Deep Value Investing: Thoughts and Analysis on Benjamin Graham’s Net Current Asset Value (NCAV) Approach Part 2

Objective:

1) Analyse and showcase the statistical returns of Deep Value investing

2) Advice on how one should approach Deep Value investing

This is a continuation from part 1 of this article

A wise man once told me, when one is attempting any endeavour in life, it is very important to look at the external data and not inside and ask ourselves which side of the statistic we are on. This same logic applies to finding a consistent investing strategy. (Of course, one needs to factor in individual temperament and lifestyle too)

One can easily grow conceited and claim he/she has found the holy grail of investing/trading systems when investing/trading in a bull market and claim that his/her system is the holy grail of all systems. Michael J. Mauboussin, former Chief Investment Strategist at Legg Mason Capital Management clearly articulates this paradox of luck and skill found in asset management in his book “Think Twice”.

Therefore, one of the best ways to access an investment strategy is to look at the consistency of its results over long periods of time and the people who have used it. In terms of investment success, one can look no further than famed Super investor Warren E. Buffett. Warren Buffett also happened to be Benjamin Graham’s Mentee and employee in Benjamin Graham’s investment firm Graham-Newman.

fig1_buffet

Figure 1

Figure 1 [1] (taken from Warren Buffett’s article titled “The Super Investors of Graham and Doddsville”) above showcases Warren Buffett’s tremendous success using Benjamin Graham’s net net strategy during the 1950s and 1960s.

In Warren Buffett’s own words:

“My cigar-butt strategy worked very well while I was managing small sums. Indeed, the 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, 2014 Berkshire Hathaway Letter

According to Warren Buffett’s biography the Snowball by Alice Schroder, Buffett only made the switch from classic Graham net net stocks to his current investment strategy (Buying wonderful companies with strong moats at a fair price) when he had to manage larger sums of money due to his growing client base.

He was once famously quoted at one of the Berkshire Hathaway annual meetings about how one could invest with small sums of capital. (The video can be found on YouTube and is titled “Warren Buffett on investing small sums”)

“Yeah, if I were working with small sums, I certainly would be much more inclined to look among what you might call classic Graham stocks, very low PEs and maybe below working capital and all that. Although — and incidentally I would do far better percentage wise if I were working with small sums — there are just way more opportunities. If you’re working with a small sum you have thousands and thousands of potential opportunities and when we work with large sums, we just — we have relatively few possibilities in the investment world which can make a real difference in our net worth. So, you have a huge advantage over me if you’re working with very little money.”

fig2_walter

Figure 2

Figure 1 [1] (taken from Warren Buffett’s article titled “The Super Investors of Graham and Doddsville”) showcases another Super Investor named Walter Schloss.

What continues to fascinate me is that Walter Schloss never had any formal education or qualifications, and never touched a computer or used the internet! Despite having such a stellar investment record and being touted as one of the best value investors of all time, Schloss was largely an unknown on Wall Street. Unlike Buffett, Schloss never deviated from his Grahamite principles. He would hold a largely diversified pool of stocks trading below their NCAV and sell when he felt the price was right.

From another recommended read by Professor Bruce Greenwald titled “Value Investing: From Graham to Buffett and Beyond” about Walter Schloss:

“…The Schlosses would rather trust their own analysis and their longstanding commitment to buying cheap stocks…This approach…leads them to focus almost exclusively on the published financial statements that public firms must produce each quarter. They start by looking at the balance sheet. Can they buy the company for less than the value of the assets, net of all debt? If so, the stock is a candidate for purchase…”

The longevity and consistency of Graham’s net net investing is indeed remarkable and fascinating. James Montier (another pure Grahamite) in his written article titled “Graham’s Net-Nets: Outdated or outstanding?” experimented holding a basket of net net stocks from 1985 – 2007. Over the time period from 1985 – 2007, buying a diversified basket of net net stocks would have generated a mean return of 35% per annum compared to the S&P 500 return of 17% per year. [2]

From my own personal experience using a deep value investing strategy, from 2013- 2017, I managed to achieve an IRR of 16.38%. More than 40% of my deep value portfolio are made up of Japanese stocks. I use a pretty stringent checklist when screening for deep value stocks.

There were 2 things I observed when studying the world’s greatest fund managers and investors, they either beat the market by

1) Having a very concentrated position in a few holdings + knowing all the ins and outs of their chosen circle of competence and how they synergistically affect other industries. They looked for moments of downturn where they could get wonderful companies at a fair prices. (Warren Buffett, Charlie Munger, Peter Lynch)

2) Holding a diversified portfolio of stocks that had no/little analyst coverage that were obscure and/or had poor earnings performance hence were avoided by institutions and the general public.

