The last blog showed how my 2013 portfolio based on Benjamin Graham’s Net Current Asset Value approach has worked – up 40% in a year (in a flat stock market). I explain more about the technique here.
As a young man Benjamin Graham was a successful fund manager in the 1920s. Then the Wall Street Crash happened.
In the years that followed he thought about the difference between investment and speculation. One of the factors is that speculators often put a great value on hope. They forecast a bright and glorious future regardless of the absence of solid ‘facts’ from the past or the present to support that hope.
He learned the hard way to consider the what-if questions, e.g. What-if the economy suddenly stops growing? What if there is a changed consumer mind-set resulting in much lower sales of the firm’s product? What if the assets in the balance sheet can’t be sold at that valuation?
Bridge building and the investor
His cautious attitude is encapsulated in the guiding principle followed by engineers when designing a bridge. They do not just build-in strengths to withstand all normal stresses and strains. They build-in a large margin of safety, so that if unusual winds or loads impact it the bridge will still stand.
So it should be with investors. They must allow a large margin of safety. Given the ‘facts’ available, that is, trustworthy balance sheet net assets and proven earnings, will this company be able to withstand shocks. Furthermore, is the current price placed on the company by the market significantly below the value that you would place on it if you were buying it as your family business in a private transaction, given very realistic assumptions about the assets, liabilities and earnings power?
Buy at bargain prices
With this mind-set Graham set to work looking for companies significantly under-priced. Between the mid-1930s and mid-1950s his main approach was to buy when the market was selling at less than the net current assets. He found dozens, sometimes over 100, in the Depression. Companies were selling at less than the realistic liquidation value of the balance sheet. Over those 20 years he significantly out-performed the market.
Some of these companies were selling at less than the cash on their balance sheet. In case you were wondering if this phenomena disappeared after the extraordinary circumstances of the 1930s, think again. Many hi-tech companies of recent times raised large amounts of money, then the stock market crashed, they fell out of favour and market capitalisation fell below BS cash.
There is much more to Benjamin Graham’s approach than this. The next blog will detail the quantitative rules.