Benjamin Graham's Net-Net Strategy: Finding Deep Value Stocks

Brief Overview of Benjamin Graham

Benjamin Graham, often referred to as the “father of value investing,” was an eminent economist, professor, and investor who pioneered many of the concepts used in modern security analysis.

Born in 1894, his investment philosophies were shaped significantly by his experiences during the stock market crash of 1929 and the subsequent Great Depression.

Through his tenure at Columbia Business School and seminal works such as “The Intelligent Investor” and “Security Analysis,” Graham imparted his wisdom and investment methodologies to future generations.

Importance of Value Investing

At its essence, value investing is the practice of identifying and purchasing securities that are priced significantly below their intrinsic or inherent value.

This intrinsic value is a calculated estimate of an asset's true worth, discerned through thorough fundamental analysis.

The primary goal of value investing is to capitalize on discrepancies between a stock's current market price and its true value, providing what Graham termed a “margin of safety” for the investor.

This margin acts as a buffer, reducing the downside risk and increasing the potential for profit.

Value investing is rooted in the belief in market inefficiencies, where stocks can sometimes be underpriced or overpriced, and a diligent investor can leverage these inefficiencies to their advantage.

Definition of “Net-Net” Strategy

One of Benjamin Graham's most distinct and rigorous approaches to value investing is the “Net-Net” strategy.

This strategy zeroes in on companies whose stock prices are trading below the value of their net current assets after all liabilities have been accounted for. To put it in formulaic terms:

NCAV = Current Assets – Total Liabilities

If a company's Stock Price is less than its NCAV, it is identified as a “Net-Net” stock. The underpinning idea of this strategy is that if the company were to face liquidation, the sale of its current assets (assets that can be rapidly converted to cash) after paying off all debts and obligations would still result in a profit for the investor.

This deep undervaluation by the market provides a profound margin of safety, making it a compelling strategy for value-driven investors.

Historical Context

The Stock Market During Graham's Era:

The stock market of Benjamin Graham's time was a vastly different landscape compared to today.

The roaring twenties, a period characterized by optimism, rapid industrial growth, and soaring stock prices, was followed by the severe stock market crash of 1929.

This crash triggered the Great Depression, a decade-long economic downturn that profoundly impacted businesses, families, and investors.

During these tumultuous times, speculation was rampant, and many investors made decisions based on rumors and gut feelings rather than solid financial analysis.

Information was not as easily accessible, and regulatory frameworks like the Securities and Exchange Commission (SEC) were in their infancy, leading to a lack of transparency.

This environment of volatility and uncertainty heavily influenced Graham's conservative and analytical approach to investing.

The Inception of the Net-Net Strategy:

Amidst the backdrop of market chaos and widespread financial despair, Benjamin Graham sought a method that would provide investors with a tangible margin of safety.

He believed that the speculative nature of the market was leading many to overlook the fundamental value of companies.

Drawing upon his background in teaching and finance, Graham formulated the net-net strategy as a systematic approach to find undervalued companies.

The premise was simple: if an investor could buy a company for less than its net current assets (after deducting all liabilities), they were essentially getting the company's long-term assets and potential future earnings for free, offering a substantial cushion against potential losses.

Notable Successes Using the Net-Net Strategy:

The net-net strategy, while stringent, yielded substantial successes during Graham's time.

Graham's investment firm, Graham-Newman Corporation, consistently outperformed the market by implementing these principles.

Some of the most notable successes came from investments in undervalued companies that the market had overlooked or written off, only for them to rebound and provide significant returns.

Beyond Graham's direct investments, his teachings influenced a new generation of value investors.

Perhaps the most famous of his students, Warren Buffett, has often credited Graham's principles, including aspects of the net-net strategy, as foundational to his own investment approach.

Fundamentals of the Net-Net Strategy

Concept of Intrinsic Value:

The term “intrinsic value” denotes the real, inherent value of an asset, a value that is typically separate from its current market price.

While the market price of an asset can swing due to various external influences like sentiment, news, or sheer speculation, the intrinsic value remains more consistent, anchored in thorough fundamental analysis.

At its core, it's what a knowledgeable investor believes the asset is genuinely worth after considering all its characteristics and prospective returns.

