How to find ridiculously cheap stocks

Ask an expert what works in investing, and quite often you'll get the reply: "buy cheap stocks".

That's all well and good. But how?

The first problem is finding something cheap. This isn't as easy as it may sound. You might be fortunate, and have a really good understanding of a company and its prospects, which can allow you to take advantage of a low stock price.

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However, often stocks look cheap for a good reason they are bad companies. Many investors have been burned after buying what they thought was a cheap stock, only to end up sitting on heavy losses a short while later.

But what if there was an investment approach that tracked down really cheap stocks for you? Stocks that were so beaten up, so unloved, that were on sale for such low prices that you almost couldn't go wrong?

There's one classic approach that does this and better yet, it uncovers a few stocks that are at least worth keeping an eye on right now

Benjamin Graham and cigar butt' investing

Ben Graham - the so-called 'father of value investing' - devised a strategy of buying very unloved stocks. He would aim to buy stocks for less than the value of their net current assets.

He would take the value of cash, stocks and debtors on a company's balance sheet, then deduct all the company's liabilities. No value would be given to assets like plant and machinery. These stocks became known as 'net nets' meaning net working capital, net of all other liabilities.

Graham reasoned that if he could buy stocks for less than two thirds of what he called their net current asset value, he could do quite well. He was buying stocks that were so beaten down that even if the worst came to the worst and the company had to be liquidated, he could still potentially make money.

Graham did well using this strategy, making money even during the Great Depression. But it's worth understanding that just because this is a value' strategy, doesn't make it low risk.

Indeed, this is only for adventurous investors. When you're fishing for stocks that are this beaten up, sometimes they're going to go bust, and you'll lose all the money you invested in them. Graham often diversified his holdings across up to 100 stocks when using this strategy.

You also need plenty of patience. It can often take some time for the stockmarket to confirm whether your reasoning is right or not.

Net nets' and the UK stock market

So are there any net net stocks on the UK market now? The answer is yes, but not many.

The best way to find them is to use a stock screener. Websites such as Stockopedia have their own tailor-made Ben Graham screen, but charge £14.99 per month (after a 14 day free trial).

Alternatively, you can use free screeners and look for stocks trading at less than book value (the book value of the company's equity or shareholders' funds) and then do a bit of legwork by subtracting the fixed assets from this figure to see if there are any candidates.

After a bit of number crunching, I've come up with two net net' stocks and another to keep an eye on. They are shown in the table below:

The first thing to note is that not many stocks meet these criteria. This probably reflects two things: firstly that the UK stockmarket is not screamingly cheap; secondly, that there aren't many types of company that are capable of meeting these criteria. Retailers and manufacturers which can carry lots of stock are the obvious candidates.

Let's take the names on the list one by one. Is house builder Bovis (LSE: BVS) really cheap? It trades below both its book value and its net working capital value. But a closer examination of its balance sheet suggests that some caution may be needed.

The bulk of its working capital value rests with the value of its land bank. If you believe that this is correctly valued on its balance sheet, then the shares may be cheap. But if you think that house prices may fall further and that this land may have to be written down in value, then you might want to pass on Bovis.

What about French Connection (LSE: FCCN)? This looks like a classic beaten up stock, trading at just one third of its working capital value. Despite dire trading in its core UK business, it has a recognised brand and no debt on its balance sheet. Surely this is a very cheap stock?

Well it might be, but for one thing it rents all of its stores and has obligations to keep on paying rent for an agreed time, or face paying exit penalties. If the exit penalties are small, French Connection could be a net net stock. The chances are that they are not, and that the low stock price could be about right.

The same caveat on leases applies to Home Retail Group (LSE: HOME). Its shares are still some way from their net working capital value, but are very unloved.

So it appears that there are very few, if any, really cheap stocks that are screaming buys out there. But does that mean that Graham's net working capital approach isn't worth bothering with? Not at all.

Calculating the working capital value per share and comparing it with the current share price is good way of screening for distressed investment candidates. There may be extra value in fixed assets or brands that could spark a takeover approach, which often happens when sentiment is bad. That's why, although I'd be wary of investing now, the three stocks listed above are certainly worth monitoring in the months ahead.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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