Classic Graham Investing...Outdated?

Graham was a big proponent of what he called "net net" stocks, or stocks trading below their net current asset value (NCAV).

NCAV is basically the net of total current assets less total liabilities.  Said differently, NCAV is the net worth of the firm NOT including any noncurrent assets such as PP&E, goodwill, long-term investments, etc.  Graham's reasoning was that, in the face of a total fire-sale of all the company's assets, only the current assets -- cash or things that can reasonably be converted to cash within a year's time -- could be used to pay down all its outstanding liabilities.  All other assets, even property, would be valued at essentially zero because its value would be irrelevant or too illiquid.

When the NCAV is greater than the firm's market cap (share price x total outstanding shares), the market is implicitly valuing the equity not only less than what the firm can cover with just its cash and near-cash equivalents, but it's even discounting the value of those near-cash equivalents.

Stocks that fit this profile were perfect value investing targets for Graham.  Provided that company was still profitable and not having trouble meeting its financial obligations, it would only be a matter of time before the market would realize the mispricing of the equity and bid up the price of the stock.

Graham would actually go one step further and advise the prudent investor to seek stocks trading at 2/3 or less than NCAV in order to build in a margin of safety that would maximize the chances of preserving principal.

That sounds pretty good!  Why not just build a portfolio of all the stocks trading at 66% of NCAV and just wait patiently for the market to correct its error?  Not so fast...

"Net net" stocks are exceedingly rare these days.  The market has gotten a tad bit wiser since the 1930s or even the 1970s, when Graham revised The Intelligent Investor.  Back then, especially after the Great Depression, the prevailing notion among many, many people was that "bonds are safe" and "stocks are risky".  This nonsense created several opportunities for companies, even well known ones, to wind up trading below NCAV.

Today, it almost never happens.  Check here to see a list of stocks that currently fit Graham's NCAV approach.  Note that the largest market cap stock trading below NCAV while I write this is a mere $132M.  [For comparison, the median market cap for an S&P 500 company is $10.75B, or 81 times bigger.  The smallest S&P 500 company is $1.22B, or 9 times bigger.]  These stocks don't even qualify as small-cap stocks, they're microcap.  Most are even (somewhat derisively) called nanocaps.

This brings up two major concerns that I need to research further:

First, I need to address an issue I touched on in my prior post: are undervalued microcap stocks regularly capable of realizing their intrinsic value?  Large institutions, equity analysts, most people are NOT looking at these tiny companies, which according to Buffett is precisely what we want.  But if almost nobody is looking at them, then who (besides me) is going to buy up these shares?  Eventually something or someone has to jump on the stock and bid up its price.  But who?  I shall research this.

Second, if in fact microcaps tend to remain more or less permanently ignored because nobody is around to buy them, what should I do?  In the 21st century, firms larger than microcap probably never fall below their NCAV.  So if the strict Graham methodology of finding stocks trading below their liquidation value is a more or less outdated strategy, what are my alternatives?  I will explore this in much more detail in later posts.

Checkpoint

I'm on page 226 of The Intelligent Investor out of 535 or so (not including appendices and endnotes).

I figured now is as good a time as any to take stock of the things I've been pondering.  Up to this point, I've had a few of my questions answered, but several that have gone unanswered.  Furthermore, having skimmed the remainder of the book and the book's index, I am fairly certain that my unanswered questions shall remain unanswered.  Let's have a look.

Questions Answered:

Q:  According to Graham, when is a stock cheap enough to call a bargain?

A:  When its current price is at least 2/3 of the intrinsic value.

Commentary:  This fascinates me.  Buying a stock for, at most, 2/3 its intrinsic value implies that my long-run expected return on any of my stock choices should be at least 50%!  Not that the market can be timed, but if I wanted to achieve 15% annual returns, I'd need every stock I choose, on average, to realize its true value in approximately 2.9 years, or a little less than 35 months.  This calculation ignores reinvestment if stock price drops and also assumes that every stock is purchased at the maximum 2/3 threshold.


Q:  Graham, as well as many other value investing experts, recommend seeking out smaller stocks, or "secondary issues", since they are often ignored by large institutional investors and frequently trade at values well below their intrinsic values.  If these stocks go largely ignored by the biggest buyers in the market, why should I believe that such an investment will ever realize its potential?

A:  In short, Graham recommends that we simply accept that such stocks trade below value.  As such, in finding a bargain, it has to be a tremendous bargain since you can and should only hope to realize a portion of its intrinsic value.  In other words, buy them at a bargain price relative to what a private owner might pay.

Commentary:  Technically, my question is answered but it spawns so many more that it is very nearly not.  Graham has famously said, "markets act like voting machines in the short run, and like weighing machines in the long run."  Fair to say, but if I'm supposed to simply "recognize" that certain issues will be perpetually undervalued, then by how much will it fall short of its intrinsic value?  How can I ever know for sure that I'm buying a bargain if I can't even set a baseline for my margin of safety?

Furthermore, how and when will such stocks begin to appreciate if they are largely ignored by the biggest players in the market?  According to this article, retail trading (i.e. yours and mine) makes up 11% of the total trading volume; the rest are hedge funds, institutional investors and market makers.