Benjamin Graham championed this concept, asserting that while stocks can often be mispriced in the short term by the market, over time, they generally gravitate towards their intrinsic value.

Calculating the Net Current Asset Value (NCAV):

NCAV provides a gauge for investors to determine what could be termed the “liquidation value” of a company.

In essence, it indicates how much investors might expect if the company were to liquidate its immediate assets and settle all outstanding debts. It offers a concrete metric to discern if a company's stock is undervalued relative to its easily accessible assets.

To find the Net Current Asset Value, subtract the company's total liabilities from its current assets.

Criteria for Net-Net Stock Selection:

For a stock to qualify as a “net-net” based on Graham's criteria, it shouldn't just be trading below its NCAV, but at a substantial discount:

  • The stock should be priced at two-thirds (or less) of its Net Current Asset Value.

Incorporating this strict criterion ensures that investors benefit from a considerable margin of safety and positions them for a greater potential return.

Reasons for Such a Discount:

There can be multiple factors leading to a stock's market price being below its NCAV:

  1. Market Oversight: Often, smaller companies don't get the attention of large institutional investors or analysts, leading to undervaluation.
  2. Short-Term Challenges: A company might be facing transient issues, which can overshadow its long-term viability and potential.

Understanding Current Assets and Liabilities

Breakdown of Current Assets:

Current assets represent items of value that a company expects to convert into cash or use up within a year or within its normal operating cycle, whichever is longer.

They are vital for day-to-day operations and in gauging a company's short-term financial health.

  • Cash and Cash Equivalents: These are the most liquid assets and include physical cash, bank deposits, and other short-term, highly liquid investments that can be easily and immediately converted into a known amount of cash. Examples might include money market funds or Treasury bills.
  • Accounts Receivable: This represents money owed to the company by its customers for goods or services that have been delivered or used but not yet paid for. Typically, these are due within a short period, like 30 or 60 days.
  • Inventory: This includes raw materials, work-in-progress goods, and finished goods that a company has on hand. The value of the inventory depends on the valuation method used, such as FIFO (First In, First Out) or LIFO (Last In, First Out).
  • Other Short-term Assets: This can encompass prepaid expenses (expenses paid in advance and set to be expensed in the future), short-term investments, and other assets expected to be turned into cash or used up in the near term.

Breakdown of Total Liabilities:

Liabilities represent what a company owes to others. They can be a result of past transactions or events, and settling them typically requires the company to sacrifice economic benefits in the form of assets.

  • Short-term Debts (or Current Liabilities): These are debts that are due to be settled within a year or within the firm's normal operating cycle. They can include accounts payable (money owed to suppliers), short-term loans, taxes payable, and other short-term financial obligations.
  • Long-term Debts: These are obligations that are due beyond one year or beyond the company's normal operating cycle. They can include bonds payable, mortgages, long-term leases, and pension obligations.
  • Other Liabilities: This category includes a mix of both current and long-term obligations that don't fit neatly into the above categories. Examples might be deferred tax liabilities, unearned revenue (payments received for services not yet performed or goods not yet delivered), or contingent liabilities (potential obligations dependent upon a future event, like the outcome of a lawsuit).

A comprehensive understanding of current assets and liabilities is foundational to many aspects of financial analysis, and particularly crucial when employing the net-net strategy.

Being able to discern what a company owns (its assets) and what it owes (its liabilities) offers insights into its short-term financial health, potential risks, and overall value.

Advantages of the Net-Net Strategy

Margin of Safety:

One of the primary benefits of the net-net strategy is the in-built margin of safety. By targeting stocks that are trading below their net current asset value, investors are essentially paying for only a portion of the company's real value.

This provides a cushion, ensuring that even if the company's assets were liquidated, the investor would still recover more than their initial investment.

This margin serves as a protective barrier against unforeseen market downturns or company-specific issues.

Potential for High Returns:

Because net-net stocks are deeply undervalued by definition, they offer significant upside potential.

When the market eventually recognizes the stock's intrinsic value, or if the company's performance improves, the price can appreciate considerably.

