How to Pick Value Stocks
Benjamin Graham’s Seven Criteria
My Favorite Value Stock
A lot has been written in previous Cabot Wealth Advisories about how to pick a growth stock. The advice from my fellow Cabot colleagues is sound and, when followed, will lead to exceptional returns. The editors of the growth-oriented Cabot letters know their stuff, and can produce performance numbers that prove it.
But I like value stocks, and I believe that value stocks should be included in your portfolio. In my opinion, your portfolio should contain half value stocks and half growth stocks and should not contain 100% value or 100% growth stocks.
Value investing, perhaps more than any other type of investing, is more concerned with the fundamentals of a company’s business rather than its stock price or market factors affecting its price.
I utilize a value strategy developed by Benjamin Graham in the 1920s. The details of the strategy are spelled out clearly in his book, “The Intelligent Investor,” published 60 years ago. The objective of Graham’s strategy is to identify undervalued and unappreciated stocks that meet certain criteria for quality and quantity … stocks that are poised for stellar price appreciation.
I use Benjamin Graham’s seven time-tested criteria to find stocks to buy.
Criteria #1: I look for a quality rating that is average or better. You don’t need to find the best quality companies–average or better is fine. Graham recommended using Standard & Poor’s rating system and required companies to have an S&P Earnings and Dividend Rating of B or better. The S&P rating system ranges from D to A+. I try to recommend stocks with ratings of B+ or better, just to be on the safe side.
Criteria #2: Graham advised buying companies with Total Debt to Current Asset ratios of less than 1.10. It is important at all times to invest in companies with a low debt load, especially now with tight lending in a weak economy. Total Debt to Current Asset ratios can be found in data supplied by Standard & Poor’s, Value Line, and many other services.
Criteria #3: I check the Current Ratio (current assets divided by current liabilities) to find companies with ratios over 1.50. This is a common ratio provided by many investment services and is especially important now, because you want to make sure a company has enough cash and other current assets to weather any further declines in the economy.
Criteria #4: Criteria four is simple. Find companies with positive earnings per share growth during the past five years with no earnings deficits. Earnings need to be higher in the most recent year than five years ago. Avoiding companies with earnings deficits during the past five years will help you stay clear of high-risk companies.
Criteria #5: Invest in companies with price to earnings per share (P/E) ratios of 9.0 or less. I am looking for companies that are selling at bargain prices. Finding companies with low P/Es usually eliminates high growth companies, which should be evaluated using growth investing techniques.
Criteria #6: Find companies with price to book value (P/BV) ratios less than 1.20. P/E ratios, mentioned in rule 5, can sometimes be misleading. P/BV ratios are calculated by dividing the current price by the most recent book value per share for a company. Book value provides a good indication of the underlying value of a company. Investing in stocks selling near or below their book value makes sense.
Criteria #7: Invest in companies that are currently paying dividends. Investing in undervalued companies requires waiting for other investors to discover the bargains you have already found. Sometimes your wait period will be long and tedious, but if the company pays a decent dividend, you can sit back and collect dividends while you wait patiently for your stock to go from undervalued to overvalued.
One last thought. I like to find out why a stock is selling at a bargain price. Is the company competing in an industry that is dying? Is the company suffering from a setback caused by an unforeseen problem? The most important question, though, is whether the company’s problem is short-term or long-term and whether management is aware of the problem and taking action to correct it. You can put your business acumen to work to determine if management has an adequate plan to solve the company’s current problems.
Now that I have given you some ideas on what to look for when picking a value stock, what can you expect? Benjamin Graham achieved 20% returns in the 1930s, ’40s, ’50s, and into the ’60s. Mr. Graham’s disciple, Warren Buffett, achieved 20% returns in the 1970s, ’80s, ’90s, and 2000s until last year. Using the same methodology, I have achieved similar returns until last year also.
How have I done lately? My Classic Benjamin Graham Value Model, which appears every month in the Cabot Benjamin Graham Value Letter, is up 26.2% during the past five months compared to a decline of 7.5% for the Dow Jones Industrial Average. Even more impressive is that 25% of my Benjamin Graham Model portfolio was invested in bond ETFs, which decreased volatility and risk.
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So what’s hot now? I can’t give you my recommendations from my May issue of the Cabot Benjamin Graham Value Letter as that wouldn’t be fair to my paid subscribers. However, here’s an idea from the April Letter.
Hubbell B (symbol: HUBB or sometimes HUB. B or HUB/B) fully qualifies as an undervalued Benjamin Graham stock selection. The S&P Earnings and Dividend Rating for HUBB is A-, which is better than the minimum requirement of B. The company’s Total Debt to Current Asset ratio is 0.54, which is well below the maximum 1.10 required. HUBB’s Current Ratio is 2.18–more than the 1.50 minimum. EPS growth during the past five years is 7.4%. There are no earnings deficits during the past five years. HUBB’s P/E ratio is 9.0, which meets the requirement of 9.0 or lower. The P/BV ratio for Hubbell is 1.14, which is less than the 1.20 requirement. The company is currently paying dividends, which equate to a healthy dividend yield of 4.2%. The company’s management team is combating the current weak economy by cutting costs and taking advantage of attractive acquisition opportunities to enhance future revenue and earnings growth.
Hubbell designs and manufactures a wide range of electrical equipment products for industrial, utility, and residential customers. Low voltage products include indoor and outdoor lighting fixtures as well as outlet boxes. High voltage products consist of insulators, surge arresters and test equipment. Foreign sales make up 14% of total sales.
Hubbell is affected by slower demand for low voltage products from industrial and residential customers. Demand for high voltage products from industrial and utility customers increased 16% in the first quarter of 2009. Additional demand could materialize for HUBB in 2009 and 2010 if President Barack Obama and Congress spend heavily on a new power grid. In addition, Hubbell will likely benefit from overseas expansion and new acquisitions. We expect EPS to decline by 5% in 2009, followed by noticeable improvement in 2010 and beyond. HUBB’s balance sheet is strong and the dividend provides a worthwhile 4.2% yield.
Hubbell B shares are undervalued at 9.0 times latest 12-month earnings per share. HUBB shares have declined 50% during the past one and a half years, which is unwarranted because of the company’s bright outlook for 2010 and future years. We believe HUBB shares will recover to our Minimum Sell Price within two to three years. I’m not going to reveal my Minimum Sell Price here, but my subscribers know what price to sell HUBB, because I give them an update every month to let them know well ahead of time when to sell and at what price.
J. Royden Ward
For Cabot Wealth Advisory
Editor’s Note: Want to find out Roy’s recommended Minimum Sell Price for Hubbell and other great value stocks? Then try a subscription to Cabot Benjamin Graham Value Letter! In each Letter, you’ll find Roy’s latest value stock recommendations along with his buy and sell advice, so you’re always balancing risk with reward. Don’t let the amazing values in the market pass you by. Click below to get started today!