Ben Graham's Fag Packet

Quickly sort through numerous investing possibilities.

A share gets tipped somewhere or other, it rises quickly, you sell it and move on -- and the investing game is all too easy. But it isn't usually like this and blindly following the advice of tipsters is a probable route to failure unless you're simply lucky.

What to do?

So what can you do about it?

Personally, I run a ten-minute "back of a fag packet" test on every company I have on my list to review. If the potential investment doesn't successfully jump this first hurdle, I discard it; simple as that.

What this means in practice is that I miss a lot of shares that go on to greatness as the exciting growth story proves to be real. After all, such a test is scant at best. So be it. For every one of these, there are several others which crash and burn lacking, as they do, in basic value.
Ben Graham's approach

The fag packet test I run is loosely based on legendary investor Ben Graham's formula.
Graham's approach is based on the principle that markets get valuations wrong, saying: "In the short run, the market is a voting machine but in the long run, it is a weighing machine". Hear, hear. When the actual (market) price of a company is below what you would expect it to be, you have the opportunity to buy with a decent safety margin.

Graham's suggested method of calculating value takes a company's last 12-month earnings per share and multiplying it with 8.5 -- the appropriate price-to-earnings ratio for a non-growth company in his opinion.

Then you add 2g -- 'g' represents your best estimate of the annual rate earnings will grow over the long term (say, the next five years).

Finally, multiply the lot by 4.4 -- the average yield of high-grade corporate bonds in 1962, when this particular model was introduced -- and divide by Y -- the current yield on AAA-rated corporate bonds.

The answer should then be divided by its current price -- less than one indicates an overvalued stock which should not be bought, whilst a number greater than one indicates an undervalued stock.

Refinement

Graham later refined his ideas into ten criteria for selecting a portfolio:

earnings yield at least twice the AAA bond yield;

price/earnings ratio below 40% of the highest P/E ratio the stock had over the previous five years;

dividend yield of at least two-thirds the AAA bond yield;

share price below two-thirds of tangible book value per share;

share price below two-thirds of net current asset value per share;

total debt less than tangible book value;

current ratio greater than two;

total debt less than twice net current asset value;

earnings growth over the previous ten years of at least 7% per annum; and

a maximum of two annual earnings falls of 5% or more over the previous ten years.
The fag packet approach

Personally, I look at current assets (stocks, short term debtors and cash) and subtract all liabilities (short and long term creditors).

I also look at yield, overall net tangible asset value and my best guesstimate of future earnings before arriving at my estimation of a company's likely value.

I do this sum (which admittedly involves too much of a subjective judgement for many investors' tastes) in ignorance of the actual market capitalisation.

Anything which is over the real market cap warrants further detailed investigation. But the vast majority don't get over this first basic hurdle and are summarily dispensed with. At least that's the theory. The practice is rather different, but that's another story...

It's amazing how many companies DO pass this test when markets are gloomy and bearish sentiment prevails -- and vice-versa. Running such ten-minute analyses last Spring was like shooting fish in a barrel. At the moment, the barrel is half-full, but there are already significantly more opportunities than a few short weeks ago.

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