A checklist approach to finding bargains with Ben Graham's deep value rules

Is value investing dead?

That’s a question I’ve seen crop up a few times recently (and in recent years) in the financial press on both sides of the Atlantic. The quantitative answer is that value isn’t dead, but rather goes through spells of underperformance. It just seems that the past decade has been a particularly barren spell.

Here’s a chart that casts some light on what the trends have been:

These are the composite performance figures of the different Guru Screen investment styles that we track here at Stockopedia – Bargain, Value, Income, Quality, Growth and Momentum.

You have to be careful about extrapolating too much from this kind of chart. But it’s pretty clear that Growth and Momentum have been very much in favour in recent years. Value… not so much.

Value and Momentum are very different styles of investing, but they’re also very connected. To borrow a turn of phrase from an OSAM paper last year, with Momentum, a stock will move from fair value to slightly overvalued to potentially very overvalued before retracing. With Value, stocks are mispriced and gradually converge on fair value over time. As OSAM say: “Both styles represent a market mistake that can be captured as alpha.”

But over the past decade, it has been Momentum that has profited the most. The market has been gravitating to fast-moving growth stocks, and that’s has left value investors with very little to go at.

This brings me to an interesting value screen that we track – Ben Graham’s Deep Value Checklist. Like a number of the value screens it’s had some strong returns at times over the past five years, but the overall performance has been volatile and underwhelming. What makes it slightly different is that it uses a checklist approach to finding cheap stocks in the market.

A different approach to value investing

Ben Graham is thought of as the father of value investing. He was an architect of some of the founding principles of buying undervalued stocks and waiting for them to recover. He was virtually wiped out in America’s great depression of the 1930s, but the lessons he learned were very profitable later on. A lot of his legacy centres on doing detailed analysis of individual securities to find mispricing.

Later in life, ahead of his death in 1976, Graham tempered his approach to individual stock selection. Together with his friend – another investor called James Rea – he came up with a much more checklist-driven approach. It aimed to harvest the value premium across a portfolio of stocks. He knew that there could be hidden problems in companies. So this was a way of absorbing some of those risks.

Graham wrote: “Try to buy groups of stocks that meet some simple criterion for being undervalued – regardless of the industry and with very little attention to the individual company. It seems too good to be true, but all I can tell you after 60 years of experience, it seems to stand up under any of the tests I would make up.”

So what was in the checklist? Typically for such a diligent student of the market, his first run – a 10 point Deep Value Checklist – was very strict…

1. An earnings-to-price yield at least twice the AAA bond rate

2. P/E ratio less than 40% of the highest P/E ratio the stock had over the past 5 years

3. Dividend yield of at least 2/3 the AAA bond yield

4. Stock price below 2/3 of tangible book value per share

5. Stock price below 2/3 of Net Current Asset Value

6. Total debt less than book value

7. Current ratio greater than 2

8. Total debt less than 2 times Net Current Asset Value

9. Earnings growth of prior 10 years at least at a 7% annual compound rate

10. Stability of growth of earnings in that no more than 2 declines of 5% or more in year end earnings in the prior ten years are permissible.

This is clearly a very detailed list. The first five of these rules look for “cheapness”, and the second five look for “financial stability” – which is very much Graham territory. But unsurprisingly, he found that the criteria left him with few companies passing his rules. So between them, he and Rea cut back the list so that they could start with a much wider pool of companies – and then apply more and more of the checks.

In the years since, there has been a lot of discussion about which of the rules in that checklist are the most important. But the bigger lesson here is that Graham realised that life was much easier when he had a template for screening the market.

If you were to apply that checklist today, what would you find? Here are some of the stocks that currently pass eight or nine of the Graham checklist rules:

Low P/E ratios and high dividend yields can be classic markers of potentially cheap stocks – and you can see from the relative price strength figures here that most of these names have underperformed over the past six months. There are different reasons in each case, and the traditional job of the value investor is to consider whether there is enough margin of safety to justify a position.

But as we’ve seen with the recruitment company Staffline today – which has been on this screen for over a year – ‘value’ stocks can get ‘cheaper’. A near 60 percent price fall on badly-received news makes it a perfect example of the risks faced by value investors. Companies that are in trouble or facing industry changes or have been mis-managed for whatever reasons are terribly unpredictable.

But in essence, that’s exactly why Ben Graham adopted this checklist approach. He knew he couldn’t always predict individual outcomes. So this idea of getting broad exposure to a basket of value stocks – rather than picking individual manes – made sense to him in the end.

While many investors will, perhaps rightly, absolutely hate the names that come up on value screens like this, it’s equally true that apparently broken companies in the mire are exactly what contrarian value investors are looking for.

In the right conditions, over time, value investing has proved to be a very predictable and profitable approach to the stock market. Ben Graham laid the groundwork, and his strategies continue to inspire. But there is no doubting that these kinds of contrarian models take discipline and the willingness to buy stocks when they might be in trouble and out of favour. Knowing these risks, Graham eventually came round to adopting a checklist-driven portfolio approach to the market – and it’s a lesson for everyone.

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