Buying something for less than it is worth would seem like the most basic of rules, but it wasn't until Benjamin Graham popularized the concept of a "margin of safety" that it sank in with investors.
Mr. Graham's margin of safety described the difference between a company's actual value – its net-working capital minus debt – and the value at which its shares sold in the market. Presumably the shares were selling for lower, and the bigger the gap, the more limited the downside risk of the stock to the investor.
This concept was a way of helping investors overcome their individual biases and avoid major mistakes.
If you could acquire a company's hard assets and the goodwill on its books for free and sit back and wait for the upside in the stock knowing it probably had very little downside, why would you pass up the chance?
Warren Buffett, a Graham disciple, has likened the margin of safety to the weight a bridge can support. "You don't try to buy businesses worth $83-million for $80-million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing."
Or as another value investor, Seth Klarman, put it, the margin of safety allows for "human error, bad luck or extreme volatility."
A group of PhDs tested Mr. Graham's theory and recently published a paper about their findings, as well as a book for the American Association of Individual Investors. They wanted to see if Mr. Graham's ideas about deep-value stocks held up in a world of electronic trading and seemingly limitless information (Mr. Graham published in the relative dark ages of the 1930s and 40s, when finding an overlooked investment took some detective work).
The researchers used a database to screen for stocks trading at prices below their net current-asset value a share. They defined this as current assets minus liabilities and preferred stock dividends divided by the average number of shares outstanding.
They also screened for profitable companies with realized positive cash flow, and they omitted financials, stocks trading below $5 (U.S.) a share and foreign companies.
This was done in 2012, when the markets were still rebounding from the financial crisis that occurred three years earlier. But the researchers found nine companies that matched the criteria they wanted.
All of the stocks traded below the value of their respective companies – by an average of 16.9 per cent. Most of them are traded over the counter, and the companies range from a furniture maker to a candied-fruit supplier and a maker of the glass that covers cockpit equipment on airplanes.
The research found that an equally weighted portfolio of these nine stocks would have returned 106.4 per cent from February, 2012, through November, 2016, compared with a 78.3-per-cent gain in the Standard & Poor's 500.
Moreover, the researchers found, each of the nine stocks they identified had a positive return, and four of them would have beaten the market on their own. The researchers concluded that Mr. Graham's deep-value theory held up, but also that market sentiment controlled how many opportunities were available at any given time.
Had they done the screen three years earlier, for example, there might have been more than nine stocks identified. There might have been fewer, too.
Validea's 10-stock portfolio, which follows Mr. Graham's strategy, is up 358 per cent from 2003 until now, outperforming the market by 230 per cent. In 2016 alone, the strategy returned 36 per cent compared with 9.5 per cent for the S&P 500. These are based on my annual rebalanced 10-stock model portfolio.
Here are three stocks that score high ratings in our Graham model portfolio:
Fossil Group: The maker of trendy watches and other fashion accessories has net current assets of about $965-million and earnings-per-share (EPS) growth over 360 per cent, though its shares are trading near their 52-week low as retailers have gotten beaten up over the past few months. The stock trades at a below market P/E (price-to-earnings ratio) of 12.2.
Cato Corp.: Another fashion retailer that scores 100 per cent on the Graham model. It has no long-term debt and $300-million or so in current assets, while its shares also linger near their low. A price-to-earnings ratio (P/E) of 9.9 and price-to-sales (P/S) ratio of 0.7 make this one a deep value play.
Sanderson Farms: This chicken producer and distributor also has no debt, and though its EPS has been negative in the past couple of years, it has long-term EPS growth of 25.5 per cent. The shares trade at attractive valuation levels.
John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.