Moreover, in some cases, corporate actions like buybacks, mergers, or acquisitions can act as catalysts, unlocking value for shareholders.

Reduced Risk of Permanent Loss:

Investing in stocks trading below their net current asset value minimizes the risk of permanent capital loss.

Given that you're purchasing assets at a discount, there's a lower chance that the stock's value will deteriorate further.

Even in adverse scenarios, like company liquidation, the value of the current assets, after covering liabilities, provides a safety net.

Ability to Exploit Market Inefficiencies:

The stock market, despite its vast number of participants and high levels of information dissemination, isn't always efficient.

Various factors, such as neglect of smaller companies, short-term news cycles, or emotional trading, can lead to mispricing. The net-net strategy thrives on these inefficiencies.

By conducting thorough analysis and sticking to the strategy's criteria, investors can identify and capitalize on these undervalued opportunities.

In sum, the net-net strategy, rooted in Benjamin Graham's principles of value investing, offers investors a systematic approach to uncovering deeply undervalued stocks.

Its emphasis on a margin of safety and intrinsic value not only protects capital but also provides avenues for significant growth, making it a compelling choice for those with the patience and diligence to sift through the market's overlooked corners.

Criticisms and Limitations of the Net-Net Strategy

Potential for Value Traps:

One of the most common criticisms of the net-net strategy is the potential to fall into “value traps.”

A value trap occurs when a stock appears to be undervalued based on certain metrics (like NCAV) but is priced low for valid reasons, such as deteriorating business fundamentals or industry decline.

Investors lured by the apparent discount might find that the stock remains undervalued indefinitely, resulting in stagnant or even negative returns.

Might Not Be Suitable for Fast-Growing Companies:

The net-net strategy primarily targets undervalued companies with tangible current assets exceeding liabilities.

This approach might exclude fast-growing companies, especially in the tech or service sectors, where most of the value is derived from intangible assets like intellectual property or growth potential.

As a result, adherents of the net-net strategy might miss out on significant opportunities in growth sectors.

Scarcity of Net-Net Stocks in Modern Markets:

With the advent of advanced analytical tools, real-time data, and increased market efficiency, genuine net-net stocks have become rarer in developed markets.

Many investors scouring for these opportunities might find that there are few genuine candidates, and those that do exist are often micro-cap stocks with limited liquidity or operate in troubled industries.

Possible Obsolescence in Today's Dynamic Business Environment:

Some critics argue that the net-net strategy, developed in the earlier part of the 20th century, might not be entirely relevant in today's rapidly changing business landscape.

Modern companies, especially in tech and service sectors, often have business models that rely more on intangibles like brand value, software, or user networks.

These assets don't neatly fit into the traditional net-net framework, leading some to believe the strategy might overlook companies that hold significant value in today's terms.

While the net-net strategy offers a structured approach to value investing, it's essential to recognize its limitations.

In the ever-evolving world of finance and business, no single strategy offers a silver bullet. The success of the net-net approach, as with any investment method, relies on the investor's ability to adapt, discern, and apply the principles judiciously.

The Modern Relevance of the Net-Net Strategy

Comparing Graham’s Era to Today's Market:

When Benjamin Graham pioneered the net-net strategy, the stock market was a vastly different landscape.

Information asymmetry was prevalent, with investors often lacking real-time data, advanced analytical tools, or widespread financial literacy. This environment led to many stocks being overlooked or mispriced, making the net-net approach especially fruitful.

Fast forward to today, with the proliferation of technology and a more globalized economy, markets are often considered more efficient.

Real-time data, financial news, and sophisticated analytical tools are available to even retail investors, reducing the number of apparent mispricings.

Adaptations and Modifications for the Contemporary Investor:

Given the changes in the market environment, sticking rigidly to the net-net strategy might be limiting.

However, modern investors can adapt and modify the approach:

  1. Expand the Definition of ‘Assets': Instead of focusing solely on tangible current assets, investors might consider giving weight to certain intangible assets or long-term growth prospects that modern companies often possess.
  2. Adjust the Margin of Safety: While Graham suggested buying stocks at two-thirds of their NCAV, a slightly relaxed criterion might be more realistic in today's competitive landscape.
  3. Consider Global Markets: With fewer net-net opportunities in developed markets, investors could explore emerging or frontier markets where inefficiencies might still be more prevalent.

