 13 year period.
Van Tharp mentions an actual investing strategy based on the
NCAV or Graham's Number as it is sometimes called, in his book
"Safe Strategies for Financial Freedom". The strategy as
mentioned by Tharp involves buying stocks at two-thirds of
their NCAV, and selling a third of your holding when a 50%
profit is achieved. If the price continues upwards to give 100%
profit, you sell a number of shares to make up half your
original holding. You now have your original investment
back and have a holding of "free" shares.
This strategy can be performed in an IRA using a large portfolio
of perhaps 30 similarly undervalued stocks. If the market has
been declining for several months, there will be several such
stocks to choose from. In an up trending market, however, it
will be much harder to find good value candidates but
diligent investors who do their homework will more often
than not be well rewarded for their efforts.
(c) 2005 The Graham Investor You may use this article, as-is, provided
this copyright notice is kept intact.
About the Author
John B. Keown is an IT specialist, website builder and private investor who enjoys all things stock-related and in particular seeking out undervalued stocks.
He can be contacted via http://www.grahaminvestor.com
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