As of June 6, the Benjamin Graham Net-Net Working Capital Screener detected about 500 company stocks that are trading at bargain prices based on their net-net working capital (NNWC) values. Among the stocks that trade in the U.S., Emerson Radio Corp. (MSN, Financial) has the lowest price to net-net working capital (P/NNWC) ratio, suggesting that Emerson Radio is the most undervalued stock based on Graham’s value investment strategy.
Ben Graham’s winning strategy and the introduction of the Graham number
Known as the “father of value investing” among peers, Graham introduced a strategy that targets stocks meeting certain criteria: stock price less than the company’s net current asset value, no negative operating cash flows during the trailing 12 months and no meaningful debt compared to cash.
According to research, Graham’s strategy screens for bargain stocks that meet the above criteria. This strategy most likely works during times immediately following a recession, when stock prices usually fall sharply below tangible book values. When Graham’s strategy was tested Nov. 24, 2008, the top 13 Ben Graham U.S. stocks made an average weekly return of 40% for the week ending Nov. 30, 2008.
In addition to his net-net working capital strategy, the “Father of Value Investing” devised a very conservative valuation method using a metric currently known as the Graham number. Graham’s formula values a company based on two financial metrics: the tangible book value and the trailing 12-month EPS without nonrecurring items (NRI). To compute the intrinsic value, Graham takes the product of 22.5 and the above two financial metrics, and then takes the square root of the product. For example, Income Opportunity Realty Investors Inc. (IOT, Financial), with a tangible book value of $20.215 and a 36 cents EPS without NRI, has a Graham number of $14.06 as of March. This Graham number is higher than 74% of stocks in Income Opportunity’s industry sector.
Ben Graham’s top three company stocks for June
The top three U.S. stocks according to the screener are Emerson Radio, Income Opportunity Realty Investors and AG&E Holdings Inc. (WGA, Financial). These three stocks meet all the criteria Graham lists in his strategy: the three stocks have no debt, positive operating cash flows in the trailing 12 months and P/NNWC ratios less than one. Furthermore, since these companies have no debt, their interest ratio is infinite.
Graham stresses the importance of diversifying the stocks to invest to reduce the risk of companies going bankrupt. In other words, it is optimal to buy a “basket” of Graham bargain stocks from different industries to protect from the risk of an industry failing during an economic recession. The top three Graham stocks based on the screener results feature two companies in computer hardware and one in real estate services.
Computer hardware industry has two of the top three Graham U.S. stocks
Emerson, a consumer electronic products and trademarks company incorporated in Delaware, is currently the No. 1 stock on the Graham net-net working screener. Another stock in the computer hardware industry, AG&E Holdings, ranks third on the screener. Both companies have relatively strong financial outlooks: Emerson has a financial strength rating of 9 while AG&E Holdings has a financial strength rating of 8. One likely reason for the high financial strength ratio is that both companies have high equity-to-asset ratios: both companies have equity-to-asset ratios in the top 10% of stocks in the global consumer electronics industry.
One of Graham’s most important financial strength metrics is interest coverage since Graham requires all stocks in his portfolio to have an interest coverage of at least 5. Since both Emerson and AG&E have no debt, their interest coverage is currently infinite. However, although AG&E has no debt, the LCD distributor and manufacturer historically had several quarters where its interest coverage was negative. On the other hand, Emerson’s interest coverage never dropped below 5.31 in the past 10 years, suggesting that Emerson historically had stronger financials than AG&E did.
Although it has a slightly stronger financial outlook than does AG&E Holdings, Emerson has a modest Piotroski F-score of 5. However, Emerson has less volatile Piotroski F-scores than AG&E Holdings does, suggesting that the 1994 consumer electronic company is more likely to experience healthy financials in the short term. Furthermore, AG&E occasionally had F-scores lower than 3, indicating a weaker business-operating system.
Despite having a high Piotroski F-score, AG&E Holdings currently has an Altman Z-score in the “grey zone,” i.e., between 1.81 and 2.99. Based on this Z-score, AG&E could potentially go bankrupt if its financials weaken in the coming year.
Although both companies have relatively weak profitability and growth ratings, the two computer hardware companies currently have P/S and P/B ratios near all-time lows. Emerson’s stock price is near five-year lows, and the current P/B ratio is close to a five-year low. On the other hand, AG&E has a stock price close to 10-year lows and a P/S ratio currently near five-year lows. These valuation ratios suggest high upside potential in the upcoming two to three years.
Real estate company is up there with the computer hardware companies
A real estate company incorporated in Nevada, Income Opportunity Realty Investors currently ranks second on the Graham net-net working capital screener, right between the two computer hardware companies analyzed above.
Among the top three Ben Graham stocks, IOT has the weakest financial outlook, with a modest financial strength rating of 5 out of 10. Despite having a very high Altman Z-score and relatively healthy Piotroski F-score, IOT historically had very high debt compared to its cash, suggesting very low interest coverage.
Although the real estate company has a weak financial outlook, the company has a good Sloan ratio of negative 9.61%. This ratio, introduced by Richard Sloan of the University of Michigan, measures how likely are the company’s earnings made up of accruals. Companies that have Sloan ratios with a magnitude of 25 or higher tend to have poor quality of earnings, which may lead to an overstatement of the company’s true earnings. Compared to the two computer hardware companies analyzed above, Emerson and AG&E, IOT has a better Sloan ratio as it is closer to zero than the Sloan ratios of Emerson and AG&E. Although Emerson’s current Sloan ratio is -9.41% as of December 2015, Emerson has had a history of high Sloan ratios. AG&E has the worst Sloan ratio of -72.62%, suggesting that most of the LCD manufacturing company’s earnings are made up of noncash accruals.
See also
For other great Graham stocks, use the Ben Graham Net-Net Working Capital Screener. You can also use the All-in-One Guru Screener to find stocks with similar financials to the stocks analyzed in this article.