Real-world Examples of Recent Net-Net Stock Successes:

While genuine net-net stocks have become rarer in markets like the US, there have been instances where investors have found success.

For example:

  1. Tech Turnarounds: Some tech companies, after experiencing significant setbacks, saw their market capitalizations dip below their net current asset value, only to recover later. Investors who identified this mismatch benefited from subsequent rebounds.
  2. Retail Recoveries: Brick-and-mortar retailers, hit hard by e-commerce competition, have at times become net-net stocks. Some of these, upon restructuring or pivoting their business models, have managed to recover, rewarding patient investors.
  3. Emerging Market Opportunities: In markets with less coverage and analysis, some companies, often due to short-term challenges, have traded below their NCAV. Astute investors who could discern between temporary setbacks and fundamental issues have reaped benefits.

In conclusion, while the strict application of Graham's net-net strategy might be challenging in today's sophisticated markets, its underlying principles remain sound.

Modern investors, by adapting and blending the strategy with contemporary insights, can still uncover deep value opportunities in the global landscape.

Alternatives to the Net-Net Strategy in Value Investing

While the net-net strategy is a cornerstone of value investing, it's by no means the only tool in the value investor's arsenal.

Over the years, several metrics and strategies have been developed to assess the intrinsic value of a stock and identify undervalued opportunities. Here's a look at some of the popular alternatives:

Price-to-Earnings (P/E) Ratio:

One of the most commonly used metrics in stock analysis, the P/E ratio compares a company's current market price to its earnings per share (EPS).

A lower P/E ratio could indicate that a stock is undervalued relative to its earnings potential.

It's crucial, however, to compare the P/E ratio within the context of the company's industry and historical averages.

Application: A stock with a P/E ratio lower than its industry average might be considered undervalued, presenting a potential buying opportunity for value investors.

Price-to-Book (P/B) Ratio:

The P/B ratio compares a company's market capitalization to its book value (i.e., its net asset value). Like the net-net strategy, this ratio focuses on the company's tangible assets but includes both current and long-term assets.

Application: A P/B ratio less than 1 suggests that the stock might be trading for less than the value of its assets, signaling a potential undervalued situation.

Dividend Yield and Dividend Growth Investing:

For many value investors, consistent dividends are a sign of a company's stability and shareholder commitment.

The dividend yield, calculated as the annual dividend payment divided by the stock's price, can be a measure of the stock's income-generating potential.

Application: Stocks with higher dividend yields can be attractive to income-focused investors. Additionally, companies with a consistent history of increasing dividends can indicate stability and growth prospects.

Other Graham-Inspired Strategies Like the Graham Number:

The Graham Number is another metric inspired by Benjamin Graham's principles, designed to find the fair value of a stock.

It's calculated using the square root of “22.5 x earnings per share x book value per share.” If a stock's current price is less than the Graham Number, it might be undervalued.

Application: The Graham Number provides a quick way to gauge a stock's value based on its earnings and book value, offering another tool for value investors to identify potential investment opportunities.

Practical Steps to Find Net-Net Stocks Today

Finding genuine net-net stocks in today's market might seem like searching for a needle in a haystack, given the advanced tools and prevalent market efficiency.

However, with a systematic approach, it's still possible to identify these deep value opportunities. Here are the steps to guide your search:

Tools and Software for Screening:

Modern Stock Screeners: Utilize stock screening tools available on platforms like Finviz, Morningstar, or Yahoo Finance. Set filters to search for stocks trading below their net current asset value.

Subscription Services: Consider subscribing to premium stock analysis platforms that offer more granular data and advanced screening options.

Custom Algorithms: Tech-savvy investors can create custom scripts or use platforms like QuantConnect to automate the search for net-net stocks based on specific criteria.

Analyzing Balance Sheets:

Current Assets Focus: Delve deep into the company's balance sheet, focusing on current assets such as cash, accounts receivable, and inventory. Ensure these assets are of high quality and can be easily liquidated.

