Iconic value investor Ben Graham built a career and a pristine reputation buying companies trading below their intrinsic value and waiting for the market to recognize their true worth. Or better yet, well below their intrinsic value, giving him a margin of safety in case business conditions were to deteriorate, further depressing the company’s valuation. Warren Buffett, Graham’s most famous student, improved on this investment approach by proving that it’s acceptable for value investors to buy companies slightly above book value, provided that the underlying business is healthy, that it consistently generates ample cash flow and that it’s run by a skilled management team focused on the long term. Buffett argues that simply buying companies trading below their intrinsic value may lead to what he calls cigarette butt investing, by which he means something like this: if you’re walking down the street and see a cigarette butt laying on the floor, with one puff left in it, why not pick it up and smoke it since your price of doing so is zero? Then you’re left with nothing but a worthless cigarette butt that cost you nothing. Investors tempted to buy stocks simply because they trade below book value may end up owning the equivalent of a cigarette butt but not for nothing. The price they paid for that single puff may end up being too steep if the underlying business is a lousy one. Buffett’s best example of this: none other than the original Berkshire Hathaway, a New England textile manufacturer that he candidly describes today as one of his worst investments ever. And while Mr. Buffett would surely disagree with some of the stocks B400 selects twice a year, since many trade well above book value, his approach sounds a lot to us like yet another definition of GARP, or growth-at-a-reasonable-price, which brings us to the subject of this week’s newsletter. Are there any stocks in today’s market that might fit Buffett’s model after the historic run equities have had since the start of the current bull market?

We looked for answers to this question within the current crop of B400 constituents and came up with a few ideas, which we present below. Two in particular caught our attention, one of which we highlight further below: Sanderson Farms (SAFM), one of the largest poultry producers and processors in the U.S. The other one, well, just lends a bit of poetic charm and a lot of financial validation to our column: Berkshire Hathaway (BRK.B).

For starters, we filtered B400 down to only the stocks that have an overall grade above 65 and an overall value grade above 80, which allows us to assume that these are all healthy businesses whose stocks might be either overlooked or undervalued by the market. This culled our list down to 45 companies. We then focused on the companies trading closest to their intrinsic value, in this case using tangible book value as the best proxy for it, limiting the list to those stocks trading at or below three-times tangible book. This narrowed the list down to eight companies, all of which appear below. We then looked at a few fundamental metrics that would allows us to feel very comfortable with the health of the underlying business model, absent a complete qualitative analysis, which is why we ended up with Berkshire and Sanderson Farms as the two best examples of Buffett’s investing style. Berkshire we will not highlight since it’s a widely followed stock and since, well, it’s run by Buffett himself; the case for Sanderson Farms is made below. But before, the list of B400’s top eight value stocks based on Price to Tangible Book:

Ticker	Company Name	Industry	Overall Grade	Overall Value	P/Tang. Book	Fwd P/E	ROE	Op. Margin
PER	Sandridge Permian Trust	Oil & Gas Production	80.7	90.7	1.4	N/A	30.5	90.3
BRK.B	Berkshire Hathaway Inc. Class B	Industrial Conglomerates	73.3	80.7	2.0	20.3	9.0	18.3
SAFM	Sanderson Farms, Inc.	Food: Meat/Fish/Dairy	74.6	88.9	2.5	9.0	23.8	11.4
FINL	Finish Line, Inc. Class A	Apparel/Footwear Retail	70.6	81.1	2.6	15.8	14.6	7.8
TSN	Tyson Foods, Inc. Class A	Food: Meat/Fish/Dairy	68.3	82.6	2.9	12.1	14.7	4.5
APEI	American Public Education, Inc.	Other Consumer Services	66.4	86.6	2.9	13.4	18.7	19.1
ALK	Alaska Air Group, Inc.	Airlines	72.7	82.9	3.0	11.9	28.4	18.8
WRLD	World Acceptance Corporation	Finance/Rental/ Leasing	70.8	83.7	3.0	7.0	37.3	26.8

Sanderson Farms Inc. (SAFM)

Following yesterday’s drop of almost 3.5%, SAFM shares are down 13.5% since the stock hit a 52-week high of $102.59 on July 14th. And even though it rose briefly for a couple of sessions following its earnings report on the Tuesday before Labor Day, the sentiment surrounding the stock lately has been decidedly negative, which is among the factors we find most attractive at this valuation level. Based on yesterday’s close of $88.73 the stock trades at 2.5 times tangible book value per share (which is in this case the same as total book value per share since the company doesn’t report any intangible assets in its balance sheet) and nine times expected earnings per share for the next 12 months. The current price to book value is almost identical to what it was a year ago, when the company’s return on equity, based on trailing 12-month results, was 15.7%. Today’s return on equity, by comparison, is 27%.

For the 12 months ended on July 31 the company generated $147.73 million in free cash flow, or 5.4% of total revenue, which compares very favorably to Tyson Foods (TSN), one of Sanderson Farms’ industry peers, which also happens to be in today’s list (see above). Their free cash flow represents only 1.2% of total sales. And this considering the ongoing capital expenditures Sanderson Farms is currently incurring as it is building two new facilities, in Texas and North Carolina, expected to be operational in 2015 and 2016 respectively, that are likely to add 26% to 27% to their production capacity, according to analysts who follow the company. Even more impressively, the company managed to double its operating margin in the last year, from 5.7% to 11.4%, which is pretty remarkable for a consumer staples company. Tyson Food’s operating margin, by comparison, is 4.5%. Oh, and Sanderson Farms’ total debt of $20 million represents less than 2.5% of total capital and, could, in fact, be paid seven times over with the cash the company has on hand.

From a qualitative perspective, the current protein shortage in the U.S., largely a result of dwindling cattle herds caused by persistent droughts across the country, should favor chicken as a viable and cost effective substitute, which is pretty much all that Sanderson Farms produces. Warrant Buffett likes to say that no matter which way the world goes, people won’t stop drinking Coke or eating Dilly Bars (in reference to two of Berkshire’s holdings, Coca-Cola and Dairy Queen), to which we might add that it’s unlikely they will stop eating chicken. Given the considerable margin of safety built into SAFM’s shares at current prices, we wouldn’t be surprised to see a savvy value investor scoop this company up. And B400 investors should rest easy about the index’s ability to continue finding solid companies priced reasonably in the years ahead, especially with its next rebalance a short two weeks away.