By J. Royden Ward, Editor of Cabot Benjamin Graham Value Letter
From Cabot Wealth Advisory 7/15/10 Sign up for free Cabot Wealth Advisory e-newsletter

Everybody loves a bargain, but some bargains seem too good to be true. How can we figure out which bargains are for real, and which ones are not? 
 
I rely on time-tested analysis to improve my odds: Analysis that relies more on a company’s history, than on unreliable predictions of future operation. I also look at the background and success of the person who devised the analysis.
 
There is no better analyst to turn to than Benjamin Graham, the father of value investing and the creator of the stock analyst profession. Mr. Graham created several investing methodologies, which are well documented in his most famous books: Security Analysis, co-authored with David Dodd in 1934, and the Intelligent Investor, which was first printed in 1949.
 
One of Benjamin Graham’s earliest analyses, created and tested 75 years ago, is the Net Current Asset Value (NCAV) approach. The objective of the NCAV formula is to find the minimum value a company would fetch if it was liquidated. The formula is:
 
Net Current Asset Value (NCAV) = cash and short-term investments + (0.75 * accounts receivable) + (0.5 * inventory) – total liabilities – preferred stock
 
The resulting value can then be divided by the number of common shares outstanding to find the NCAV per share. If the current stock price is less than the NCAV per share, the stock is a bargain. However, further analysis is necessary to determine if the company is prosperous.
 
Companies with earnings deficits or with erratic earnings histories are likely to become less prosperous and should be avoided. Companies in the financial sector should also be avoided, because their balance sheets are not comparable to those of other companies.
 
Finding profitable companies selling below their NCAV is a simple process. However, not many companies are selling below their Net Current Asset Values. I screened 9,000 companies and found only 12 companies selling below their NCAV. And most of the companies are not very prosperous.
 
Back in 2003, I used the NCAV formula to find bargain stocks, and in March 2003, 15 stocks clearly qualified. The number of qualified companies dwindled during the year until 12 months later, no stocks qualified. However, during the 12 months when some stocks qualified as bargains, the stocks tripled in price!
 
Most stocks that qualify as NCAV bargains are small companies, which usually are risky investments. However, Benjamin Graham surmised that any companies selling below their NCAV values carry lower risk: “They are indubitably worth considerably more than they are selling for, and there is a reasonably good chance that this greater worth will sooner or later reflect itself in the market price. At their low price these bargain stocks actually enjoy a high degree of safety, meaning by safety a relatively small risk of principal.”
 
When should you sell a bargain stock? Benjamin Graham held his stocks until a 50% gain was realized but no longer than two years. Mr. Graham also advocated investing in as many NCAV bargain stocks as possible. The more stocks you invest in, the more you can reduce your risk. 

Click on these links for more information on Value investing:

Benjamin Graham's Seven Criteria for Picking Value Stocks
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On Adding Bonds to your Value Portfolio
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Some Value Investing History
The investment principles taught by Graham at Columbia University became legend in the field of professional stock analysis.

Benjamin Graham's Mr. Market
One of Benjamin Graham's favorite parables is that of Mr. Market. Graham refers to him several times in his book, The Intelligent Investor.

Value Investing Frequently Asked Questions
Cabot Benjamin Graham Value Letter Editor Roy Ward answers common questions on his value investing strategy.

Making the Case for Value Investing
For every hyper-inflated stock, there is an undervalued stock with a low price to earnings ratio, strong balance sheet and a solid outlook.

Benjamin Graham Value: A Carved-in-Stone System that Works
This system will suit you if you're the type of investor who needs a strong dose of rigidity injected into his life.

How to Know Whether a Stock is a Bargain?
J. Royden Ward explains how he finds the estimated value of a company.

Value Investing Takes Advantage of Market Fluctuations
The basic principal is simple: the stock market and the individual stocks that make up the stock market have always bounced back and forth from overvalued to undervalued to overvalued, over and over again.

Guide to Value Investing
This guide explains the value investing strategy and defines intrinsic value and margin of safety.

Benjamin Graham, the Father of Value Investing
Since 1926, Benjamin Graham’s timeless value investing approach has achieved returns of 20% per year with low risk regardless of the market's ups and downs.

Is the Cabot Benjamin Graham Value Letter Right for You?
If you like the idea of buying stocks with low prices and calmly hanging on, Cabot Benjamin Graham Value Letter may be the right advisory for you.