How 16 Benjamin Graham Inspired Rules Return 38% Annually

Everybody is looking for stocks that will increase in price but few investors focus on increasing the value of their entire portfolio.

Ironic, isn't it?

A rising stock can make you money but it's your portfolio returns that increase your net worth. You really have to look at your portfolio as a whole to be a successful investor -- and that's why I focus so much on playing probabilities.

Probabilistic investing means putting together a portfolio based around some criteria that has been shown to yield solid average yearly returns in the past. It means seeking out a base rate, a rate of return typical of specific types of stocks, and then putting together a portfolio of those stocks with the goal of trying to mirror that base rate. This could mean building a portfolio based around low PE, PB, or PCF stocks.

If you're like me, however, and you want the highest possible returns than it means putting together a portfolio of NCAV stocks and then leveraging additional criteria to boost your returns.

...when it comes to growing your own net worth through investing, limit your downside and the upside will take care of itself.

Instead of putting together a portfolio of stocks that stack the odds of great returns in their favour, however, many people look for lottery type stocks. They focus on trying to find stocks that will increase in price in dramatic fashion and don't pay much attention to the downside risk.

Benjamin Graham, obviously, understood this to be a serious mistake. According to both Benjamin Graham and Warren Buffett, safety should be a primary concern when investing since risk leads to losses which in turn erode your overall returns and can even leave you broke.

When it comes to my own investments, my philosophy is focused as much on avoiding losses as it is on seeking out high potential opportunities. When I invest, I follow Warren Buffett's two rules religiously:

  1. Never lose money, and
  2. never forget rule #1.

Only after I judge that a stock is unlikely to lead to losses do I focus on the upside potential. Screening out firms with specific characteristics helps decrease the chances that you'll suffer large losses on any stock in your portfolio. It's these kind of companies that I pass on to those who signed up to receive free net net stock ideas.

Value Investing? Avoid investment losses.
Value Investing? Avoid investment losses.

Ultimately, when it comes to growing your own net worth through investing, limit your downside and the upside will take care of itself.

How to Adapt Benjamin Graham for Safety and Profit

I think everyone should use a checklist when putting together a great classic Benjamin Graham portfolio. A checklist will help you avoid mistakes by focusing your attention on key factors that you might otherwise gloss-over.

I've put together a NCAV investment scorecard to assess the investment merit of each net net stock I come across. My checklist has been put together based on a detailed study of Benjamin Graham and an analysis of a number of different studies that examine the returns of various NCAV stock portfolios. While I've focused on Benjamin Graham to form the base of my portfolio, it's hard to argue with the data that's come out of these scientific studies. As a result, my criteria reflects a blend of Benjamin Graham and findings in contemporary scientific studies.

Let's run through our Net Net Hunter Core7 scorecard briefly before we see how I would apply it to a specific stock:

Core NCAV Criteria

  1. Not Chinese -- There have been many reverse takeover scams that have left investors with large losses. Most Chinese net nets have been penalized in the market due to allegations of fraud. Ultimately, who knows what the asset value of these companies are.
  2. Low Price to NCAV -- The cheaper you buy your stocks the fewer paper losses you'll suffer and the greater your ultimate returns will be. Even if any one of your cheap net nets doesn't bounce back up to full NCAV you can still make money.
  3. Low Debt-to-Equity --  Debt can be a huge benefit to a company when times are good, but destroy a company when it runs into problems. Debt-free troubled companies can't go bankrupt.
  4. Adequate Past Earnings or Catalyst -- I want to invest in firms that have run into major, yet solvable, problems. Companies with a history of barely scraping by could stay valued below NCAV for a very long time. Obviously this doesn't matter if there's a catalyst on the horizon that will either move the stock price or increase profitability.
  5. Past Price Above NCAV or Catalyst -- This is a good way to tell whether you're buying into a perennial net net or not. I want to see a company that has traded above its NCAV sometime in its recent history, sometime in the past 5 years. The same catalyst clause applies here, as well.
  6. Existing Operations or Liquidation -- When investing in tiny companies, sometimes management will sit on a big bank account "managing" it while they collect large salaries. This is a great way to erode shareholder value slowly while making themselves rich. Avoid Avoid Avoid.
  7. Not Selling Shares -- If a company is using equity financing when the firm's shares are drastically undervalued then it's destroying value, destroying your potential for capital gains, and indicating that it's in a very difficult spot with few options. Why else would management choose to destroy value like that?

