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Bargain shares for 2010

FEATURE: Investors Chronicle's Bargain Shares portfolios have beaten the market in all bar one of the past 11 years. Simon Thompson presents his portfolio of undervalued shares for 2010.
February 12, 2010

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.

Each year we use the investment criteria outlined by Mr Graham in his book The Intelligent Investor to pick our portfolio of bargain shares. (For those new to the rules, a brief summary of the selection procedure is given below). The system, contrarian as it may first seem, has stood the test of time, with our portfolios outperforming the FTSE All-Share index in all bar one of the past 11 years and returning a compound annual return of 14.8 per cent in this time, including a record breaking 146 per cent performance in 2003. To put this in perspective, the FTSE All-Share has risen from 2607 to 2661 in the same period - an annual gain of only 0.2 per cent. So £10,000 invested in our first Bargain Portfolio and reinvested every subsequent year in the following portfolio would now be worth £45,737. The same investment in a FTSE All-Share would have only grown to £10,207.

Last year maintained this impressive track record with my motley crew of six bargain shares returning a net 53 per cent return, handsomely outperforming the FTSE All-Share index, against which all our portfolios have been benchmarked.

Bargain Share Portfolio: 11 Year Track Record

YearBargain Portfolio One Year Performance (%)FTSE All-Share Index One Year Performance (%)
199959.017.3
200028.1-4.5
20012.5-17.2
2002-29.0-31.0
200314629.0
200417.111.0
200550.016.1
200616.911.3
2007-0.9-6.0
2008-60.1-30.9
200953.425.6
Compound Annual Return14.80.2

Source: Investors Chronicle

Bargain portfolio rules

In 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 fixed assets, such as property, machinery, goodwill, etc, are in the price for nothing.

Finding companies that match this strict criteria has become more and more 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 - significantly boosts net current assets.

Housebuilders inevitably have bargain ratios above 1 simply because accounting policy is to include land banks as current rather than fixed assets. This does not mean to say 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 ran the programme over 2,800 listed shares, as expected only a handful turned up with a bargain ratio of 1 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 because of short-term difficulties, but it is the resolute nature of the balance sheet that will see them through. Hence our balance-sheet based approach.

Diversify the risk

The overall record of Investors Chronicle's bargain portfolios has been very good over the years, but it is worth remembering that you may end up being in for the long haul - namely two to three years - so don't expect instant profits. It is also important to buy a decent number of our recommendations to diversify risk. Finally, with small-cap companies, market-makers could easily raise the price they are quoting by 10 to 15 per cent on publication day and our advice is to hold off for a few weeks, until the shares fall back.