Previous part of Returns of Benjamin Graham’s Net Current Asset Value (NCAV) Strategy we viewed different studies which showed that outperformance of this strategy is unquestionable.
How about the reality? No one can purchase every single net-net stock. You have to make choices. Commissions must be paid. Spread between bid and ask prices can make it difficult or expensive purchase these stocks.
Benjamin Graham’s Net Current Asset Value Strategy in practice
As we said studies are different thing and only practice shows how this strategy will work. The best proof of Graham’s method are those investors who have used it. Their success on real markets will tell us a lot.
The developer of the strategy, Benjamin Graham, is the first and best evidence of profitability of his own method. Returns of Graham-Newman Partnership between 1926 and 1956 was about 20% annually. Of course they used also other strategies, like special situations, but net-nets were very important part of his portfolio.
One of the most successful deep value investor was Walter Schloss. His exceptionally long career and great track record is still unbeaten. He worked for Ben Graham at Graham-Newman before started his own partnership in 1955. From 1955 through 2002, Walter Schloss has managed the same investment partnership. Walter’s son, Edwin, joined the partnership In 1973 and the fund became known as Walter & Edwin Schloss Associates. The compound rate of return for his Limited Partners was about 21% per year compared to a gain for the S&P Industrial Average of 11% per year.
Another alumnus of Ben Graham and also his teaching assistant at Columbia Business School was Irving Kahn. Irving Kahn was a Chartered Financial Analyst and founded Kahn Brothers Group with his sons, Thomas and Alan, in 1978. Irving Kahn began his career in 1928 and continued to work until his death (aged 109) in 2015. Kahn Brothers Group continue its successful investment operations leading by Thomas Graham Kahn. Over time when the fund got bigger, Kahn Brothers’ investment philosophy has evolved from Graham’s original “discount to net asset purchase” model into a contrarian value strategy focusing on margin of safety and capital appreciation over long periods of time.
Talking about Benjamin Graham’s disciples you cannot ignore the most famous one, Warren Buffett. When Buffett began his career managing partnerships by Buffett Partnership Ltd., Graham’s net current asset value strategy was one of his most important methods. Buffett called it cigar-butt investing. From 1957 until end of his Partnership 1968 Buffett achieved an average return of 31.6% compared to tiny 9.1% return of S&P 500 index.
California based Charles Brandes met Ben Graham early 1970s while still managing the front desk of a small brokerage firm in La Jolla, California. Inspired by Graham, Charles ventured out and started his own firm Brandes Investment Partners in 1974. By applying the value-oriented investing principles of Graham and Dodd, Brandes seeks deep undervalued stocks. Of course size of his company enables the use of the net-net method only a limited. But you can still see them to find net-nets, especially globally. Charles Brandes has also written following books: ”Value Investing Today” and ”Brandes on Value: The Independent Investor.”
Another classical nowadays global value investing power house is Tweedy, Brown Company. The firm founded 1920s as a dealer in closely held and inactively traded securities. Graham-Newman Corp., was one of the firm’s primary brokerage clients in the 1930s, 1940s, and 1950s. After retirement of the founder Bill Tweedy, Graham’s disciple Tom Knapp joined the firm in 1957 from Graham-Newman and led its conversion from broker to investor together with Howard Brown and Joe Reilly. The firm’s investment approach derives from the work of the Benjamin Graham. Even today they have an eye for deep value investments involving some net-nets.
Very multi-dimensional personality was 2011 deceased Canadian value investor Peter Cundill. He enjoyed his life to the fullest and was always ready for challenges or new experiences. His love for travelling turned him to one of the best global investors. After reading about Benjamin Graham from George Goodman’s “Super Money” Peter Cundill knew “this is what I want to do for the rest of my life.” Cundill started Peter Cundill & Associates Ltd in 1974. He was throughout his career a pure deep value investor. Cundill has himself stated: “Ninety to 95% of all my investing meets the Graham tests. The times I strayed from a rigorous application of this philosophy I got myself into trouble.” From 1974 to 2006, when Mackenzie purchased the company, Peter Cundill earned his investors a 19% annual compound return. Fund’s assets under management surged from $10 Million to nearly $20 Billion under the management of Cundill.