Key Quantitative NCAV Criteria

  1. Large Current Ratio -- A larger current ratio is an insolvency buffer. I want the firms I invest in to be able to cover their current liabilities as easily as possible. A larger current ratio also means that the firm's balance sheet can erode to a greater degree without having a large impact on the firm's NCAV.
  2. Small Market Cap -- Tiny firms are correlated with large outperformance so I want to stick with smaller firms. Large net nets may have serious problems since there are more large institutional investors who can purchase them but haven't.
  3. Low Price to Net Cash -- I like situations where the firm is trading below net cash (cash less ALL liabilities) since these firms are paying me to buy stock. The value of cash is also highly certain, since $1 usually equals $1 while other assets might be worth more or less than stated value.

Key Qualitative NCAV Criteria

  1. Financial/regulated/ADR/Real Estate/closed fund -- Avoid. I generally understand these less than I do retail or manufacturing companies so I stay away from them. This will change as my circle of competence shifts.
  2. Company is Buying Back Stock - This is a great sign because it displays management's confidence in the business's future, plus increases the NCAV per share for remaining investors.
  3. Insider Ownership -- If management's money is on the line then they will have an incentive to realize the maximum shareholder value.
  4. Major/Minor Insider Buys Vs. Sells -- I look for insider buys because I see it as a vote of confidence while I don't like to see management cash out at deflated prices. While buys are a stronger signal than sells, both are important.
  5. Burn Rate -- The rate at which the firm's NCAV is eroding provides a good estimate of the amount of runway you have left before your deep value stock isn't much of a bargain anymore. I want a small or positive burn rate.
  6. Catalyst -- A catalyst isn't necessary but it is a bonus. I like situations where shareholder value will be unlocked sooner.

If you want a more detailed discussion of some of these items, then click to visit My NCAV Investment Scorecard. So let's see how I used this scorecard to assess one of the stocks that I came across last January.

The Life and Death of Albemarle & Bond Holdings

Albemarle & Bond Holdings was a British company traded on the London Stock Exchange. The company first caught my eye in January when I was scanning through our website's Raw Screens looking for possible investments. The company's stock was cheap -- dirt cheap. Rather than the minimum 1/3rd discount needed to be shown for me to even consider the investment, Albemarle & Bond was priced at just 20% of NCAV -- a massive 80% discount to intrinsic value.

Albemarle & Bond operated pawn shops in the UK. It's main business was gold. The idea was to let poor broke people come into the shop and pawn off family heirlooms so they could make the rent. The pawnshops would under pay for the gold, netting a bit of a spread for their services.

I opened up Finder on my Mac and then pulled up my investment scorecard so I could do a quick analysis before digging deeper.

Core NCAV Criteria

  1. Not Chinese -- Pass -- Checking names and addresses, the company was definitely not Chinese.
  2. Low Price to NCAV --  Pass -- Since this is what attracted me to the business in the first place, the company definitely nailed this.
  3. Low Debt-toEquity -- Fail -- The company's debt level came up and smacked me in the face like a pile of bankruptcy filings. I like it when firms are debt-free but Albemlare & Bond had a 70% debt-to-equity ratio. I should point out right now that I consider my core criteria to be black and white criteria. Having said that, I have been guilty of bending this one particular rule when the situation warrants. The investment opportunity has to be overwhelmingly in the investor's favour, however. Let's see how this company stacked up to the rest of the standards I set.
  4.  Adequate Past Earnings or Catalyst -- Pass -- The company was profitable previously so the business did fit the mould of a firm that was suffering a huge problem. The question was whether the problem was survivable.
  5. Past Price Above NCAV -- Pass -- A quick look at their stock chart and it's fairly obvious that they were priced above NCAV most of the time.
  6. Existing Operations or Liquidation -- Pass -- The company was currently operating its shops, though they were rapidly closing up unprofitable locations. This is actually a positive, rather than a negative development.
  7. Not Selling Shares -- Pass -- It was nice to see that the company wasn't diluting shareholder value.

Key Quantitative NCAV Criteria

  1. Large Current Ratio -- Fail -- Most companies fail on some of the checklist items but are still strong buys. My key quantitative NCAV criteria are important but not deal-breakers if the company doesn't pass one or two. In terms of current ratios, I like to see them big. A&B's current ratio was only 1.51x. When combined with it's debt load, the two ratios made it pretty clear that the company's balance sheet was weak.
  2. Small Market Cap -- Pass -- The business was priced below 4 million GBP. That's pretty tiny. I usually only look at firms trading below $50 million USD and tend to screen out firms nearing $100 million USD but there's a lot of leeway here.
  3. Low Price-to Net Cash --  Fail -- Despite having buckets of gold, the company did not have cash and equivalents net of all liabilities.

