How to Invest Like Warren Buffett’s Teacher

The greatest influence on the investment style of Warren Buffett was Benjamin Graham, widely considered to be the originator of value investing. In 1934, Graham even wrote the book on value investing when he published “Security Analysis” with David Dodd. This was the first book to provide a detailed explanation of how to value a stock. This book was one of the most important books ever written about finance and remains on the book shelves of many investment managers more than 80 years after it was published.

After reading the book, Buffett decided he should go to Columbia Business School so he could study under Graham. Over the years, Graham also counted legendary value investors like William Ruane, Walter J. Schloss and Charles Brandes among his students.

Graham had a great deal of success as an investor, buying many stocks at what he considered bargain prices during the Great Depression. This disciplined investment approach continued to deliver profits throughout his life. Graham was often able to buy stocks that traded for less than the amount of cash the company had in the bank. Such bargains are rare in today’s market and usually only occur as a company plummets into bankruptcy.

While it’s rare to find stocks trading below the value of their cash holding, Graham’s general principles are still sound. From his books, we can identify several strategies Graham used. One strategy focused on finding value in companies with little debt. The specific criteria we used are:

  • Price-to-Earnings (P/E) ratio less than 25 based on earnings over the past twelve months. This high level is appropriate to today’s market given the yields on long-term Treasury bonds. Graham recommended using higher ratios when rates are low and lower P/E ratio when rates are high. This recognizes the idea that stocks and bonds compete as income investors.
  • Price-to-Book (P/B) ratio less than 1, a criteria Graham strongly advocated in many of his writings. In theory, when the P/B ratio is less than 1, investors are paying less than a dollar for a dollar’s worth of assets. A P/B ratio of 0.75, for example, indicates investors are paying $0.75 for $1.00 of assets. Because companies can, and do, write down the value of assets at times, companies with low P/B ratios still carry some risks.
  • Debt-to-equity ratio less than 1. Graham believed companies with low debt ratios were more likely to survive in the long run. He did believe companies should have some debt because using debt wisely can help a company increase its earnings.
  • A volume filter to avoid illiquid stocks. We required the stocks to have an average daily trading volume of 100,000 shares.
  • Price less than $20 to focus on low cost stocks that could provide larger percentage gains.

We also limited our search to companies based in the US. This helps us avoid potential problems that could be caused by different accounting standards applied in other countries. Finally, we eliminated financial stocks since the minimum equity of many financial companies is determined by regulation. Graham generally recommended excluding financial companies from screens like this because different techniques should be used to value companies in this sector.

Our screen looked like this using the free screener available at FinViz.com:

Link to chart: http://finviz.com/screener.ashx?v=111&f=fa_debteq_u0.5,fa_pb_low,fa_pe_u25,geo_usa,sh_avgvol_o100,sh_price_u20&ft=4&o=-marketcap&r=21

Eight stocks passed our screen.

Nobilis Health Corp. (NYSE: HLTH) is a full-service healthcare development and management company, with 25 locations in seven states, including 4 hospitals, 10 ASCs and 11 clinics. In addition, Nobilis partners with an additional 38 facilities across the country. The company  owns and manages ambulatory surgical centers (ASCs), and acute-care and surgical hospitals in the United States, which provide surgical procedures in various clinical specialties, including orthopedic surgery, podiatric, vein and vascular, pain management, gastro-intestinal, gynecology, and general, as well as ear, nose, and throat.

FreightCar America, Inc. (Nasdaq:RAIL)  designs, manufactures, and sells railcars for the transportation of bulk commodities and containerized freight products. The company’s customers primarily include railroads, shippers, and financial institutions. RAIL offers a variety of freight cars, including, covered hoppers, gondolas, well cars, open top hoppers and more. The company also leases and rebuilds rail cars, as well as exports manufactured railcars to the Middle East and Latin America.

Verso Corporation (NYSE: VRS) produces and sells printing papers, specialty papers and pulp. The company’s printing papers are designed primarily for commercial printing, media and marketing applications, including magazines, catalogs, books, direct mail, corporate collateral and retail inserts. Its specialty papers are used primarily for label and converting, flexible packaging and technical paper applications.

Cloud Peak Energy Inc. (NYSE: CLD) is one of the largest U.S. coal producers and the only pure-play Powder River Basin (PRB) coal company. As The company mines low sulfur, subbituminous coal and provides logistics supply services. The Company owns and operates three surface coal mines in the PRB, the lowest cost major coal producing region in the nation. The Antelope and Cordero Rojo mines are located in Wyoming and the Spring Creek Mine is located in Montana. Last year, Cloud Peak Energy shipped approximately 59 million tons from its three mines to customers located throughout the U.S. and around the world. The company also owns rights to substantial undeveloped coal and complimentary surface assets in the Northern PRB, further building the Company’s long-term position to serve Asian export and domestic customers.

Vitamin Shoppe, Inc. (NYSE: VSI) operates as a multi-channel specialty retailer and contract manufacturer of nutritional products in the United States and internationally. The company offers vitamins, minerals, herbs, specialty supplements, sports nutrition, and other health and wellness products of approximately 900 brands, such as own brands comprising Vitamin Shoppe, BodyTech, True Athlete, Mytrition, plnt, ProBioCare, Next Step, and Betancourt Nutrition; and national brands, including Optimum Nutrition, Cellucor, Garden of Life, Quest Nutrition, Solaray, Solgar, and Natures Way.

International Seaways, Inc. (NYSE: INSW) provides energy transportation services for crude oil and petroleum products in International Flag markets. The company owns and operates a fleet of 55 vessels, including one ULCC, eight VLCCs, eight Aframaxes/LR2s, 12 Panamaxes/LR1s and 20 MR Tankers. Through joint venture partnerships, the Company has ownership interests in four liquefied natural gas carriers and two floating storage and offloading service vessels. In 2016, it owned or operated a fleet of 55 vessels totaling an aggregate of 6.5 million deadweight tons and 864,800 cubic meters. The company serves independent and state-owned oil companies, oil traders, refinery operators, and international government entities.

New Media Investment Group Inc. (NYSE: NEWM) owns, and operates local media assets in the United States. Its primary products include 125 daily newspapers with total paid circulation of approximately 1.4 million; 314 weekly newspapers with total paid circulation of approximately 315,000 and total free circulation of approximately 1.9 million; 124 shoppers with total circulation of approximately 3.0 million; and 538 locally-focused Websites, including Internet and mobile devices with approximately 224 million page views per month. Print and online products focus on the local community, primarily covering topics such as local news, politics, community and regional events, youth sports, local schools, as well as local market information.

SandRidge Energy, Inc. (NYSE:SD) is an oil and natural gas company that engages in the exploration, development, and production of oil, natural gas, and natural gas liquids in the United States. As of December 31, 2016, the company had 2,310.0 net producing wells; approximately 950,000 net total acres under lease; 1 drilling rig in the Mid-Continent; and a total estimated proved reserves of 163.9 million barrels of oil equivalent.

There seems to be hidden value in potential inflation hedges right now. These stocks could soar if inflation picks up. It’s interesting to see a value screen telling us maybe inflation isn’t dead after all.