Liabilities Check: Scrutinize both short-term and long-term liabilities. Be wary of hidden liabilities or contingent liabilities that might not be evident at first glance.

Evaluating Company Management and Future Prospects:

Management Track Record: The quality of management can be a determining factor in the company's ability to turn around. Research the management team's past performances, decision-making patterns, and alignment with shareholder interests.

Industry Outlook: Even if a company is trading as a net-net stock, it might be in a declining industry. Analyze the industry trends, competition, and growth prospects to gauge the potential for recovery.

Operational Strength: Look at the company's core operations, product lineup, and customer base. A temporary setback might be an opportunity, but structural issues could indicate deeper problems.

Importance of Diversification within a Net-Net Portfolio:

Spread the Risk: Given the inherent risk associated with net-net stocks, avoid putting all your capital into a single stock. Spread investments across multiple net-net opportunities to mitigate company-specific risks.

Sector Diversification: Ensure that your net-net portfolio is not heavily concentrated in a single sector. Different sectors react differently to economic cycles, so diversification can provide a safety net.

Geographic Diversification: Consider expanding your search to global markets. Emerging or frontier markets might offer more net-net opportunities than developed markets. However, be mindful of the risks associated with investing in unfamiliar territories.

Case Studies: Delving into Net-Net Investments

Understanding the practical applications and outcomes of the net-net strategy can be better achieved through case studies.

Here, we’ll delve into both historical and modern examples, providing insights into the factors that led to successes and failures.

Historical Examples of Successful Net-Net Investments:

  1. Berkshire Hathaway: Before it became the conglomerate it is today, Berkshire Hathaway was a textile company. In the 1960s, Warren Buffett identified it as a net-net stock and started buying shares. Although the textile business eventually folded, the assets provided a foundation for Buffett to pivot the company towards more profitable ventures, leading to the Berkshire Hathaway we know today.
  2. Japanese Stocks in the 1970s: In the 1970s, many Japanese companies were trading below their net-net value due to pessimistic market sentiment. Investors like Walter Schloss capitalized on this, buying a basket of Japanese net-net stocks that yielded substantial returns over the next decade as the Japanese market rebounded.

Modern Examples of Net-Net Opportunities:

  1. Retailers in the E-commerce Era: With the rise of e-commerce giants like Amazon, several traditional brick-and-mortar retailers found their stocks trading below NCAV. While some of these retailers went bankrupt, others successfully transitioned to a hybrid retail model, resulting in significant upside for investors who had identified them as net-net opportunities.
  2. Tech Turnarounds: Companies like BlackBerry, once a leader in smartphones, saw their stock prices plummet as competitors took over the market. However, their tangible assets and pivot to software and services made them a potential net-net opportunity. For investors who could differentiate between a company's structural issues and short-term setbacks, these situations presented significant upside.

Analysis of Successes and Failures:

Factors Leading to Success:

  • Strong company management able to pivot or adapt the business model.
  • Temporary external factors causing the undervaluation, rather than structural business issues.
  • Market overreaction leading to undervaluation, providing an entry point for value investors.

Factors Leading to Failures:

  • Structural industry shifts rendering a company's main business obsolete.
  • Excessive debt and liabilities overshadowing the value of current assets.
  • Poor company management unable to address core business challenges.

Case studies underscore the point that while the net-net strategy can offer significant returns, it’s not without its risks.

Success hinges not just on numerical analysis but also on an in-depth understanding of the company, its industry, and broader market dynamics.

The combination of quantitative metrics with qualitative insights can guide investors in navigating the intricate world of net-net investing.

Conclusion

The net-net strategy, pioneered by the legendary Benjamin Graham, stands as a testament to the enduring power of value investing.

Rooted in the simple yet profound idea of buying companies for less than their current assets minus liabilities, this approach offers a clear margin of safety.

Graham's legacy in the world of finance is indomitable, with principles that have withstood the test of time. However, in today's dynamic and often efficient markets, identifying genuine net-net opportunities requires more than just a cursory glance at balance sheets.

For investors keen on walking this path, a blend of caution, thorough analysis, and unwavering diligence is essential. The treasures of deep value investing await those who approach the task with both skepticism and curiosity.