The Almighty Investment Strategy Following the Footsteps of Ben Graham

This is a guest post by Evan Blekker, founder of netnethunter.com

What’s the best way to invest $50 000 in cash?

One thing that shocks me is just how many investors go into investing without a clear and focused strategy. They hear a rumor from Uncle Tom and invest, or just plow their money into a hot stock because they like the product or growth trajectory. It’s the select few that actually consider the investing strategies open to them.

To be fair, finding a strategy is tough.

There are a lot of strategies open to investors. Deciding on a mechanical investment strategy is equally difficult.

Since at least the early 2000, investors have been bombarded with a whole host of new, promising, mechanical investment strategies. With the Magic Formula, Piotroski formula, or ERP5 stocks all vying for contention. The number of choices make it really tough to make a strategic decision.

Personally, the decision came down to choosing the strategy that made the most intuitive sense, and also had the longest verifiable record of working as advertised.

While a lot of formulas seemed promising, only one seemed to fit what I was looking for – Benjamin Graham’s classic low price to Net Current Asset strategy.

So Simple a Caveman Could Do It

Despite the strategy’s age and exceptionally good returns, most of the investment community is completely unaware of its existence.

The strategy is really simple.

Investors screen for a subset of low price to book stocks. Essentially investors are looking for companies that are trading below liquidation value but, rather than just using book value as a measure of liquidation value, investors completely ignore long term assets in their calculations.

The formula is written as:

Net Current Assets = Current Assets – (Total Liabilities + Preferred Shares)

From here, you just divide the market cap by the net current asset value to get a measure of how cheap the company is on a liquidation basis.

Market Capitalization / Net Current Assets = X%

Simple.

Amazing Returns

In a digitally saturated world, it might be surprising that such a simple strategy could work so well, but study after study has come out showing that low price to NCAV stocks outperform – a lot.

If you read old school value, you have probably been in the value investing game for a while now. You also know that Buffett achieved his highest returns back when he was running his investment partnership instead of the 2000 decade.

His results are a matter of public record – and we have all of his partnership letters available at Net Net Hunter.

From 1957 to 1968 Buffett achieved a fantastic record, racking up investment returns just north of 31% per year, and he did this primarily by using a net net stock strategy.

Other investors have had similar results.

More recently, Peter Cundill was able to put together a great record for unit holders at his Cundill Value Fund, 26% over the first ten years, and 19% over the first 20.

Still not convinced, or think that this is a dangerous way to invest? There are a number of studies on the  performance of Ben Graham’s net net stock strategy. All of them show tremendous results.

Studying Different Systematic Value Investing Strategies on the Eurozone Stock Market looked at the 2000-2010 period. It found that even taking into account the great crash of 2008-2009, a net net stock portfolio would return just over 300% at the end of that ten year period, far higher than the market itself.

Net Nets are Garbage. Why Buy Garbage?

One of the reasons that investors don’t flock to this investment style is because most net nets are garbage. Investors don’t want to own garbage.

Net nets usually run into major business problems and some are bleeding a lot of red. The situation looks bleak and investors are generally pessimistic about the company’s future.

Cigar butts, dumpster-diving for stocks, the worst of the market, whatever people call it, investors are generally afraid to own these types of companies. Instead, they prefer to buy big beautiful names like Google, Amazon, or Facebook.

That’s totally fine by me. Long term investment profits are made by investors who have a good handle over their emotions.

Do investors have a right to be fearful of these stocks? Not according to Buffett.

Buried deep within the Buffett Partnership letters Buffett tells investors that about 80% of these investments will work out within 2 years. That’s definitely been my experience and the stocks that haven’t worked out haven’t been big losers, either.

• About 10% of the net net stocks I buy fumble around near my purchase price, never reaching full NCAV while I own them.
• 10% percent lead to moderate losses.
• Of the 80% that have worked out, some have doubled in less than a year and most have met my sell target in less than three years.

In the end, the gains made from the stocks that work out more than offset the bad apples.

So, why do these stocks work out so well?

The price to value discrepancy definitely has something to do with it. If you think of all the possible ways you can value a company, looking at a strict measure of liquidation value is among the most conservative.

Forget paying for future earnings, or even current earnings – net net stock investors don’t even pay for the full net value of the company’s assets. The figures used in the valuation are rock solid too. While earnings projections often miss and current earnings may not stay current for very long, a company’s net current asset figure is much easier to calculate and depend on.

