Value Investing: Tools and Techniques for Intelligent Investment

Chapter 22. Graham's Net-Nets: Outdated or Outstanding?^[22]

One of Ben Graham's favoured valuation signals was a stock selling at a price below net current assets (that is selling for less than its 'net working capital, after deducting all prior obligations'). Graham's methods are often dismissed as anachronistic. However, rather than dismissing Graham's approach as outdated, our evidence shows that buying net-nets is still a viable and profitable strategy. Buying a basket of global net-nets would have generated a return of over 35% p.a. on average from 1985 to 2007. Right now, Japanese small caps are providing half of all the net-nets we can find.

• Warren Buffett once described Ben Graham's approach as 'cigar butt investing'. The basic idea was that the stocks which Graham liked were akin to cigar butts found on the street, still smouldering, from which it was possible to snatch one or two last puffs. This appeals to the cheapskate in me.

• It is well known that simple strategies based on cheapness (as measured by variables such as P/E, or P/B) tend to generate outperformance over the long term. However, as I have noted before, Ben Graham often preferred valuations based upon the balance sheet. In particular, he liked stocks trading at less than two-thirds of their net current assets.

• Testing such a deep value approach reveals that it would have been a highly profitable strategy. Over the period 1985–2007, buying a global basket of net-nets would have generated a return of over 35% p.a. ...