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Simon Thompson's Bargain Portfolio

Created:
29 February 2008
Written by:
Simon Thompson

Every year we use the investment criteria used by Benjamin Graham in his book The Intelligent Investor to pick our portfolio of bargain shares. The system has stood the test of time. Our 2003 selections rocketed by 146 per cent, our 2004 portfolio produced a 17.1 per cent return, our 2005 portfolio generated an investment return of 50 per cent, handsomely beating the FTSE All-Share index. That was a hard act to follow. Our 2006 bargain shares rose by an average of 16.7 per cent, but that was still better than the 11.3 per cent return on the FTSE All-Share index. However, the bear market of 2007 has ended the golden run. Our star picks last February fell by 1 per cent in value - although that was still better than the market, which fell by 6 per cent in the same period.

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So, once more we have run the rule over 3,000 listed businesses to come up with a portfolio of companies where the asset backing should be strong enough to overcome any short-term trading difficulties and, in the end, reward long-term investors handsomely.

The rules of the bargain portfolio

Benjamin Graham, the father of value investing, once said: "If we assume that it is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will undervalue - relatively, at least - companies that are out of favour because of unsatisfactory developments of a temporary nature. This may be set down as a fundamental law of the stock market, and it suggests an investment approach that should be both conservative and promising." In a nutshell, that is what the bargain portfolio is all about.

In his book, The Intelligent Investor, first published in 1949, Ben Graham outlines the criteria for the bargain portfolio. The approach is balance-sheet-based and concerns the net current assets - stocks, debtors and cash less any creditors - of a company. Graham believed that a bargain share is one where net current assets less all prior obligations - such as creditors falling due after one year, deferred taxation and provisions for liabilities and other charges - exceeds the market value of the company by at least 50 per cent. This means that fixed assets, such as property, machinery, goodwill etc, are in the price for nothing.

Finding companies that match this strict criteria has become increasingly difficult over the years as the link between market capitalisation and asset value has become more tenuous.

For example, information technology companies will rarely match the criteria and biotechs generally only appear when their share price is depressed and the cash pile on the balance sheet - intended for future research and development (R&D) - significantly boosts net current assets.

Housebuilders inevitably have bargain ratios of around 1 (so that the net current assets are equal to the market capitalisation) simply because accounting policy is to include land banks as current rather than fixed assets. This does not mean that we ignore them - we have successfully prospered in the past eight years with the likes of Bryant, Alfred McAlpine, Bellway and Bovis- but this should be taken into consideration.

When we screened more than 3,000 listed shares, as expected only a handful turned up with a bargain ratio of 1.0 or above. So to widen the net, and as in previous years, the cut-off point has been lowered to 0.4. Some companies may drop into bargain territory due to short-term difficulties, but it is the resolute nature of the balance sheet that will see them through. Hence our balance-sheet-based approach.

The overall record of INVESTORS CHRONICLE bargain portfolios has been very good over the years, but investors should note that there can always be one or two selections that turn out to be complete stinkers as the dire performance of Molins in 2004, Abbeycrest in 2005 and Barratt last year clearly shows. Therefore:

• It is important to buy a decent number of our recommendations or you could end up with the only share that does badly.

• With small-cap companies, market makers could easily raise the price they are quoting by 15 to 20 per cent on publication day so we advise holding off for a few weeks until the shares fall back.

• If the shares race away and you've made good gains, always think about taking profits.

• You may end up being in for the long haul - perhaps two to three years - so don't expect instant profits.

MORE ON BARGAIN SHARES...

So how did we do? See how last year's selection of bargain shares did by clicking here.

(You will need to register to see this. Registration is free)

IC Advantage subscribers can get the low-down on this year's six shares here.

IC Advantage subscribers can also:

■ Read more of Simon's investment ideas columns on his IC home page...

■ Use our stock screening tool to help identify other bargain shares.

(For more on subscription options, click here)

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