Four Ways a Net Net Makes You Money

While the valuation is based on a conservative liquidation estimate, investors tend to profit through one of four events.

1. Take overs
2. Turnarounds
3. Liquidation
4. Dead-cat bounce

Let’s start with takeovers.

A net net stock fits the criteria because it has the right mixture of assets and liabilities on the balance sheet. Namely, assets with highly certain values and comparatively few liabilities. This means that these companies are often very conservatively financed.

Combine an extremely low price with a conservative balance sheet and you get a prime takeover candidate. Even though these companies have major problems they’re working through, other firms routinely spot attractive assets and swoop in to make a bid.

Of all the net net stocks that I’ve held, maybe 40% have been taken over at a price far above where I bought.

Turnarounds are nearly as common as takeovers.

I’m usually able to spot a turnaround in mid-turn, such as the one that took place at Trans World Entertainment. Trans World found itself in an unfortunate place, selling CDs and DVDs as iPods, iPhones, and digital media began to take off.

As a result, many of their stores started losing money. When I found the company, management was busy trimming its store count and changing its merchandising mix. It was obvious to anybody who had ever dug into the financial statements of a retail company just what was going to happen.

I bought too late.

If I bought in 2009 I would have made roughly 700% by 2013. Instead I doubled my money in a little over a year.

Ironically, while the investment strategy bases its valuation on liquidation value, few net nets actually liquidate.

Personally, I have never had one of my firms liquidate, but I would prefer it if they did. Since I buy below liquidation value, liquidating would mean I profit much sooner – immediately after the announcement as the price is bid up, essentially.

That leaves us with the dead-cat bounce.

Investors as a rule have no stomach for big business problems. Instead of staying on course when a crisis hits, investors start dumping the stock. The price of net net stocks hints that investors see these companies as worth more dead than alive… but that liquidation won’t happen anytime soon.

These stocks are typically dead-cheap and investors are extremely pessimistic. Any improvement in the company’s situation often attracts optimistic new buyers, sending the share price flying. Just take a look at what happened to IFON (not to be confused with iPhone) in January 2012.

Alright, What’s the Catch?

For starters, forget winning friends at cocktail parties.

Investors are infatuated with big beautiful names like Salesforce and Netflix.

If you start talking about the problems at fish-packing plant company you just bought, then even your best friends will likely make excuses to find somebody else to talk to about Netflix.

Garbage is not sexy.

A much bigger problem is the lack of investment opportunities during average or heated market conditions.

Net net stocks are not easy to find in the American markets these days. See Jae’s article on what the number of net nets in a market tells you.

To put together a high quality net net stock portfolio, investors have to start looking internationally.

Canada, the UK, Ireland, New Zealand, Australia – these friendly English speaking countries have vibrant world-class markets that net net stock investors should take advantage of.

That’s why Net Net Hunter has focused its members’ site on international net net stocks, allowing members to find great net net stock ideas quickly and easily. If you can’t find enough opportunities in your home country then you have to increase your stock universe. You have to start flipping over more rocks.

The Rest is Up to You

The great thing about Graham’s net net stock strategy is that larger sophisticated investors can’t use it.

Net net stocks are usually very small and only have enough volume to handle smaller portfolios. As soon as someone’s portfolio starts approaching $10-20 million it becomes more difficult to buy net net stocks. This keeps them from being picked over by value investment firms and makes the strategy perfect for investors like you and me.

Investors interested in value investing really can’t go wrong by adopting a net net strategy.

The strategy is so easy and has shown to work so well for so many years that it would be a real mistake not to incorporate it into your portfolio.

Here’s my plug. Value investors can start by subscribing to Net Net Hunter’s free net net stock suggestions – there’s a sign up box just below each of our posts.

On the other hand, if you’re ready to turbocharge your portfolio returns, if you’re ready to make net net stocks a core part of your portfolio, then sign up for full Net Net Hunter Membership. The profit you’ll make off of even just one net net stock will be enough to pay for membership for years.

About Evan

Evan Bleker is author of Net Net Hunter, a site dedicated to international net net stocks. It often pays to look outside of your own backyard when investing. Net Net Hunter is a community based site helping investors make the most of their financial future. If you’re ready to earn 25% annual returns by making net net stocks a key part of your portfolio then sign up for a full Net Net Hunter membership.