Both strategies mentioned above are equally hard to apply. This is what makes investing simple and yet so difficult. How many people possess the business acumen, foresight, and compounded knowledge of a Peter Lynch / Warren Buffett to hold a concentrated portfolio of Value/growth companies?  How sure are you that those companies will remain profitable in the long run? Do you really know what you think you know?

As for 2), how many people have the stomach to resist that gag reflex and cope with the stress when holding a diversified basket of ugly cheap companies? This is why it is so much more comforting to hold a diversified basket of profitable safe companies. However, while doing the latter, your returns will be very close to the index and you would be better off buying the index and spending your time elsewhere.

For people attempting to go with 2), let me use an analogy to illustrate a framework about deep value investing.

If you would to take a bet on which way a coin would land, heads you lose $100, tails you get $200. An equally weighted coin of probability 0.5. Would you take the bet? To be very frank, I don’t know many sensible intelligent people that would take this wager.

Now, what if I would to offer the same wager, but repeated 100x in a row. The same probability and expected value. Would you take it? Clearly, the results here would have been totally different from a single coin toss.

I used the first example of a single coin toss to illustrate human in built nature of loss aversion. We humans have an inbuilt tendency to see losses/failures as something far more painful and traumatizing than our successes. In the case of example 2, when we combine the wager into a series of wagers, or in the case of investing a portfolio, we minimise the amount of risk of an individual event and begin to focus on the overall statistical results as a collective.

This same concept applies to deep value investing. One needs to be diversified and not get too fixated about the individual performance of a stock. The empirical evidence in this article has clearly shown that holding a diversified basket of Deep Value stocks does produce market beating returns in the long run. Of course, a stringent checklist when selecting deep value stocks is required. Therefore, one needs to look at the overall portfolio results and not get too fixated about the losses of an individual stock. By further applying a margin of safety and buying net net companies as cheaply as possible, one can further negate downside risk even more.

In conclusion, despite the proven stellar records of Deep Value investing, it is not an investment strategy for everyone. This is due to loss aversion bias that is so instinctive of human beings. However, if one can go against that gag reflex and approach a deep value portfolio not as a group of superhero performers but as a collective result as a whole, and applying a large margin of safety, one will find very satisfactory returns.

There will be 3rd part of this Deep Value Investing series where we will look into the common pitfalls and value traps of Deep Value investing

“Tranquillity can’t be grasped except by those who have reached an unwavering and firm power of judgement. The rest constantly fall and rise in their decisions, wavering in a state of alternating rejecting and accepting things. What is the cause of this back and forth? It’s because nothing is clear and they rely on the most uncertain guide – Common Opinion.

Seneca, Moral Letters, 95.57b -58a

References

[1] Graham, B. (1973). The Intelligent Investor. Revised Edition. USA: Harper Business Essentials, pp.18-34.

[2] Montier, J. (2009). Value Investing Tools and Techniques for Intelligent Investment. Wiley, pp.229-235

Deep Value Investing: Thoughts and Analysis on Benjamin Graham’s Net Current Asset Value (NCAV) Approach Part 1

Objective: Define and interpret Benjamin Graham’s Net Current Asset Value (NCAV) metric and approach

When I first started investing in the stock market in 2012, I would often ask myself this question:

1) What is the ideal price to pick up a “good stock”?

2) How do I beat the market?

It was only until one eventful day while waiting for a friend I randomly walked into a book store and picked up a copy of Benjamin Graham’s investing classic “The Intelligent Investor”. That was when I found the answers I was looking for.

In Chapter 1 of “The Intelligent Investor” Benjamin Graham writes:

“In his endeavour to select the most promising stocks either for the near term or the longer future, the investor faces obstacles of two kinds. The first stemming from human fallibility and the second from the nature of his competition. He may be wrong in his estimate of the future; or even if he is right, the current market price may already fully reflect what he is anticipating. In the area of near-term selectivity, the current year’s results of the company are generally common property on Wall Street; next year’s results, to the extent they are predictable, are already being carefully considered. Hence the investor who selects issues chiefly on the basis of this year’s superior results, or on what he is told he may expect for next year, is likely to find that others have done the same thing for the same reason.” [1]

This statement made very logical sense to me. It is obvious that “good” stocks being good are wanted by everybody (a subjective term).  Therefore, there will a lot of media coverage and analysts following it. Therefore, in my humble opinion, with so many smart and brilliant analysts with all their excel spreadsheets and financial models following a darling sexy stock, future forecasts or expectations of the company would have already being reflected in the stock price due to market efficiency. The more analysts following a particular company, the more efficient its price is. Therefore, in order to generate a higher return than the market, I will need to adopt a contrarian strategy. I will need to avoid the competition and take the path less travelled.  This is where Benjamin Graham’s Net Current Asset Value (NCAV) Approach (Also known as net net investing/ Deep Value Investing) comes in.

