(MONEY Magazine) – Benjamin Graham would understand how investors feel today. He was the victim of an earlier bubble. After producing stellar investment returns in the 1920s, Graham's portfolio lost 70% of its value in the three-year market slump that followed the crash of 1929.

But that blow didn't knock him out of the game. Instead, his experience in that tumultuous period helped Graham devise the techniques that served him so well as the market slowly recovered over the next 20 years.

That means today, in the aftermath of our own market meltdown, is a particularly good time to revisit Graham.

Stocks are cheaper than they have been in years, so the current market is ripe for bargain hunting. Also, the fundamentals of the economy are improving, making it ever more likely that those inexpensive issues will soon rise.

So how do you pick stocks like Mr. Graham did? Even Graham himself was undecided on the best technique. Throughout his life, he continued to test different combinations of criteria--low price/earnings ratios or high dividend yields--to determine which would most reliably produce a list of stocks that were about to rise. "Graham would have certainly endorsed a number of value styles today," says Michael van Biema, a professor of finance at Columbia University, where Graham was once on the faculty. "If he were still alive, his investment technique would have evolved."

This article will explain Graham's basic investment philosophy. We'll go step by step through his two favorite stock-selection methods, adapting the techniques to fit today's market. Along the way, we'll highlight six companies that Graham might agree are good buys now.

Two paths to glory

Graham believed that any successful stock-selection strategy starts with determining a company's intrinsic value--its true worth. Calculating that value, though, is more art than science. Earnings aren't always a trustworthy guide. Assets are often less valuable than they appear. And liabilities are sometimes hidden. So when valuing a company, Graham took a very conservative approach, counting only those assets he could be reasonably confident about and ignoring questionable ones.

Even so, he knew that he could be wrong. So he developed the concept of a "margin of safety"--some assurance that even if he had overestimated the true value of a company, he was still getting a good deal. To create that margin of safety, Graham favored two methods: buying stocks that were selling substantially below the value of their assets, and selecting companies that boasted consistent earnings and solid financial foundations. The first approach tends to find troubled companies trading at bargain prices. The second approach turns up reliable performers at slight discounts. Over the long term, both are likely to generate healthy investment returns, but the first method will probably produce more home runs and more strikeouts along the way.

To find stocks that would catch Graham's eye today, we ran 1,500 large publicly traded companies through two different sets of screens to detect those that, according to Graham's definitions, are selling for much less than their true worth or are consistent earners. (We did our research using Thomson/Baseline, a service for institutions. You can search for stocks that meet some of Graham's criteria on such free websites as MultexInvestor .com and Quicken.com. But if you want to re-create Graham's favorite screens and our adapted versions, you will need to purchase more advanced stock-selection software.)

After running the screens, we looked for companies with the greatest prospects for earnings growth. In making our final picks, we tended to side with stocks that were also owned by well-known value investors with proven track records. While value investing--buying stocks that the rest of the market hates--is traditionally a lonely pursuit, we felt that we'd be more comfortable if we had some company in our contrarian picks.

Screen one: Asset plays

Graham thought that the most reliable guide to a company's value was its balance sheet. He approached a balance sheet as though the company were going out of business, figuring what the assets would fetch if they were sold on the open market. The difficulty with this approach is that not all assets on corporate balance sheets are logged at what they would sell for in liquidation. Accounting rules, for reasons that make sense only to accountants, call for valuing assets at what they cost at the time they were built or bought, not at their current value on the open market. "As you go further down a balance sheet you should trust it less," says Bill Nygren, portfolio manager of the Oakmark fund.

Cash, often the first item on a corporation's balance sheets, is probably the only asset where what you see is what you get. Dollars are dollars and worth the same to everyone. Go down the balance sheet and more of the dollars turn into cents. Accounts receivable--what a company is owed by customers who have bought its products but not paid yet--often comes next. Receivables are probably worth only about 90% of what they are valued at on the balance sheet. Collecting on those bills takes time and money, and some customers will never pay. Inventories, the next item, are worth even less. Raw materials often don't hold their value, especially if they're used for a product nobody wants anymore. (How much would you pay for the liquid that goes inside mood rings?) Farther down on the balance sheet is goodwill, which is essentially the amount a company overpaid for an acquisition. That's a classic paper asset--one that's not even worth what it's printed on.

Graham assumed that a company in liquidation would get value out of only a few items: cash, receivables and inventories--its current assets. He deducted debt from that figure to arrive at net current assets. He would buy a stock only when it was trading 33% below the value of the company's net current assets.

Graham developed his theories in the 1930s, a time when few people trusted the market. He was able to peruse hundreds of orphaned stocks that were trading for far less than their net current assets. Today, even after a three-year market decline, there are only a few dozen stocks trading 33% below the value of their net current assets, and most of them are so small that they're too risky for us to consider.

So we had to modify Graham's formula. In addition to cash, receivables and inventories, we decided to include plant, property and other tangible assets in our calculations. Here's our reasoning: Most companies in Graham's day were manufacturers, with a large amount of specialized fixed assets that were hard to sell. More and more companies these days are service-oriented. Their plants and equipment are office buildings, desks and Aeron chairs. Even manufacturing equipment is more adaptable now, making it easier to sell. We also added back such long-term assets as tax credits, which are harder to sell but do have some value. We still ignored intangible assets like goodwill. We deducted debt from our tangible-asset figure to arrive at net tangible assets.

We found 54 companies with market values that were less than their net tangible assets. Many of the companies were in the beaten-down technology and energy sectors. We also discovered a number of cheap retailers and insurers. (The full list is available at our website, www.money.com.) To make our final selections, we dug through financial statements, reading the notes to determine how hard the assets on the companies' balance sheets really were. To create the margin of safety Graham liked to have, we settled on companies with market caps that were at least 20% less than their net tangible assets. As we expected, many of them had significant business problems, but that goes with the territory.

