Ben Graham’s Rules for Cheap Stocks: Four Cheap Stocks Warren Buffett’s Teacher Might Buy

1  Ben Graham is considered to be the founder of the value investing philosophy. He began investing in the 1920s, just in time to suffer large losses in the 1929 stock market crash. Graham decided to learn from the crash and began studying how to buy safe stocks. Within a few years, he coauthored the first book on the subject of value investing with a former student, David Dodd. That 1934 book, Security Analysis, is still found on the bookshelf of many investment professionals. Although Graham’s work is important on its own right, it was the work of another student, Warren Buffett, that would make Graham famous. Buffett studied under Graham and has become the most successful of his many students.

Graham’s investing philosophy is simple enough that it can be explained in three steps. The first step is to find undervalued stocks. The second step is to wait for the market price to rise so that it accurately reflects the fair value of the stock. The third step is to take profits by selling after the stock price moves up. The first step is the problematic one for investors and many researchers have tried to provide details on how to find undervalued stocks, including Graham.

Among the techniques for finding value Graham identified was one based on the company’s net current asset value (NCAV). NCAV is the value of the company’s current assets minus its total liabilities. This value is divided by the total number of shares outstanding to find NCAV per share (NCAVPS). When the market price of the stock is less than the NCAVPS, the stock is buy.

Graham’s logic was that the NCAV is the most stringent measure of assets because it ignores long-term assets like buildings and equipment. If a company can satisfy all its debts using just its current assets, shareholders will still own the long-term assets that can produce additional wealth in the long run.

In a later book, The Intelligent Investor, Graham explained why this approach works, “It always seemed, and still seems, ridiculously simple to say that if one can acquire a diversified group of common stocks at a price less than the applicable net current assets alone—after deducting all prior claims, and counting as zero the fixed and other assets—the results should be quite satisfactory.”

Even though these should be safe investment, Graham wanted a margin of safety and he specifically suggested buying when the stock price is at least one-third less than the NCAVPS. A study done by academic researchers in the 1980s found that following this approach would have resulted in an average annual gain of 29.4% a year from 1970 to 1983, almost seven times better than the broad stock market. Over that same time, the S&P 500 gained an average of 4.4% a year. Of course, not all of the stocks selected by this screen will be winners. Some of these companies could even enter bankruptcy and wipe out all of the stock’s value. To offset this risk, Graham advised buying several companies that passed this test. In the long run, he believed the large winners would offset the inevitable losses.

Graham developed the NCAVPS strategy between 1930 and 1932, in the midst of the Great Depression. At that time, a number of stocks would pass the screen. In the years since then, markets have become more efficient and it is difficult to find companies that are trading at a price below their NCAVPS.

Recently, just four companies passed Graham’s NCAV test. To reduce the risk of buying a company headed for bankruptcy, we also required the company to have positive earnings per share (EPS) over the past twelve months and to have positive cash flow from operations (CFO).  CFO is used to fund current operations and growth. The stocks we found are all relatively cheap, trading under $10 a share with a couple priced under $1.

2  YaSheng Group (Nasdaq: HERB) is a China-based company that produces more than 30 agriculture products including cotton, corn, barley, wheat, flaxseed and alfalfa; vegetables: onion, potato, beet and pea; fruit: apple, pear and apricot; specialty crops: hops, wolfberry, cumin, hemp and liquorices root; seeds: black melon seeds, sunflower seeds, corn seed, hemp seed and flax seed, and poultry: eggs. It also operates a concrete plant. These diverse operations generated nearly $940 million in revenue over the past twelve months and EPS of $0.45. The company has reported a profit every year since 2009.

The stock is thinly traded and illiquid stocks often trade at a discount relative to their peers. Companies based in China might also face skepticism about their accounting practices which results in a discount. Companies with diverse operations, like agriculture and concrete, can also trade as a discount since investors are unsure how management can be effective in both business.

These factors could partly explain HERB’s relatively low stock price. But, HERB easily passes Graham’s test with current assets of $0.75 and total liabilities of $0.29. In the long run, this value should eventually be noticed in the stock market.

3  Yew Bio-Pharm Group, Inc. (Nasdaq: YEWB) grows and sells yew trees and manufactures products made from yew trees in China. These products include the trees themselves; raw materials for traditional Chinese medicine; furniture and handicrafts made of yew timber; and yew candles and other assorted products. The stock trades with a price-to-earnings (P/E) ratio of 3. This stock is also thinly traded and if you trade illiquid stocks, consider using a limit order to buy and sell. Limit orders can reduce trading costs. Total current assets of $0.49 significantly exceed total liabilities of $0.09.

4  ADDvantage Technologies Group, Inc. (Nasdaq: AEY) distributes and services a range of electronics and hardware for the cable television and telecommunications service companies. AEY is also a small company with a market cap of less than $20 million and annual sales of about $40 million. The company has reported a profit in six of the past seven years, reporting a loss of just $0.001 in 2014. AEY reported current assets of $3.42 per share and total liabilities of $0.98 per share in its most recent financial statements.

5  West Marine, Inc. (Nasdaq: WMAR) sells boating and water recreation products. It provides service through physical stores and two e-commerce Websites, operating nearly 260 stores located throughout the US, Puerto Rico and Canada. Its products include electronics, sailboat hardware, anchors/docking/moorings, engine systems, boats/outboards, ventilation, navigation, trailering, seating/boat covers and barbecues/appliances. Customers also find clothing accessories, fishing, watersports, paddlesports, coolers and waterlife lifestyle accessories in WMAR’s stores.

WMAR recorded more than $700 million in sales over the past twelve months and reported EPS of $0.21. With a market cap of about $200 million, WMAR is large enough to be covered by analysts. Three analysts have published earnings estimates for next year. The consensus estimate is for EPS of $0.32. WMAR reported current assets of $14.07 per share and total liabilities of $4.90 per share. WMAR’s most recent quarterly report showed the company holding $3.76 per share in cash on its balance sheet, an asset that should limit the downside risks in the stock.

These four companies are the only ones among the 6,604 stocks in our data base that passed Ben Graham’s NCAVPS test and had a margin of safety provided by earnings and CFO. In the long run, a portfolio consisting of companies like this have been proven to deliver market-beating returns. These four have the added advantage of being relatively cheap in a market that appears to be becoming increasingly expensive.