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A simple way to get rich

Every year, in early September, retailers roll out huge signs to announce the great deals they're offering on pencils, calculators, notebooks and everything else a student needs. But frugal students - an unusual clique to be sure - learn a lesson if they wait only a few weeks. Then, with little fanfare, the school gear quietly goes on sale. The lesson? The best deals come when nobody else is shopping.

You can apply that lesson in the stock market as easily as you can in a store. Smart students of investing pass up the glamour sectors and hot companies du jour. They shop instead for solid companies that, for one reason or another, are out of season.

If you're looking for a quick way to identify these companies, I suggest taking a tip from Benjamin Graham, the legendary Wall Street financier and Columbia University professor who taught Warren Buffett about investing. Graham devised many techniques for identifying undervalued companies, but particularly remarkable is the record of his Simple Way formula, which he outlined in a 1976 article called The Simplest Way to Select Bargain Stocks. Despite its utter lack of complexity, this recipe has been a smashing success.

I highlighted the Simple Way to MoneySense readers in early 2004 and I provided an update in 2005. I'm pleased to report that both batches of Simple Way stocks have performed superbly, gaining an average of 45.2% in less than 32 months, not including dividends. Over the same period the S&P500 was up only 16.3%.

The 15.2% annualized return provided by MoneySense's Simple Way stocks is remarkably close to what the master himself would have predicted. Back in 1976, Graham calculated that the Simple Way would have provided investors with fairly consistent 15% average annual returns during the prior fifty years.

The Simple Way is built on two principles: stocks should be cheap and they should be relatively safe. Graham began by defining a cheap stock as one with an earnings yield that was at least twice as large as the average yield on long-term AAA corporate bonds. The yield on 20-year AAA U.S. corporate bonds was 6.1% at the time I selected my new batch of Graham stocks, so I looked for stocks with earnings yields of 12.2% or more.

Don't let the terminology confuse you: the earnings yield on a stock is simply the earnings per share divided by the share price (expressed as a percentage). It's the inverse of the more popular price-to-earnings ratio. An easy way to convert an earnings yield to a P/E ratio is to divide 100 by the earnings yield. So, looking for stocks with an earnings yield of 12.2% or more is roughly equivalent to searching for stocks that possess a P/E ratio of 8.2 or less.

We now come to the safety side of the Simple Way formula. Graham was battered and bruised by the crash of 1929 and the subsequent Great Depression. Perhaps as a result, he detested excessive debt and insisted his chosen companies be well capitalized as a hedge against bad times. He stuck to stocks with leverage ratios (the ratio of total assets to shareholder's equity) of two or less.

When it came to selling, Graham suggested waiting for either a 50% profit or for no later than the end of the second calendar year after purchase. If, as Graham recommended, MoneySense readers had sold after a 50% rise then the average annualized performance of our Graham stocks, not including dividends, would have been 20.7% compared to a 5.9% annualized gain for the S&P500. For simplicity sake, though, I like to stick to the more straightforward approach of selling the previous crop of Graham stocks when I pick a new bunch.

With Graham's criteria in hand, I used the msn.com deluxe stock screener to find this yearís list of interesting candidates. Because our minimum earnings yield shot up on higher bond yields, I decided to widen my net and focus on U.S. stocks with market capitalizations of more than $1.5 billion, which is down from the $2.5 billion used last year. (All figures are in U.S. dollars.)

The 2006 Bargain Bin is filled with an eclectic mix of old-economy and new-economy companies. Oil and gas companies remain popular with Apache Corp (APA), Anadarko Petroleum (APC), and Cimarex Energy (XEC) getting the nod. But cheek-by-jowl with these energy firms, you find drug and technology companies such as RealNetworks (RNWK) and beleaguered Biovail (BVF). Drug maker Biovail is a riskier pick and comes with a good dose of controversy. Youíll get a sense of the soap opera by reading the companyís regulatory fillings, news stories, and the Ontario Securities Commissionís recent accusations against Biovailís chairman. With such a diverse group, you should be able to find a Graham-style bargain that piques your interest.

I have high hopes that Grahamís method will continue to do well in the long run, but all the usual warnings apply. Be sure to use Grahamís list as a starting point for further research and not the final destination. Dig deeper and do your own homework before diving in.

Bargain Bin 2006: Benjamin Graham, the famed value investor, would have loved these stocks for their combination of value and low cost
CompanyIndustryMarket Cap ($M)Price P/E Leverage Ratio Dividend Yield
Apache Corp (APA) Independent Oil & Gas 22,082 $67.07 7.8 1.9 0.6%
Anadarko Petroleum (APC) Independent Oil & Gas 20,834 $44.95 7.1 2.0 0.8%
American Capital (ACAS) Diversified Investments 5,354 $37.65 7.4 1.9 8.8%
IPSCO (IPS) Steel & Iron 4,351 $92.20 7.3 1.4 0.8%
Cimarex Energy (XEC) Independent Oil & Gas 3,118 $37.69 7.5 1.7 0.4%
Biovail (BVF) Drug Delivery 2,698 $16.84 7.4 1.6 3.0%
Overseas Shipholding (OSG) Shipping 2,668 $67.47 7.1 1.8 1.5%
Kennametal (KMT) Machine Tools & Accessories 2,053 $51.87 8.0 2.0 1.5%
Louisiana-Pacific (LPX) Lumber, Wood Production 2,003 $19.04 5.4 1.7 3.2%
M.D.C. Holdings (MDC) Residential Construction 1,916 $42.61 4.0 1.9 2.3%
Seaboard Corp (SEB) Meat Products 1,719 $1,363.00 6.7 1.7 0.2%
RealNetworks (RNWK) Internet Software & Services 1,665 $10.39 5.1 1.4 0.0%
Source: MSN.com, August 23, 2006

From the October 2006 issue.

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