Key Quantitative NCAV Criteria

  1. Financial/regulated/ADR/Real Estate/closed fund – Pass -- I wouldn't call this firm a financial firm even though I'm sure it originated some loans.
  2. Company is Buying Back Stock - Fail -- The share count was more or less the same year-over-year.
  3. Insider Ownership -- See Below
  4. Major/Minor Insider Buys Vs. Sells -- See Below
  5. Burn Rate – Fail -- 14.6% is higher than I would like to see but not horrible. Ideally, I would like to see the firm's NCAV growing.
  6. Catalyst – Fail -- I thought about various catalysts but none seemed likely. The company had tried shopping itself around to other firms, looking for an acquisition, but it had no takers. Eventually the company called off the quest to find a buyer. This, again, was a big red flag.

You're probably wondering why I wrote "see below" under insider ownership and insider buys. The truth is, I never looked those figures up. I had already made my mind up about the company based on its balance sheet, burn rate, and inability to find a buyer.

My key criteria, as I wrote above, aren't critical factors but they do really impact the attractiveness of the opportunity. A firm growing its NCAV that has a likely catalyst, and is buying back stock is a really promising investment opportunity. If the qualitative picture looks good enough then I'll sometimes bend one of my core criteria but these cases are incredibly rare. In fact, I've only done this once in the last two years and that company was profitable, growing NCAV, shrinking it's monster-sized debt load, and improving its current ratio. On top of that, the business had strong insider ownership.

Things did not end well for Albemarle & Bond Holdings. Two months after I first ran the company down my checklist the firm filed for bankruptcy protection. Shareholders who bought in have been pretty much wiped out. While this is one of the first NCAV firms that I know of that has actually gone bankrupt, it was pretty easy to see how risky the investment was after some simple surface sleuthing.

Trust Benjamin Graham -- avoid debt to avoid bankruptcy when value investing.
Trust Benjamin Graham -- avoid debt to avoid bankruptcy when value investing.

Benjamin Graham and the Impact of Loss

Let's take a look at two hypothetical cases: one in which I bought the company and another in which I put the money into another existing investment.

Option One: BuyOption Two: Skip
Portfolio size: 10 equal sized positions @ $10kPortfolio size: 8 equal sized positions @ $8k + 1 position at $2K (No A&B)
Hypothetical returns to each profitable stock: 30%Hypothetical returns to each profitable stock: 30%
A&B Loss: -100%A&B Loss: -100%
A - 1K = 1.3KA - 1K = 1.3K
B - 1K = 1.3KB - 1K = 1.3K
C - 1K = 1.3KC - 1K = 1.3K
D - 1K = 1.3KD - 1K = 1.3K
E - 1K = 1.3KE - 1K = 1.3K
F - 1K = 1.3KF - 1K = 1.3K
G - 1K = 1.3KG - 1K = 1.3K
H - 1K = 1.3KH - 1K = 1.3K
I - 1K = 1.3KI - 2K = 2.6K
J - 1K = 0KNill
End value: $11 700End value: $13 000
Year's Return: 17%Year's Return: 30%

The impact of including A&B in a portfolio would be massive. Here, the difference is 13% per year! Not only do investors get hit with the 100% loss of A&B but they also miss out the capital gains that could have been earned by investing in another high-potential investment.

This is exactly how I run my own real money portfolio. Rather than investing in a large number of net nets that run the spectrum in terms of quality, I focus on buying the highest quality net net stocks and have a much more concentrated portfolio as a result. I think this increases the chances that each of my stocks will work out which means higher overall returns.

Click Here to view my 2014 10 month returns.

Follow Benjamin Graham -- Play it Safe

By now it should be pretty clear just how much of an impact losses can have on your portfolio. If you're going to invest in net net stocks -- as you should be! -- then put the effort into screening out any company that looks like it could potentially lead to losses. Doing so means focusing on key characteristics that distinguish the weak firms from the strong, high potential, investment candidates.

I've spent a lot of time developing my Core7 Scorecard to do just that and work hard to identify the best investment candidates for Net Net Hunter members. Enter your email in the box below to get a free monthly net net stock pick sent straight to your inbox. No catch, obligations... just free net net stock picks that you can use.