In the first part of this series, ‘The beginner’s guide to value investing’ I touched briefly on the method used by Benjamin Graham, the Godfather of value investing, to find undervalued equities. In this part, I’m going to explore his method of valuation further.
Deep value investing
Benjamin Graham invented value investing in response to his experience in the Great Depression. He was working on Wall Street at the time and lost virtually all of his money in the crash of 1929. Other investors and partners, he knew also lost significant sums.
Following this disaster, Graham set out to build a strategy that would ensure he never had to stomach significant losses again. The result was his so-called net-nets strategy.
Put simply, this strategy was designed to minimise the chance of a permanent capital impairment or 100% loss.
Graham’s thesis was simple. He wanted to find stocks that were trading at a value less than, or equal to the net value of their current assets. That is: current assets minus total liabilities.
You’ll notice in the example above, long-term assets are not included, that’s because they are treated as being virtually worthless. The reason why is to give a margin of safety. If you are buying the company for less than the value of its current assets minus all liabilities, in the event that the company is liquidated if all of its current assets are used to settle outstanding liabilities. The remaining cash and assets would then be distributed to investors. Graham saw this as a way of being able to buy $1 for $0.50.
The one thing to note with this approach is that certain current assets will undoubtedly be worth less than their carrying value on the balance sheet.
In the event of a liquidation, a company may be forced to conduct a fire sale, in which case the total liquidation value will be greatly reduced. Nevertheless, by excluding long-term assets from the initial calculation, you have a margin of safety whereby if current assets are not worth as much as you expect, long-term assets may make up the difference.
Mixed bag
Unfortunately, companies that become net-nets are typically mediocre at best and poor at worst, especially today.
At the beginning of this series, I mentioned that value investing has changed significantly over the past 100 years because financial information is far easier to get hold of today. When Benjamin Graham first rolled out his net-nets strategy, finding high-quality companies trading at a discount to asset value was relatively easy — if you were willing to do the extra legwork.
Today, net-nets are far rarer than they were in Graham’s time, and the quality of them tends to be much worse. Graham always recommended having at least 30 net-nets stocks in every portfolio to hedge the risk of some not working out.
Today, I think you would struggle to find 30 high-quality net-nets to build this kind of diversification.