Of the energy companies we turned up, El Paso has the most upside. The natural gas company has had its share of Enron-like issues. It recently agreed to pay $650 million to settle claims with regulators that it manipulated energy prices in California. But the company has one of the most valuable assets in the energy business--$18 billion worth of natural gas pipelines. Gas prices have climbed 80% over the past 12 months, and many economists are predicting that the trend will continue for the next few years; higher gas prices mean higher profits for El Paso. The company has shuttered its gas trading business and is returning to being a traditional energy company. Says David Dreman, a longtime value investor who owned 9.3 million El Paso shares at the end of the first quarter: "If you believe that the company has transitioned back to just a gas transmission company, then I think this is a stock that could double."

The disability insurance company UnumProvident is another promising stock that passed our asset screen. A number of juries recently have decided that UnumProvident unfairly denied claims. And the company had to restate its past three years of earnings because it improperly accounted for its investment portfolio. Finally, disability claims tend to increase and last longer in economic downturns, which could mean more big outlays for UnumProvident. But corporate executives say the percentage of claims that go to litigation has remained steady at 0.5%. The company's restatement amounted to about 2% of the $1.5 billion it has earned in the past three years. Also, the company has shifted its focus to group disability claims and away from the riskier business of liability insurance for individuals. Well-regarded Smith Barney analyst Colin Devine recently began recommending the company's shares.

Of the retailers on our list, we selected Circuit City. The electronics chain has lost sales and market share in the past few years to Best Buy and other competitors. But corporate executives are using studies of customer traffic patterns to redesign their stores and boost sales. They have also cut costs by taking salespeople off commission. Bill Nasgovitz, who owns 2.2 million shares in his Heartland Value fund, says Circuit City meets every one of his buying criteria. He believes the stock, recently at $6.76, can rise to $11.

Screen two: Consistent earners

Even though Graham believed strongly in buying stocks trading at less than their net current assets, he noticed that there were some shares you could buy at a premium to book value and still get solid returns. The key was to buy higher-quality companies--financially sound firms with a long history of steady earnings growth. In these cases, consistency would provide the margin of safety.

To find such stocks, Graham started with companies that had been reliably in the black over the preceding 10 years and had increased profits by at least a third over that time. He insisted on a 20-year record of dividend payments, another sign of financial stability. Of course, Graham still scrutinized balance sheets. He wanted companies with current assets that were double their current liabilities (giving a current ratio of at least 2), and at least equal to their total debt.

Finally, Graham looked at the stock's valuation. Instead of the price/earnings ratio commonly used today, he looked at the inverse--the earnings/price ratio, or earnings yield. This figure, he believed, should be 20% above the yield on a high-quality bond. In Graham's day, that generally would have translated to a P/E ratio of 15 or less.

Again, a screen this strict would produce precious few stocks today, so we modified it a bit. To construct our list of consistent earners, we started with companies that had averaged positive earnings over the past three years. We looked for growth over the past decade of at least 50%. We dropped the 20-years-of-dividends hurdle, asking only that the company be making payouts now. We stuck to Graham's benchmark of a current ratio of at least 2, but dropped the requirement that current assets had to be greater than total debt. A well-managed business doesn't need to have that much cash on hand, because it should be generating enough money to make its debt payments. We wanted price/earnings ratios (based on the average earnings for the past three years) of less than 18, which equates to an earnings yield of 5.6%--or 20% above the recent 10-year, AA-rated corporate bond yield of 4.6%.

We found 29 companies that met our criteria. (Again, go to www.money.com for the full list.) Many of them were home builders or in a related sector. Low interest rates, which drive home sales, have produced consistently rising earnings for the group. We have recommended home builders in the past and still like their prospects, even if interest rates have hit their lows. The largest home builders are taking market share, because their economies of scale allow them to produce homes cheaply and more profitably than their local competition. Of the bunch, Centex caught our eye, though we still like another stock that showed up on this screen, Lennar, which we recommended last month. Centex earned $8.83 a share in its fiscal 2003, which ended March 31. Management says the company can earn as much as $10.50 in fiscal 2004. The company is also exiting the lower-profit manufactured-housing market, which has weighed down its stock. The company's shares, at a recent $77.68, trade at 13 times last year's earnings.

Bond insurer MBIA, another stock we have recommended before (see "Rock-Solid Stocks" in the March issue), also fared well in our screens. The company boosted its earnings in the past year, even in the face of criticism that it was risking its bottom line by expanding into the more speculative credit derivatives market. Investors in the stock say that MBIA is properly diversified. Demand for MBIA's services is growing as more municipalities issue bonds to close budget gaps. Also, banks now turn such things as car loans and credit-card balances into bonds through securitization. Buyers of those bonds want insurance as well. Analysts believe that the company can earn $4.51 a share this year, up 15% from $3.92 in 2002. "As a cheap stock in book-value terms and a steady grower, MBIA is squarely in our strike zone," says Laura Jereski, an analyst at money-management firm Tweedy Browne, which owns 4.2 million shares and was once a broker for Graham.

Finally, it's not just the breakfast that is cheap at IHOP. Its shares are too. New CEO Julia Stewart is waking up growth at the flapjack joints by adding such breakfast items as stuffed French toast and expanding lunch and dinner offerings as well. She also altered the way the company finances new outlets, which will slow growth in the short run but will increase profits over the next few years. The moves are working. Sales at restaurants that have been open at least a year rose 2.2% in the first quarter, the largest such rise in more than five years.