So when it comes to value investing in small, largely ignored stocks, am I to rely on that 11% to identify my undervalued position?  Who else is out there and how long will it take them to bid up my position?




Questions Unanswered


Q:  In a concentrated portfolio of 5-10 stocks, how do I choose my allocation to each stock?

Commentary:  Graham is disappointingly silent on this topic.  If I choose 5 stocks, how do I allocate my investable funds?  Shall it be 20% into each, or should it vary according to some measurable parameters?

I've considered the standard business school process, Modern Portfolio Theory.  Though MPT appears to be among the best asset allocation models we've got, it is woefully inadequate for a litany of reasons.  Returns are most definitely not normally and jointly distributed; even if they were, that is definitely not how we as investors measure risk.  Also, a value investor not only shrugs off the notion that past returns and volatility are an indicator of future stock behavior, but fundamentally relies on that assumption.  If long-run stock returns could be statistically modeled, then it would be futile to buy cheap stocks since their future returns would be nothing but a probabilistic average (at any price)!  Indeed, many academics and passive investor proponents agree that this is, in fact, the case.

I've also entertained Post-modern Portfolio Theory, which seeks to address some of MPT's deficiencies.  It mostly fixes issues with jointly and normally distributed returns and the implicit assumption risk also includes "upside" risk.  I was intrigued with PMPT at first, but ultimately PMPT must lean on past performance as some indication of future returns.  No matter how sophisticated you make a statistical model, it will always be flawed in the eyes of a value investor because of the aforementioned reasons.

I have no choice but to continue thinking about this.


Q:  At what point should I begin selling my position?

Commentary:  Graham is unclear on this.  Should I begin selling as I achieve my target return?  Do I sell when the stock hits the intrinsic value I've computed?  Or do I let the investment ride until it drops by some predetermined percentage or absolute value?

I partially understand why Graham is unable to offer hard and fast rules on this.  Much of it depends on your general risk tolerance and ultimate financial goals.  However, I am a little frustrated that there aren't tighter guidelines on this.

For now, I believe I must operate on two basic tenets:

1. Allow the stock to ride until it sustains a sufficiently large downturn.  In other words, put a stop-loss order on the position once it approaches the intrinsic value.
2. Be on the lookout for better bargains.  If the remaining upside I can conservatively expect from an existing position is less than the upside from a new bargain stock, it serves to exit the position in order to enter the new one.

All the same, these tenets require a great deal more refinement.  For example, should I base my stop-loss order on a percentage loss or an absolute dollar loss?  What if the upside potentials are approximately the same?  What about tax considerations?  This is but a fraction of the questions I need to hash out.

Main Takeaways So Far

Graham distinguishes two types of investors, the "defensive" one and the "enterprising" one.  A defensive strategy is much like the one my financial advisor follows.  I will cover this in more detail later, but suffice it to say for now that a defensive posture mostly adopts a passive investing approach, deriving the bulk of returns from dollar cost averaging.  The enterprising strategy involves the active search, analysis and management of a (usually) smaller set of stocks.  There are two approaches to enterprising: the negative approach and the positive approach.  The negative approach is more like a defensive-plus posture: invest in a market portfolio but actively avoid crappy stocks.  The positive approach involves uncovering gems through diligent research.

I prefer positive-approach enterprising investing.  It's more or less the Magellan Fund's strategy and the only one I believe can achieve appreciable returns in excess of the market.

Goal Setting

When it comes to investing, nothing is guaranteed.  But that doesn't have to stop me from setting some lofty goals.  I list them here, in rank order of importance.

1. The number one goal is to not lose money.  Protecting principal is job #1.  For instance, 20% returns for 4 consecutive years can be almost completely erased with a -50% return in the 5th year.  I must try my hardest to avoid harsh negative returns.  I will define this in more detail in a later post.
2. I am benchmarking myself against the S&P 500, and thus intend to beat it over the long term.  My assumption is that the default investing strategy for normal people should be to invest in a broad market index fund.  Deviating from that strategy should result in improved returns otherwise why bother?
3. I also want to benchmark myself against my own financial advisor.  If I can't beat my financial advisor on a net basis, I am better off paying him to manage my funds.  Historically, my advisor has consistently outperformed the S&P 500, as his strategy already mostly adopts Graham's "defensive, dollar-cost-averaging strategy" with slight tactical allocations to favorable sectors.  Beating him will actually prove a fairly high water mark, since I'm competing against a version of my own strategy.  I will discuss this in more detail in a later post.
4. I want to double my money in 5 years.  That would require nearly a 15% year over year return over 60 months.  Common sense says that this is quite a stretch, but it doesn't hurt to aim high so long as I don't allow myself to take stupid risks in order to reach this goal.

** Updated on 2012-02-13 **

Beginning my Apprenticeship

If sound investing as simple as studying a book while exercising a modicum of prudence, patience, and diligence, why aren't we all rich?

This is the question I seek to answer.  Welcome to my investing blog, Graham's Apprentice.

