Benjamin Graham “changed my life”, says Warren Buffett. In a recent interview with Fortune magazine, billionaire Buffett said that he would “probably still be delivering papers” if he hadn’t read Graham’s book The Intelligent Investor.
Graham is known as the father of value investing. He believed the best way to invest was to buy shares for less than their fair value, and then wait for them to rise. Today, I want to explain how I use Graham’s methods to help me find cheap stocks to buy for my portfolio.
The Graham method
Graham was the original source of many ideas that are associated with Buffett today. One example is the concept of margin of safety. This means buying shares that trade below their intrinsic value. This idea originated with Graham. He believed investors should aim to buy into a business when the market share price was below the stock’s true value.
Graham also introduced us to the idea of ‘Mr Market’. This imaginary person is prone to mood swings but shows up each day, offering different prices for our shares.
We can always choose to buy or sell, but we never have to. Buffett and Graham advise a patient approach, waiting until Mr Market offers the right price before taking action.
At the heart, Graham’s methods was the idea that investors should calculate the value of a business themselves. These valuation calculations can be useful, but they’re also quite complicated.
To hunt for ideas more quickly, I’ve developed a simpler method I can do using online stock screeners and free company information.
How I find cheap shares to buy
What I want to do is to find shares that are cheap and offer a margin of safety. As a starting point, I look for businesses with above-average dividend yields and low price/earnings ratios.
However, I want to try and make sure that I’m not buying into a company that’s in distress. To do this, I look at a company’s debt levels and check out the latest broker earnings forecasts.
What I’m looking for are cheap stocks with healthy finances and the ability to deliver rising profits. Ideally, I’d like a decent dividend yield too.
If I find a stock with all of these characteristics, then I do some more in-depth research. I want to understand how the business works, and why the shares might be cheap. If I’m happy with what I find and can see opportunities for growth, then I might consider buying the shares.
FTSE 100 companies that satisfy most of my value criteria at the moment include Tesco, Unilever and Imperial Brands. In the financial sector, I’m interested in Direct Line Insurance and Legal & General.
There’s no guarantee these businesses will do well in the future. Some may suffer unforeseen problems. But they’re all large, mainstream and profitable businesses, with strong brands.
These are qualities Buffett often looks for. I think they’d probably also be typical of the companies Graham might buy if he was still around today.
