Benjamin Graham

Graham’s Net Current Asset Value Strategy

Finding low-risk stocks should be priority number one in this market. Benjamin Graham, considered by many to be the architect of fundamental analysis, described a strategy for identifying deep value stocks, which in his view are low-risk candidates, in his book, “The Intelligent Investor,” published in 1949.

Graham’s strategy, dubbed the “net current asset value” approach, apparently works very well. One research study, covering the years 1970 through 1983 showed that portfolios picked at the beginning of each year, and held for one year, returned 29.4 percent, on average, over the 13-year period, compared to 11.5 percent for the S&P 500 Index. Other studies of Graham’s strategy produced similar results.

Despite the impressive results, Graham’s net current asset value (NCAV) approach is relatively unknown to individual investors. That’s probably because finding stocks meeting Graham’s requirements requires some digging. No Web site provides tools to screen for NCAV stocks.

However, it’s not hard, and anyone willing to devote a couple of hours to the task should be able to come up with a few candidates. Here are my ideas for finding NCAV stocks.

Graham’s Value Strategy

Graham’s NCAV strategy calls for buying stocks trading below their calculated value. Many value stock selection strategies can be described similarly. What’s different is how Graham determines value.

Book value, the usual value measure, is a firm’s assets minus its liabilities. Graham does the same calculation, but only includes current assets (cash, inventories, and accounts receivables) in the computation. He ignores long-term assets such as buildings, equipment, patents, and the like. However, he still counts all liabilities including short- and long-term debt, and everything else that appears in the liabilities column of the balance sheet.

Thus, net current asset value is current assets minus total liabilities. Graham’s NCAV strategy calls for buying stocks trading at two-thirds or less of their net current asset value.

That’s a stringent requirement, since most companies have negative NCAVs. But Graham was looking for firms trading so cheap that there was little danger of falling further. His strategy calls for selling when a firm’s share price trades up to its NCAV.

Finding Graham’s Value Stocks

According to Graham, some of the companies meeting his NCAV criteria could end up failing, so he recommended buying a large number of stocks to diversify the risk. Since that’s not practical for individual investors, I’ve come up with additional qualifying criteria to minimize the insolvency risk. I’ll describe these additions as I describe how to screen for prospective NCAV stocks.

Screen for Value

While you can’t search directly for NCAV stocks, you can set up a screen that will hone down the list to a reasonable number of candidates.

You can use a variety of Web screeners, but I’ll demonstrate the process using BusinessWeek Online’s Quick Stock Search (www.businessweek.com).

Note: the Business Week screener is no longer available.

Enter the following search parameters into the screening program.

Stock Price

Price/Book Ratio

Most NCAV candidates have P/B ratios well below 1. Specify a maximum P/B of 0.8 to screen out unlikely candidates.

Price/Cash Flow Ratio

Cash flow, the amount of cash that moved into, or out of, a firm’s bank accounts due to its operations is a reliable profitability measure. Requiring positive cash flow eliminates many high-risk companies. You can limit your search to positive cash flow companies by specifying a minimum 0.1 P/CF.

Price/Sales Ratio

Most NCAV stocks show very low P/S ratios, usually below 0.2. Require a 0.3 maximum P/S ratio to rule out stocks unlikely to meet Graham’s requirements.

Debt/Equity Ratio

The lower the debt/equity ratio, the more likely that a stock will meet NCAV criteria. You can’t require zero D/E, however, since most NCAV stocks do have some debt. Stipulating a maximum D/E of 0.1 should pick up most NCAV stocks. However some do have higher D/E ratios, so try higher values if you don’t come up with enough NCAV stocks.

Use the dropdown menu to select a maximum of 50 stocks to list before running the screen. I found 30 candidates when I ran it last week.

Your next step is to determine which of the stocks turned up by your screen meet Graham’s requirements.

Evaluate Candidates

Hoover’s (www.hoovers.com ) is the best site to do the analysis because it displays the balance sheet information in a user-friendly format.

Enter a ticker symbol, and then click on Financials to see Hoover’s combined income statement and balance sheet for each stock.

Liabilities vs. Current Assets

Save yourself time by first visually determining if current assets exceed total liabilities. Both figures are shown near the bottom of the page. Most stocks won’t meet this test, so eliminate them here.

Otherwise, compute the net current asset value by subtracting the total liabilities from the current assets. Then, convert the NCAV to a per-share figure by dividing by the number of shares outstanding listed on the bottom line of the balance sheet.

Finally, compare the per-share NCAV to the recent stock price shown on your screen results. The stock passes if the current share price is no more than 67 percent of the NCAV.

Goody’s

For instance, Goody’s Family Clothing turned up on my screen. Goody’s current assets totaled $273 million compared to $196 million total liabilities. So Goody’s NCAV was $77 million ($273 minus $196).

Hoover’s listed 32.5 million shares outstanding for Goody’s, so its per-share NCAV was $2.37 ($77 divided by 32.5).

Goody’s share price, at $10.60, exceeded its NCAV, so it didn’t qualify as a NCAV stock.

Two Passed

Only two of the 30 stocks turned up by my screen, Manchester Technologies, and Gentiva Health Services, qualified as NCAV stocks. (Since this column was published, several readers pointed out that Gentiva had sold a major product line to another firm in June, so Hoover’s March quarter data may no longer apply.)

It sounds like a lot of work to analyze 30 candidates to come up with only one or two NCAV stocks, but it goes quickly once you get the hang of it.

Run the screen around once a month. You should pick up a five to 10 qualifying stocks in a year’s time.

published 6/30/02