Benjamin Graham’s Value Investing Principles Stand Test of Time
This article on Benjamin Graham’s Value Investing Principles was written by Luis Sánchez. Luis is a lawyer and investment manager based in Bogotá, Colombia, who is primarily focused on net net stocks. Net net investing was Ben Graham's strategy of choice and even helped Warren Buffett earn the best returns of his career. Get our Essential Net Net Stocks Guide to understand this strategy in detail. Click Here. Article image (Creative Commons) by Zengame, edited by Net Net Hunter.
Benjamin Graham’s value investing principles and investing strategy find themselves under siege today.
That’s right — according to some studies, value stocks have underperformed growth stocks for almost a decade, and the divergence between both kinds of stocks is at its highest in 70 years!
These figures have analysts and the media asking whether Benjamin Graham’s value investing principles are still relevant. After all, if they were, then value stocks should outperform — or so the thinking goes.
So, are Benjamin Graham’s value investing principles worthwhile today? Or, is value investing dead?
Benjamin Graham’s Value Investing Principles: The Margin Of Safety and the Value Premium
All value investors understand the margin of safety concept, but few consider its profound implications for the value premium as it stands today.
While it's been written about in countless articles, for the uninitiated, here's a brief recount of Graham's margin of safety: Essentially, a margin of safety is the difference between the value of a stock and its price. For example, if the intrinsic value of a business is $100, and you buy it for $50 on the stock market, you nailed down a 50% margin of safety, reducing your risk and increasing your profit potential.
What’s the intrinsic value of a business, though?
The intrinsic value of a business is the figure that results from discounting its future cash flows, or just the value of its net assets — because assets are worth the cash flows they can earn. In any case, intrinsic value rests upon the value of earnings and assets. That pretty much sums it up.
Every once in a while, though, the market departs from these reasonable measures of value.
For example, in the ’90s, during the dotcom bubble, people would measure the intrinsic value of a tech stock based on “eyeballs” — i.e., customers that clicked to enter the company’s website, regardless of whether they bought something or not. The more “clicks” a company’s website got, the higher the business’ intrinsic value. Investors herded around the stocks of asset-light, website-based firms like Yahoo! and eBay and fled from cash-producing, asset-based firms that lacked an internet presence.
The gap between growth and value stocks widened during that period, of course. Such delusional measures of value led investors to think they were buying “cheap” tech stocks when, in reality, they were grossly overpaying for them.
When reality set in, many people lost their life savings. Stable, cash-producing firms with hard assets thrived, and those who had bought them at discounts cashed in a handsome reward.
This takes us to today’s current divergence between growth and value stocks. Value stocks have been underperforming for a long time and are currently unloved, forgotten and unpopular. On the other hand, growth stocks such as FANG (Facebook, Amazon, Netflix and Google) have been very profitable — and expensive.
We even have creative valuation metrics among unicorns — i.e., private firms that are worth $1 billion or more. Take a look at WeWork’s “community-adjusted EBITDA,” and you’ll see what I mean.
Bottom line is that the current situation clearly reminds me of the ’90s. So, is value investing dead?
Famous superinvestor Joel Greenblatt has an interesting answer: “Yes, no, maybe, and I don’t care.” As long as you buy a group of stocks with a wide margin of safety, he says, you’re bound to make money.
Benjamin Graham’s Value Investing Strategy: The Group Outcome and Net Nets
A focus on the group outcome is key, though.
Indeed, Benjamin Graham’s value investing strategy relied on the outcome of a group of undervalued stocks. While any individual cheap stock could actually fail, with a group of them, you were very likely to earn decent returns in the long run.
His favourite group of undervalued stocks was net nets.
What is a net net?
A net net is a stock selling for a price below two-thirds of net current asset value (NCAV) — i.e., the value of current assets, less all liabilities, preferred shares and off-balance sheet liabilities.
For three decades, Graham earned around 20% a year on average just buying hundreds of these “sub-liquidation” stocks. He eventually dropped all other investment strategies — arbitrages and hedges, for example — and focused exclusively on net nets.
