Three Small-Caps That Graham Could Like

• ByJohn Reese, RealMoney Contributor
• On 4:00 pm EST, Monday November 2, 2009

If you are going to invest for the long term, it makes sense to invest using a strategy that has proven itself over the long term. No major investment strategy has been around longer than the one formulated by Benjamin Graham.

Graham was the Warren Buffett of his time, or perhaps it is more correct to say that Buffett is the Graham of his time. Graham taught Buffett at Columbia University, and later Buffett worked for Graham. Buffett has publicly stated on more than one occasion how indebted he is to Graham.

Buffett is not the only investor who regards Graham as a legend; many other savvy Wall Street investors appreciate Graham's approach to investing and his contributions to the world of investment strategies. Since 2003, I have followed trading strategies based on the approaches of some of Wall Street's greatest investors, and to date, the best-performing of them is Graham's, with a 169.0% return. This compares to the S&P 500's 6.7% return for the same time period.

The strategy has outperformed in six of the seven calendar years that I have followed it (2007 was the one year it underperformed), and it was down only 14.1% in the 2008 bear market, vs. a decline of 38.5% for the S&P 500. You can see year-by-year performance for my Graham based model at my Web site, Validea.com.

Graham was born in 1894 and died in 1976, so it is telling that investors still talk about him and that his investment approach still works more than 30 years after his death. This is a tribute to his astuteness as an investor and strategist. Graham did not view buying a stock as buying pieces of paper. Rather, he took the view that the investor was buying a piece of the company, including everything that came with it. This was a holistic view, with the investor buying the company's income streams, all its profits, all its assets and all its debts -- the real value of the company.

His thinking was that in the short term, stocks are unpredictable, but long term, stock prices tend to move with and reflect the real value of the business. The real value is measured by such variables as price-to-earnings and price-to-book ratios, sales levels, debt in relation to assets and the like. Graham believed that over the long term, stock prices reflect the underlying value of a business. So if you can buy the stock of a good company when that stock is relatively cheap, your chances of making money over time are quite good.

If this sounds prosaic and common-sense-like, it is. There's nothing fancy about Graham's approach. What's important is that over the decades, it has proven itself. If you want to build your net worth, Graham's strategy is as good an approach as exists.

Graham did not invest in very small companies (they had to be of adequate size, which is annual sales of $340 million or more), but he certainly appreciated the growth potential of small-caps. Currently, my Graham model is finding the most value in smaller-cap stocks, and given its track record, some of its current favorites might be worth taking a look at.

One is Triumph Group, whose market cap is $814 million. It makes components for the aerospace industry. For example, the company was just awarded a series of contracts by Sikorsky Aircraft to develop systems and critical components for the CH-53K helicopter that Sikorsky is developing for the U.S. Marine Corps.

A financial conservative, Graham required that a company's current ratio (current assets to current liabilities) be at least 2:1; Triumph easily passes this test with a current ratio of 4.22:1. In addition, long-term debt cannot exceed net current assets, and this holds true for Triumph. The strategy also wants EPS to have increased at least 30% over the past 10 years, and Triumph's has increased 66.4%. Another aspect of Triumph that would make it a Graham favorite is that its P/E ratio is not too high. Finally, when multiplying the P/E by the price-to-book ratio, the product cannot exceed 22. Triumph's is half this at 10.8.

Jakks Pacific, with a market cap of $425 million, also gets a high grade from the Graham strategy. The company manufactures toys and related products, and it licenses such brands as Nickelodeon, SpongeBob SquarePants and Finding Nemo. The company's current ratio is 2.12:1, and, to the Graham's strategy's delight, it has no debt. Long-term EPS growth has been a healthy 120.9%, and the P/B ratio times the P/E is a low 7.6.

The third stock that currently passes my Graham model is Cabela's, which has a market cap of $940 million. If you are unfamiliar with this Sidney, Neb.-based retailer and mail order purveyor of outdoor clothing and gear, it is probably because you live in a state where Cabela's has yet to open one of its huge stores, or you are not into hunting, fishing, boating or camping.

The company is well-known in its market, and it calls itself "the largest mail-order, retail and Internet outdoor outfitter in the world." The company's current ratio is 2.22:1, while its long-term debt of $490 million is well below its net current assets of $761 million. EPS has grown 61.2% during the past 10 years, and when its P/E is multiplied by its P/B, the result is 14.0, well below the strategy's 22 limit.

These stocks are well priced and their prospects are strong. The Graham strategy has proven itself over time and when it says a stock is worth a serious look, I definitely take notice. Not many investment approaches stand the test of time, but Graham's approach is one of those exceptions.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider JAKK to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Buzz up!