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Analyzing intrinsic value unearths some bargain stocks

December 1, 2008
With the Dow Jones industrial average fluctuating around the 8,000 level, investors looking at business valuations — and who are able to ignore the toll a nasty bear market exacts on one's psyche — likely will conclude there are companies selling at prices less than their intrinsic values.

Intrinsic value can be defined as the discounted value of the cash that can be taken out of a business during its remaining life. It is the estimated price a rational investor would pay to acquire the entire business based on an analysis of all the relevant facts.

Today, all sorts of market measures point to significant undervaluation. According to Barron's, the recent 11-year low of 741 on the S&P 500 was further below its all-time high than at any time since 1949. If 2008 had ended at that low, it would be off for the year by almost 50 percent. That would rank as the worst calendar performance for the index since 1872.

The S&P hasn't been this far below its 200-day moving average since 1932. Amazingly, almost 40 percent of the stocks that make up the S&P 500 index would not qualify today since their valuations are below the minimum $4 billion market value needed to join. And for the first time since 1958, the dividend yield on the S&P 500 has risen above the yield on a 10-year Treasury bond.

Another telling sign that stocks are cheap is the reappearance of stocks selling below their net current asset value, also called "net-nets." In 1932, the investor Ben Graham wrote a three-part series in Forbes titled, "Is American Business Worth More Dead than Alive?" Graham provided a list of companies that were selling below this theoretical liquidation value. The net-net calculation is simply the current assets on a company's balance sheet (which include cash, accounts receivables and inventory) minus the liabilities of the firm (current liabilities plus long-term debt). If the market value of the stock is at or below net current asset value, the investor essentially gets the fixed assets of the business-the property, plant and equipment-for free.

Around 100 companies fit these characteristics today, and the list is likely to grow. Graham recognized that these were typically businesses that had fallen on tough times and were extremely out of favor. However, he reasoned that a diversified portfolio of net-nets, bought at two-thirds of the net current asset value (thus allowing for a 50-percent gain back to 100 percent), would provide good results. Graham later calculated that his investments into net current assets stocks provided a 20-percent annual rate of return over a 30-year period.

In spite of the above, experienced investors know that just because stocks appear cheap doesn't mean they can't get cheaper. (Just as overpriced stocks in a bull market can rise even higher.) And that is the challenge facing investors today-how long and how deep will this downturn endure? Since nobody can answer that question, the wise investor will continue to allocate cash into undervalued securities, increasing his purchases the further stocks fall.

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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