The next generation of Benjamin Graham’s famous disciples are among other Seth Klarman, Joel Greenblatt, Bruce Berkowitz and David Einhorn.
Seth Klarman might be the most prestigious of all current value investors – after Warren Buffet. As a young student Klarman worked for legendary value investors Max Heine and Michael Price of the Mutual Shares fund. It was excellent place to learn value investing. He founded his own hedge fund, the Baupost Group in 1982. Klarman is a traditional value investor, looking for companies, bonds, credit instruments and real estate opportunities that all trade below what he, and his analysts believe is intrinsic value. Klarman is also very conservative investor and often holds a significant amount of cash in his investment portfolios and always take care of downside protection. On average Baupost has returned nearly 20% annually, which is an amazing return on its size fund.
Joel Greenblatt is famous for his books ”You Can Be a Stock Market Genious”, ”The Little Book That Beats the Market”, ”The Little Book That Still Beats the Market” and ”The Big Secret for the Small Investor”, which are all classics. In his first book “You Can Be a Stock Market Genious”, Greenblatt deals excellently with special situation investing. In 2009 Greenblatt launched Magic Formula Investing in his bestselling book “The Little Book That Beats the Market.” As a hedge fund manager, his Gotham Asset Management earned annual average returns of about 40% from 1985 to 2006. Greenblatt’s first few years astonish returns came mainly from special situations and net-net investing.
Bruce Berkowitz from Florida started his investing career in Merrill Lynch. Then he worked as a senior portfolio manager at Lehman Brothers Holdings and a managing director of Smith Barney. Berkowitz read Brrkshire annual reports written by Warren Buffett which led him to the works of Benjamin Graham. In 1997, Berkowitz started his own firm, Fairholme Capital Management. Fairholme’s strategies are rooted in a school of Benjamin Graham and David Dodd. Berkowitz is looking for deep undervalued and distressed stocks. He is very focused investor who concentrate to own just a few stocks and his top idea represents a major part of their portfolio. Berkowitz was named 2009 Domestic-Stock Fund Manager of the Year and 2010 Domestic-Stock Fund Manager of the Decade by Morningstar.
David Einhorn is a modern comprehensive value investor whose toolbox contains almost all instruments of the value investing. Einhorn founded Greenlight Capital in 1996 with just $900,000 under management – and from this amount half was borrowed from his parents. In order to be profitable they had to get quickly returns. Einhorn put 15% of his fund into a small Graham net net, C.R. Anthony. And Einhorn really found early success. Stage Stores buyout C.R. Anthony shortly after Greenlight Capital initiated the position. C.R. Anthony finally returned 500% and Greenlight returned 37% for the year – and then the rest is history. Recently Einhorn has also become known his short selling, special situation investing and being activist in many companies. He is an investor worth paying attention to for his value-based fundamental approach, excellent research, and long-term focus. From the beginning until today Greenlight has returned average 29% annually.
One might wonder why Graham’s Net Current Asset Value strategy isn’t even more popular amongst the professional investors, although the evidence of strong outperformance is unquestionable. One of the reason is its lack of scalability. Huge funds with billions of dollars under management cannot implement this stock selection approach using such a rigorous stock selection criterion. The amount of money needed under management for the fund to be profitable and the extreme selectivity of the filtering criterion are incompatible from a business model standpoint. Especially when the market is high Graham’s NCAV screen eliminates too many stocks. During those times it may be a problem even for smaller private investor. Of course, if your playing ground is global, you will get more stocks to choose. Roughly speaking, if you have less than $1 million under management you can use solely NCAV strategy, but if you have under management over $10 million, then it can be only part of your overall strategy.