Benjamin Graham’s Dirty Little Secret for the Small Investor

Heading into what could be a volatile earnings season, many investors gravitate to large cap stocks.

Since the media tends to focus on big, recognizable names, you may think large cap stocks are safe and predictable. If the stock has a large percentage of institutional investors, small investors generally assume, it is likely it will offer greater returns. After all, institutional investors have access to a level of research and analysis that small retail investors don’t. The reasoning may be convincing but, as those who signed up for free net net stock checklist know, the truth is more complex.

When institutional investors, such as large mutual funds, pension plans and hedge funds trade, they are extremely limited by liquidity. This means that most of their dollars must go into large cap companies that can handle the volume.

Smaller companies can’t handle larger orders. They simply don’t have the volume to match up buyers and sellers, which all but takes the “smart money” out of the microcap game. This means smart investors have an opportunity to get great returns without worrying about competition from institutional investors.

With so many choices, though, the majority of retail investors don’t have the education or ability to research at the same level of professional traders. This makes trading micro cap stocks a gamble that could have the potential for extreme losses. If you’re considering value investing, you should really focus on finding Benjamin Graham’s “net net stocks.”

Benjamin Graham’s Dirty Little Secret for the Small Investor

In a book called The Intelligent Investor, Benjamin Graham wrote about the highly effective methods he used at his investment firm Graham-Newman. The most famous and popular strategy was investing in what Graham referred to as net nets, or net working capital stocks.

Ben Graham’s net net stock strategy a technique for finding highly profitable value investments where a company’s value rests solely in its net current assets. By focusing on tangible liquid assets, Graham was able to find valuable stocks that were destined to skyrocket. These stocks offer phenomenal returns even when selected through a simple buy and hold strategy.

Benjamin Graham found these stocks by subtracting each firm’s total liabilities and preferred shares from its current assets. Firms trading at a significant discount to this value were attractive and gained his attention. Trading below a firm’s net current asset value essentially meant trading below real world liquidation value — a phenomenon Benjamin Graham thought was fundamentally irrational.

Why would a firm be priced below its net current asset value?

Quite simply because net nets are ugly, dirty, firms that most investors don’t want to touch. They have usually suffered a major business problem that has disrupted business, eroded revenue, and completely destroyed profitability. These firm's are quite literally given up for dead. Investors avoid these firms like a muddy pig running through a crowded mall (picture that!).

But not everybody sees the world the same way, and what’s ugly to many investors is beautiful to shrewd value investors prepared to follow great time-tested strategies. While ugly, firms that qualify as net nets are usually fiscally conservative. Since they tend to have strong balance sheets with little long term debt, they rarely go bankrupt or lead to large losses. James Montier calculated that net nets lead to large losses only 5% of the time versus the 2% rate of S&P 500 firms, and you can significantly reduce that rate by following Net Net Hunter's NCAV Investment Scorecard.

What Can You Expect From Benjamin Graham’s Net Nets?

Graham’s strategy worked. Between the years of 1951 through 2009, a standard net net portfolio generated compound average annual returns of 19.9 percent. It beat the S&P 500 handily, which climbed only 10.7 percent over the same time period. Remember, this is the return for all net net stocks as a group. Graham himself claimed that a portfolio of net nets were good for compound annual returns of 20% per year, as shown by the great returns Graham had running Graham-Newman.

"[Ben Graham] liked intellectual challenges. I think Wall Street was a challenge. Then, he discovered that he could make good money by just buying stocks at 2/3rds of their working capital. ...After he found out he could make good money this way, he kind of lost interest."

- Walter Schloss, Outstanding Investor Digest, March 6th, 1989.

Quite frankly, Graham’s returns were on the low side for net net stock investors, generally. Benjamin Graham liked wide diversification, which meant pooling the most promising net net stocks together with less promising picks. Investors who came later ran more concentrated portfolios of higher quality net net stocks and earned much higher returns.

Benjamin Graham’s net net stock strategy became the strategy of choice for some of the most important investors in the world. The most well-known, of course, is Warren Buffett. When Buffett first started his investment partnership, he panned through Moody’s manuals hunting for these depressed stocks and built a reputation for having a sixth sense about the market. Other investors who capitalized on the strategy include Seth Klarman, Walter Schloss, Tweedy Browne, Peter Cundill, and Martin Whittman. This group of value investors represent some of the most successful of all time, making billions of dollars for their individual firms.

The simple idea here is that investing in tiny companies is your best chance to beat the market and create a portfolio that will earn remarkable returns. When Buffett used his variation of Benjamin Graham’s net net strategy, he earned an average of 29.5 percent annually between the years of 1957 and 1969. To put that in perspective, his total return in that time period equaled 2794.9 percent! In the same time period, the Dow grew just 152.6%.

"My cigar-butt strategy worked very well while I was managing small sums. Many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performance." 

- Warren Buffett, Berkshire Hathaway’s 2014 Annual Letter

Investors should look at what works in investing, use rational judgment, and put together a sound strategy. Buffett’s strategy of finding net net stocks was one of the most lucrative of all time. Yet, both Buffett and Schloss are victims of their own success. Now that they are responsible for such large portfolios, they can no longer delve in microcap stocks the same way you as an individual investor can.

Can You Still Find Benjamin Graham’s Net Nets?

The big limiting belief now is that net net stocks no longer exist. With the advancement of technology and the ability to gain information at the speed of a mouse click, finding net-net stocks is harder than it was in the days of Graham and Buffett. The truth is that, at any time, there might only be 5-10 net-net stocks available in the American market — and many of those are either dangerous resource exploration companies or Chinese reverse merger frauds. Both of those are hazardous to your portfolio’s health. This is likely the reason most retail investors don’t pursue this strategy religiously. Digging through thousands of microcap stocks to find a few winners is time-consuming and monotonous.

On the other hand, not spending the time to research could be equally costly. Sticking to an easier strategy or focusing solely on mutual funds and ETFs means growing a much smaller nest egg. The difference over the long run, with a good investment basket, could total millions of dollars.

Despite the difficulty of finding net net stocks in the American markets, once you step out to invest globally you end up finding a large number of high quality net nets. You don’t have to invest in money-sucking resource companies or take a gamble on a Chinese reverse merger fraud to fill your portfolio full of net net stocks. Some of the companies we’ve been able to dig up are even solid growing firms with low PE ratios. Those stocks, as Joel Greenblatt showed in his forgotten original magic formula, can return up to 42% per year as a group!

Those types of investment opportunities aren’t exactly common, but I do try to pick them up whenever I can since they really add high octane to a net net stock portfolio.

When it comes down to it, by choosing value stocks based on a low price to net current asset value, you are able to profit from a portfolio of high potential microcap stocks that large, institutional investors can’t.

Think of these big firms as large ocean liners. They are large, luxurious, and ultimately will take their clients where they need to go, but turning around or changing course is a long, arduous process. They simply aren’t as agile as a smart, individual investor. A retail investor is able to play around in a pool of stocks that is basically off-limits to the biggest market players.

By using Benjamin Graham’s proven net net strategy, you can achieve returns that have the potential to beat the market by a very wide margin over the course of your life.

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Article Author: Evan Bleker