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How to spot a bargain

Here is a method from Benjamin Graham that can help you pick stocks at throwaway prices

How to spot a bargain

People usually invest in the shares of companies that they expect will grow. Benjamin Graham, the legendary value investor of yore, came up with a method to pick companies which had obvious growth prospects. In 1949, Graham wrote a book The Intelligent Investor, which introduced this method, called the 'net-net' ratio. It helped Graham select stocks which were trading close to their liquidation value - the market thought they were more likely to go bankrupt than reach the proverbial commanding heights. There are two components of the net-net ratio:

1. Net current asset value (NCAV) = Current assets - Total liabilities
2. Net net working capital (NNWC) = Cash + Short-term investments + (0.75 × Debtors) + (0.50 × Inventory) - Total liabilities

Graham's method picked companies that were trading below 66 per cent of their NCAV or NNWC.

Danger ahead?

The market is thought to be efficient. There are usually good reasons for a stock to trade at rock-bottom prices. These could range from the loss of a major customer to technological obsolescence to management troubles and much else. Graham proposed that even in case of bankruptcy, stocks would earn a positive return for the buyers following the net-net method. This is because the entry price gives an investor the company's fixed assets and future profits (if any) for free.

Sifting through the wreckage

An investor following this method needs to ascertain the reasons for the stock's fall from grace and determine if its position is likely to worsen significantly. He also needs to keep a close eye on the promoter - a key determinant of the company's future direction. Also, bankruptcy in India is a slow, time-consuming and costly process (though the passage of the bankruptcy code is likely to smoothen it). Here's a four point roadmap for the bargain hunter:
1. Filter the stocks that are trading 66 per cent below their NNWC or their NCAV.
2. Look for the reasons responsible for the wreckage.
3. Determine if the reasons are fully priced in. Can it get much worse?
4. Gauge the promoter's ability and willingness to revive the business.

We have put together a list of stocks selected on the basis of the net-net ratio. However, we have used a less stringent 30 per cent discount to NNWC and NCAV. This still gives buyers a substantial safety net in case of bankruptcy. In order to further refine the results and eliminate any bad surprises, we focused on cash flows.

The first table lists the companies which have a positive free-cash-flow yield (which is obtained by dividing free cash flow by market cap). These companies have sound cash flows and are likely to be more promising. The second table lists the companies which have negative free-cash-flow yields.

The lists above are based on quantitative filters and don't consist of our recommendations.

How to spot a bargain