Al Frank (2)

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One of the things I like about Al Frank's book, Al Frank's New Prudent Investor, is his repeated emphasis of the fact that investing need not be difficult.  Wall Street perpetuates the myth that it takes advanced degrees, a genius IQ and esoteric analysis of all sorts of business minutiae in order to succeed in the market.  He argued against that as follows:

There is no limit to the amount of inquiry and effort analysts can expend evaluating a corporation, but it is not necessary to go into great or subtle detail.  A selection of relatively gross measures is usually sufficient to make such evaluations and selections for successful stock speculation.

Mr. Frank listed seven criteria which he felt were good indicators of a corporation whose stock merited consideration.  He listed them as follows:

1. Price to earnings (P/E).  Normally, industrial stocks trading below 10 times earnings to 30 percent below their P/E norm (average P/E).

2. Price to sales or revenues (P/R).  Normally, stocks trading near their out-of-favor levels or below their accepted P/R levels.

3.  Price to book value (P/BV).  Normally, stocks trading below their book value per share of 30 percent below their book value norm.

4. Price to cash flow (P/CF).  Normally, stocks trading at less than six times cash flow or 30 percent below their cash flow norm.

5. Return on equity or net worth (ROE).  Normally, stocks trading at a 15 percent return on equity or better. (Likewise a return of 15 percent or better on the cost of shares).

6.  Market capitalization (market cap).  Normally, stocks with a market capitalization of less than $200 million (computed as shares outstanding times price per share) are considered "small cap."  While returns on small company stocks (below $100 million in market cap) are significant over long time periods, I tend to buy bargains in value and growth of any size market-capitalization stock, especially as a mix can aid diversification (risk reduction) for those periods when large-cap stocks outperform small-cap stocks.

7. Return on assets (ROA).  Normally stocks trading for an ROA comparable to or higher than their historical ROA, although somewhat lower ROAs in stocks found to be otherwise undervalued may indicate room for improvement.  Pay attention to the trend of this component, as well as in all the other criteria.

When referencing an "average" ratio, its "norm" or the ratio's "accepted level", Mr. Frank means the average for that criteria for the previous 5 years.  This means an investor might have to do some digging, but it is worth the effort.  Looking at a 5 year average for a company's financial metrics minimizes the effect of what would be an abnormal ratio for a company due to any unusual economic or financial forces currently affecting it.

Mr. Frank was also a strong proponent of diversification, as reflected in his comment in criteria number 6 above.  Like Carret and Graham, he recommended a portfolio with a number of stocks.  He had the following to say about diversification:

I want to be widely diversified with many different stocks from several industries in my portfolio.  I want to have at least 25 or preferably 35 or more stocks in 15 to 17 different industries in a portfolio, so that when 5 or 10 stocks underperform, that result is offset by the good performance of the 15 or 25 others.

We will continue with Mr. Frank in the next blog.

The material from Al Frank's New Prudent Speculator by Al Frank, copyright 1995 by Al Frank, is used with permission of the copyright holders, the heirs of Al Frank.

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