12 Undervalued Stocks That Pass The Graham Number And How You Can Profit From It
If you read the book the Intelligent Investor, then I guess you're already familiar with Chapter 14: Stock Selection for the Defensive Investor, where he discussed his famous "Graham number".
You've probably realized that if you follow the criteria of the Defensive Investor, you'll not find many stocks that'll pass the screening.
We can, however, tweak this strategy so that we can get possible investment ideas.
Well guess what? I found a handful.
In this post, I'll walk you through on how to build a portfolio of undervalued securities that meets the Graham number criteria.
If you love buying cheap stocks but don't know how to make a profit from it, then this post is for you.
The Modified Stock Selection Process
The first thing to do is to screen stocks using the criteria below.
I found 28 stocks that are possible candidates. They are listed on the table below.
Prices as of writing (March 12, 2018)
Some of the stocks have prices that are above the buy below price. I removed the overvalued stocks, narrowed them down and came up with 18 stocks namely; EW, PCOR, SCC, VLL, PSB, MARC, PMPC, ROCK, FLI, JOH, COSCO, SLI, FDC, PNB, V, IRC, SHNG, KPH.
Another criteria I added is the dividend. Does the company pay dividends?
Additional screening criteria:
How To Execute The Strategy
The best way to do this is to build a portfolio starting with the 12 stocks mentioned. Set a one year holding period with a target price on the buy below price.
For example, East West Banking Corporation's (EW) current price is ₱30.35. It's trading below ₱32.76 which is the buy below price at 33% margin of safety. At this price level, you can decide to buy the stock now and sell later at ₱32.76. This will give you a 7.94% gain.
You can also make money on the dividends while waiting for the price to rise to your target levels. For example, you can buy EW and hold until the dividend payment. You gain 1.10% which is the current dividend yield. Sell the stock at 7.94% gain after a few months. All in all, you get a 9.04% return assuming all this happens within a year.
The important thing here is to look at your performance on a portfolio level. This is why you should diversify with proper position sizing. You don't go all-in in one stock. Let me explain.
Let's say you have ₱120k, you can buy ₱10k worth of each stock. In this way, you distribute the risk. If one under-performs, the losses are minimized by the other performing stocks. This strategy doesn't require you to cut losses; you just need to be diversified and let your out-performers cover your paper losses.
On a portfolio level, your goal is to achieve a net gain. It is said that Graham made 20% compounded annually on his fund by adhering to his set of investing philosophies. If he made 20% consistently, then you can possibly do it too.
What To Do With The Other Stocks In The List
Since they are classified as overvalued as per Graham's criteria, we don't buy them now. Instead, we put them on our watchlist. If the stock plummets below the buy price that offers a good return, then we buy them with the same position sizing.
The main goal is to buy as many stocks as possible with the same criteria. The idea behind this is again, to diversify and minimize the risk.
These stocks are cheap. And for some reason, they may stay cheap for a long time. Diversifying gives us a higher chance of making money from these type of stocks. For example, if a news is disclosed about a particular stock, it may go up fast and you can take profit from that event.
Even if you hold the stock for an extended amount of time, at least, you still get a nice return through dividends. You can make money on the dividends until such time you decide to sell based on your parameters.
One important rule is you do not over expose your portfolio into a single stock. You need to diversify. If you have ₱300k and you were able to find 30 stocks that meet this basic criteria, then you should spend ₱10k on each position. The rule is simple; The more undervalued stocks you buy, the better chance of success. If you're unsure what to buy first, then choose the stock with the highest return on equity or dividend yield.
If prices reach your targets, sell. Before the year ends, re-balance the portfolio and repeat the strategy again.
Is This Strategy Effective
When Graham explained the concepts of the Net-current-asset (or "Bargain") issues in Chapter 15, it became crystal clear that this will certainly work. Remember that one of the criteria we're looking for are positive earnings and dividends. This meant that there's a good chance that the business you're buying are making money and are able to grow.
If you'll be able to build a well diversified portfolio that meet the Graham number criteria, then I'm pretty certain that you'll make money. If the NCAV strategy works, then I see no reason that this will not.
Just to recap, to make money on undervalued securities, you can start by screening stocks that meet the Graham Number. You then build a well-diversified portfolio from these stocks and manage it along the way.
One thing you need to consider is that we don't consider the 'qualitative' side of the stock. This strategy is purely a quantitative approach. It's easy to implement and that's why you need to diversify to minimize the risk of you being wrong on a particular stock.
If you can stick to this concept consistently, I believe that you can make money in the most less risky way.
Have anything to add? Let's discuss it in the comments section below.
Disclaimer: Made money on COSCO, MEG and MPI. Lost money on EW. I currently don't own any stocks mentioned in the list as of this writing.