Warren Buffett focused almost exclusively on net nets while running his partnerships in the ’60s. He called them “generally undervalued stocks,” and his annual returns confirmed net nets rendered spectacular returns in the long run.
Superinvestors such as Walter Schloss or Peter Cundill — to name a few — also loved net nets and invested heavily in them whenever they found them.
Benjamin Graham’s Value Investing Strategy: The Mechanical Approach
But Graham also realized small private investors ended up earning below-average returns in the long run because they panicked and sold when the market tanked, then bought when stocks were climbing again.
How could the average investor sidestep these behavioral biases?
Graham had an answer for that: a mechanical investing strategy. If investors focused on buying groups of undervalued stocks — like net nets — and selling them according to very strict selling rules, they could actually benefit from the expected group outcome.
After Graham’s death, Henry R. Oppenheimer published his famous study Ben Graham’s Net Current Asset Values: A Performance Update.
He compared the returns of a hypothetical net net portfolio with those of a small firm index during a 12-year period and found net nets beat the average with a compounded annual growth rate (CAGR) of around 30%.
Oppenheimer also found that stocks with the widest discounts to NCAV outperformed stocks with smaller discounts.
Joel Greenblatt and Michael Pzena published a paper back in 1981 analyzing the returns of four different hypothetical portfolios of stocks selling below NCAV. Each portfolio had different sets of criteria; all of them beat the index, one of them with a 29% CAGR.
Tweedy, Browne’s famous study What Has Worked On Investing compiled the results of numerous academic studies. Buying a group of net nets certainly proved more rewarding than any other strategy in the long run.
Recent backtests and academic research confirm that net nets still outperform the market in the long run.
These studies had something else in common besides comparing returns of different portfolios. The hypothetical portfolios were equally weighted and were rebalanced every year, meaning Graham was not only right about net nets as a group of undervalued stocks, but also about the mechanical investing strategy overall.
So, are Benjamin Graham’s value investing principles worthwhile today? At least when it comes to net nets, the answer is yes. Hence, value investing isn’t dead.
Besides, price will always gravitate towards intrinsic value in the long run. The world isn’t crazy enough yet to reward undeserving businesses indefinitely.
Benjamin Graham’s Value Investing Strategy: The Mechanical Approach for Small Private Investors
At Net Net Hunter, we’ve developed two mechanical investing approaches for small private investors based on the extensive academic research available about net nets: the Ansan Simple Mechanical Strategy and the Net Net Hunter Scorecard.
Each month, we comb through a raw list of about 1,000 net nets from around the world and apply a detailed selection criteria to arrive at a Shortlist of 50 high-quality net nets.
But cherry-picking among the Shortlist and selling when you “feel” is the right time could end up paving your way to poverty.
The Ansan Simple Mechanical Strategy consists of buying the cheapest 20 net nets on the Shortlist, holding for 12 months and then rebalancing, year after year. Twenty stocks give you enough diversification to actually benefit from the statistical advantage of net nets as a group, and studies confirm that the cheapest net nets have the best returns.
Remember, this is a group performance. Some of your bets will fail, and that’s part of the process.
Greenblatt’s study mentioned above shows that additional criteria can make a huge difference in performance in the long run, though.
That’s why we developed the Net Net Hunter Scorecard, with additional criteria to help you increase the odds of actually picking winners among the net nets on the Shortlist.
Both Ansan and Scorecard share selection criteria like a low debt to equity ratio, no major Chinese operations, and a small market cap. However, the Scorecard focuses on finding the highest quality net nets available.
For that, the Scorecard has additional criteria. For example, academic research shows that firms where insiders are heavily buying the stock at depressed prices, or firms that are buying back large chunks of their own stock, outperform. Also, the Scorecard includes the need for a catalyst — i.e., a future event in sight that could unlock value, such as an acquisition, an activist investor, or a turnaround.
These qualitative assessments are a bit harder to assess, though, so keep that in mind.
In the long run, a portfolio full of firms that check all the criteria on the Scorecard should perform better than a simple Ansan strategy, but it takes more effort on your part.
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