How To Use The Benjamin Graham Formula
Some times the worst classic Benjamin Graham stocks can be the best investments.
Special Special Situations
I was skimming through "Common Sense Investing," a collection of writings by Benjamin Graham, when I came across a section on special situation investments. The reading was interesting to say the least. For a while now I've been thinking of investment in terms of likely upside, and likely downside. That's to say, probabilities. To me, it seems that the reason net net stocks as a whole pay off so well is because of their solid foundation of value, how far below that value they're priced, and because of their high likelihood of closing the gap.
Benjamin Graham defines a special situation as an investment situation where the ultimate payout is independent of stock market factors. A typical example of this is a risk arbitrage play, a situation where a company announces that it entered into an agreement to sell itself to a firm for slightly more than the current price of the common stock. In this situation, the spread between the current market price and the price being offered for each share constitutes a profit for the investor despite what the stock market does within the time it takes to realize the deal. The profit is also, at least not directly, independent of the stock market's behaviour.
Benjamin Graham's net net stocks just barely fit the definition of special situation. The fact is that a net net stock will see a huge upside gain for typically one of three reasons: it's getting purchased by a third party, the assets it represents are being liquidated and the money distributed to shareholders, or the company is able to right whatever significant challenge it faces at the moment. If it were just a matter of buying companies that were soon to be acquired or liquidated then the fit with the definition would be more rock solid. The absence of an announced deal at the time of purchase and the common theme outside the special situations category of depressed prices due to major business problems is enough to make this fit questionable. Even still, liquidations and corporate takeovers happen often enough to make Benjamin Graham's formula useful, and net net stocks usually right themselves in a predictable fashion.
Back in the 1960s, Buffett commented that a net net stock will workout roughly 80% of the time withing 3 years. This has definitely been my experience, as well. If we use this figure as the actually likelihood that a stock will work out, then we can use Benjamin Graham's formula to calculate the return you should expect to see.
How's it done? Simple. Let's take a look:
For all the variables, let...
G - be the expected gain if successful
L - be the expected loss if the investment isn't successful
C - be the expected chance of success, or the expected chance of failure
Y - be the holding period
P - be the current price
The formula then is...
Indicated Annual Return = [GC -L(100%-C)] / YP
Let's say that a net net stock is trading at $5, 50% below it's NCAV. If we use Buffett's assessment then assuming a rise to 100% of NCAV over a period of three years...
IAR = [($5x.8) - (0x.2)] = /3x$5
IAR = 27%
Of course, these are annualized returns, not compound returns, but 27% is still fantastic.
Hold on a minute...
You'll notice a questionable core assumption within Benjamin Graham's formula: why do I expect to lose no money if the investment doesn't work out? I've had a few net net stocks that haven't worked out but in general I haven't lost a whole lot. Very few of the stocks that haven't worked out have been money losers. If anything, I've sold them for around what I bought it for or they just haven't advanced to reflect full net current asset value. I'm not saying that this situation will continue in the future but given how financially conservative and how cheap these stocks are I can't see my experience turning significantly worse.
What This Mean For the NCAV Investors
One thing that classic Benjamin Graham value investors can do is to look at the NCAV opportunities available to them and then rank them by expected return. This is different from the blanket approach that I advocated before when laying out in our Net Net Hunter Scorecard. The scorecard can definitely yield good results because it's based on the results of academic studies that look back over a number of decades to see how well the investment strategy works. In the scorecard, I do things like screening out companies with more than 25% debt-to-equity but this wouldn't be an issue using Benjamin Graham's special situation formula because it would be just one factor in the expected return of the stock.
All this means that a company with a supernaturally high debt load could be a supernaturally great buy if it's priced low enough. A company with a 200% debt-to-equity ratio, for example, could be a great investment if it will pay off 50 to 1. While it may only have a 10% chance of reaching fair value after it's current crisis, if it does pay off, the returns would be nothing short of magical. Make enough of these bets and the results should be good.
G - $49
L - $1
C - 10% chance of success, 90% chance of going bust
Y - 3 years
P - $1
The formula then is...
Indicated Annual Return = [($9x.1) -$1(100%-.9)] / 3x$1
= 0.9 - .1 / 3
Not bad! And the assumptions used here were far worse than they were above. Keep in mind that the likelihood of the company going bust is 90%, so the 27% expected return would be an average return if you kept investing in companies like these.
A Word of Caution
I don't recommend that classic Benjamin Graham investors put together a basket of these kind of stocks due to variance in portfolio returns. A portfolio of ten of these companies, which have a 90% likelihood of going bust, has a mathematical probability of paying off since one of these companies should workout. Unfortunately, the variance in portfolio returns means that an investor might lose all of his or her money rather than see that one stock pay off. Much too risky. On the other hand, an investor should feel free to add one or two of these low likelihood stratospheric payoff companies as part of a higher quality portfolio.
A much better route might be to use the formula to assess companies that just miss your own screening criteria.
A Shift in Focus
Value investors should consider Benjamin Graham's special situation formula a good but imperfect way to pick net net stocks. While it's imperfect, all stock selection methods have their issues to deal with. Investors should be careful about the type of assumptions their using to generate inputs into the formula and collect reliable data either through research or experience in order to solidify their assumptions. With more accurate assumptions that go into predicting whether a less than ideal net net stock will work out, the formula would prove a valuable tool by which to assess a wide range of net net stock opportunities.