In Graham’s other investing classic “Security Analysis” NCAV is defined as

(Current Assets – (Total Liabilities + Preferred stock))/Total Amount of shares

We then screen for companies where their stock price is trading below their NCAV per share.

Benjamin Graham and many of his prodigies including Warren Buffett utilised this approach to achieve market beating returns.

The NCAV equation is essentially a conservative proxy liquidation value of a company. Which is the amount residual after paying off all debtors. In an event of a firm’s liquidation, the current assets like inventory or accounts receivable may suffer impairment, this is when the long term assets (depending on the quality their long term assets and level of impairment too) steps in to fill the gaps.

I may argue that certain long term assets like prime land grade A office buildings and securities and investments can be added into the current assets equation due to their liquidity and quality. Therefore, it is crucial to read the financial statement footnotes to perform an estimation of their quality and liquidating value.

In many discussions and articles I have read both online and offline, NCAV is interpreted as a more conservative form of book value. As it discards all intangibles and severely writes off the long term assets due to the many unforeseen errors of liquidation. Therefore, the whole point of buying a stock below its NCAV is equivalent to buying sometime so cheaply that the loss of capital is very minimal (Classic Value Investing framework). Without a doubt, this practice of buying stocks at a discount to book has been proven to be very effective (there are many case studies available online).

However, I humbly feel that this interpretation is only one side of the lattice. Benjamin Graham was an innovator way ahead of his time and his Net Current Asset Value approach opens up an entire new framework on investing.

Allow me to explain why:

Firstly, Benjamin Graham’s NCAV approach screens companies that are obscure and ignored by the market either due to low analyst coverage or low market capitalisation. Think about how difficult it would be to get the informational advantage for large cap companies that are covered by so many analysts and brokerages. This is why when one screens for obscure ugly companies, one has a higher chance of buying them at a significant discount to assets/earnings. Of course, not every cheap stock out there is a good buy. When one see a stock trading below its NCAV, one needs to ask whether the stock is in cyclical decline or due to business model disruption. There needs to be a filter and checklist to select the wheat from the chaff. (This will be discussed in subsequent articles)

Logically, only beaten down obscure ugly companies with disappointing earnings would be trading at prices below their NCAV. It would make no sense to value profitable companies using the NCAV approach as it would only ignore their intangible branding and income streams and thus undervalue them.  There could be many reasons why the market would value NCAV companies as such. The companies might be faced with problems such as gloomy industry prospects, obsolete business models, ridden with lawsuits, or an overall distrust of management by the market.

Secondly, Benjamin Graham’s NCAV approach screens companies that have a large current ratio. (This makes sense, given that current assets could easily pay out all liabilities) A very high current ratio could be interpreted as been poorly managed. (Many Japanese NCAV companies have a current ratio of 9) These kind of companies generally attract shareholder activists or private equity firms. These people could either buy out the company, restructure them, or force a liquidation. These catalysts will therefore improve shareholder value. A good example would be how famed activist investor Carl Icahn forced Apple to pay out more dividends, given Apple’s huge amount of cash in their balance sheet.

Generally, in order to unlock value for a stock trading below is NCAV, there needs be strategic actions taken by the management (Selling off business arms, turning the operating business around) or by private equity/ activist firms (Mergers, buyouts).

This article attempts to define and interpret Benjamin Graham’s NCAV approach. There will be a part 2 continuation of this article where we will look into the stellar results of net net investing and discuss how one should approach net net investing.

 “There are many respectable fathers scattered across the centuries to choose from. Select a genius and make yourself their adopted son. You can even inherit their name and make claim to be a true descendant and then go forth and share this wealth of knowledge with others.”

Seneca on the Shortness of Life Chapter 15

 

References

 [1] Graham, B. (1973). The Intelligent Investor. 4th ed. USA: Harper Business Essentials, pp.31.