This blog is best described as a real-time, real-money experiential study in Benjamin Graham's value investing philosophy.  Using real dollars, I will create and manage a small portfolio of stocks.  These stocks will be selected strictly according to the philosophy and methodologies endorsed by Mr. Graham's famous book, The Intelligent Investor.  I may use other value investing books as references as well as whatever skills and education I have already accumulated.  Other than that, however, I consider myself "regular folk": I have only a relatively modest sum of investable funds and a full-time job as well as other commitments and pursuits.  Like you, dear reader, I cannot stare at a Bloomberg terminal all day.  Nor can I research stocks ten hours per day.  Nor do I have enough money that could singlehandedly swing a stock price.

That said, I will perform all the diligence and exercise, to the best of my ability, the sound judgment prescribed by The Intelligent Investor.  Once I've built the portfolio, I will publish my selections and track them meticulously.  All of this work will be made available to you, dear reader, completely free with no strings attached.

The Intelligent Investor, written by famed investment adviser Benjamin Graham, has been in print since 1949.  To this day, it is heralded as a "stock market bible" by nearly everyone who has read it, including Warren Buffet.  Skim the reviews on Amazon.com, and it difficult to find anybody who has something negative to say about Mr. Graham's work.  Warren Buffet himself has expounded several times over that Graham's work and philosophy has guided his (extraordinarily successful) career for over 40 years.

And yet, when I perform a simple Google search for a regular guy who has followed the acclaimed wisdom of The Intelligent Investor and become financially successful because of it, I come up empty handed.

Thus I return to my original question: if one could just study and embrace the teachings of a book that is so widely considered the most sound approach to investing for the long-term, why can't I find empirical evidence that gives credence to it?  Sure, there are people out there such as Warren Buffet and Peter Lynch who have achieved great success with the philosophy of The Intelligent Investor, but where is everyone else?  The book has been in print for over 60 years; surely others have adopted the philosophy and achieved success?

Logic dictates that it must be some combination of the following:

1. Value investing doesn't work.
• Burton Malkiel posits that consistently beating the market is an impossible endeavor and that investors should simply invest for the long-term in index funds rather than actively manage a portfolio of stocks and bonds.  This is because markets behave as a "random walk", thus making it impossible to predict outcomes with any regularity.  Furthermore, actively managed funds and portfolios incur overhead expenses and trading fees that detract from overall returns that make it even less likely to generate market-beating strategies.
• Nassim Taleb echoes a similar ideology, only with a more pessimistic twist.  He posits that participating in the stock market is a giant Monte Carlo simulation.  Statistically, there will always be a spread of winners and losers and, even over relatively long periods of time, it is a statistical inevitability that we will observe outliers who have been very lucky to have beaten the market repeatedly.  In other words, guys like Warren Buffet are not the product of hard work and prudent investment management but rather a natural, statistical outcome that could have just as easily been somebody else (probabilistically speaking).
2. Value investing only works for certain people.
• Warren Buffet takes enormous stakes in his investments.  Sometimes his holding firm Berkshire Hathaway acquires entire firms if he feels the price is right.  These actions make Mr. Buffet privy to information and data that aren't available to the general public (i.e. you and me).  While not legally classified as insider trading, his buying power gives him an inside track that allows him to capture value where small players cannot.
• The same can be said of successful investment managers such as Peter Lynch.  Mr. Lynch will physically meet with companies' management teams as part of his due diligence.  Regular folks have neither the time nor the resources to conduct their research with this sort of precision and granularity.  If the philosophy only works for those who dedicate their entire working lives to it, then for regular folks The Intelligent Investor can only best serve as an instructive resource but never as a key to building wealth through investing.
3. Value investing is a lot of work and hard work is almost never popular or desirable.
• People always want a magic bullet that grants great reward without having to put in the effort.  From diet fads to magic formula investing, the great American Dream seems to have evolved into an attitude in which we seek to achieve the greatest rewards with the least amount of effort.  Is it possible that so few people try this because true value investing requires good old fashioned hard work?
4. Value investing works just fine, but the amount of effort it requires does not sufficiently compensate most investors.
• A hedge fund manager manages hundreds of millions, sometimes billions, of dollars.  Beating the market by even 1% means a marginal payoff in the millions of dollars.  The vast majority of regular folks of course do not have millions of dollars to manage.  It could be only a few hundred, perhaps a few thousand, and the luckiest of us might have a few hundred thousand.  Even with $100,000 to invest, however, beating the market by, say, 5% results in a marginal gross profit of $5,000.  If diligent value investing requires 500 hours of effort, is it worth it?  My guess is that for most people, it probably is not.

The above list's final reason is my hypothesis.  Given my current understanding of value investing, I believe it to be a sound investment strategy for anyone who can devote the effort and maintain patience.  However, I suspect that it will not generate attractive enough returns to justify the amount of work required.

Nothing can be known, however, until I try.  My curiosity has gotten the best of me and in spite of the long hours and hard slogging ahead of me, I am determined to complete my apprenticeship under Benjamin Graham's guidance.