In the first part of this series testing Benjamin Graham’s net current asset value (NCAV) strategy, we reviewed different studies that confirmed the effectiveness of this strategy in regard to outperformance.
But what about reality? No one can purchase every single net-net stock. You have to make choices, commissions must be paid. The spread between bid and ask prices can make it difficult or expensive to purchase these stocks.
Graham’s strategy in practice
Studies differ from reality, and only the execution of the strategy will prove its effectiveness. The best proof for the success of Graham’s method lies with those investors who have used it. Their success in real markets will be the best evidence for us.
Benjamin Graham
As the developer of the strategy, Graham is the first and best evidence of the success of his method. According to Graham-Newman's letters to partners, the returns between 1926 and 1956 were about 20% annually. Of course, they used other strategies like special situations, but net-nets were a very important part of this portfolio.
Walter Schloss
One of the most successful deep-value investors was Walter Schloss. His exceptionally long career and great track record is still unbeaten. He worked for Graham at Graham-Newman before starting his own partnership in 1955. From 1955 through 2002, Schloss managed the company. His son, Edwin, joined the partnership in 1973 and it became Walter & Edwin Schloss Associates. The compound annual rate of return for his firm was about 21% per year, compared to the S&P Industrial Average's gain of 11% per year.
Irving Kahn
Another alumnus of Graham, who was also his teaching assistant at Columbia Business School, was Irving Kahn. Kahn was a chartered financial analyst and founded Kahn Brothers (Trades, Portfolio) Group with his sons, Thomas and Alan, in 1978. Kahn began his career in 1928 and continued to work until his death (aged 109) in 2015. Kahn Brothers continues its successful investment operations, led by Thomas Kahn. As the fund got bigger, the firm's investment philosophy 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.
Warren Buffett
You cannot talk about Graham’s disciples without mentioning the most famous one, Warren Buffett (Trades, Portfolio). When Buffett began his career, Graham’s net current asset value strategy was one of his most important methods. Buffett called it cigar-butt investing. According to his letters to shareholders, from 1957 until end of 1968, Buffett achieved an average return of 31.6%, compared to the tiny 9.1% return of S&P 500 index.
Charles Brandes
California-based Charles Brandes (Trades, Portfolio) met Graham in the early 1970s while still managing the front desk of a small brokerage firm in La Jolla, California. Inspired by Graham, Brandes 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 deeply undervalued stocks. Brandes has also written several books, including ”Value Investing Today” and ”Brandes on Value: The Independent Investor.”
Tweedy, Brown Co.
Another global value investing powerhouse is Tweedy, Brown (Trades, Portfolio). The firm was established in the 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, 40s and 50s. After the retirement of founder Bill Tweedy, Tom Knapp joined the firm in 1957 from Graham-Newman and led its conversion from broker to investor with Howard Brown and Joe Reilly. The firm's investment approach derives from Graham's work. Even today, they have an eye for deep-value investments involving some net-nets.
Peter Cundill
Deceased Canadian value investor Peter Cundill's love for travelling turned him into one of the best global investors. After reading about Graham in George Goodman’s “Super Money,” Cundill knew what he wanted to do for the rest of his life. Cundill started Peter Cundill & Associates Ltd. in 1974. Throughout his career, he was a pure deep-value investor. He once said, “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, Cundill earned his investors a 19% annual compound return. The firm's assets under management surged from $10 million to nearly $20 billion.
Seth Klarman
Seth Klarman (Trades, Portfolio) might be the most prestigious of all modern value investors – after Buffett. As a young student, Klarman worked for legendary value investors Max Heine and Michael Price (Trades, Portfolio) of the Mutual Shares fund. It was excellent place to learn about 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 trading below what he and his analysts believe are their intrinsic values. Klarman is a very conservative investor and often holds a significant amount of cash. On average, Baupost has returned nearly 20% annually, which is an amazing return considering the size of the fund.
Joel Greenblatt
Joel Greenblatt (Trades, Portfolio) is famous for his books ”You Can Be a Stock Market Genius,” ”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 Genius,” Greenblatt deals excellently with special situation investing. In 2009, Greenblatt introduced Magic Formula Investing in his best-selling book, “The Little Book That Beats the Market.” His Gotham Asset Management earned annual average returns of about 40% from 1985 to 2006. Greenblatt’s first few years of astonishing returns came mainly from special situations and net-net investing.
Bruce Berkowitz
Bruce Berkowitz (Trades, Portfolio) started his investing career with Merrill Lynch. He then worked as a senior portfolio manager at Lehman Brothers Holdings and as a managing director at Smith Barney. Berkowitz read Berkshire Hathaway's (BRK.A)(BRK.B) annual reports, which led him to the works of Graham. In 1997, Berkowitz started his own firm, Fairholme Capital Management. Fairholme's strategies are rooted in Graham-Dodd methods. Berkowitz is looking for deeply undervalued and distressed stocks. He is a focused investor who manages a concentrated portfolio. His top ideas represent a major portion of the portfolio. Berkowitz was named the 2009 Domestic-Stock Fund Manager of the Year and the 2010 Domestic-Stock Fund Manager of the Decade by Morningstar.
David Einhorn
David Einhorn (Trades, Portfolio) is a modern comprehensive value investor whose toolbox contains almost all instruments of value investing. Einhorn founded Greenlight Capital in 1996 with just $900,000 under management. In his book, Einhorn describes how he put 15% of his fund into a small Graham net-net, C.R. Anthony. After that, he really found early success. Stage Stores Inc. (SSI, Financial) bought out C.R. Anthony shortly after Greenlight Capital established the position. The company finally returned 500% and Greenlight returned 37% for the year - and the rest is history. Recently, Einhorn has become known for short selling, special situation investing and being an activist in many companies. He is an investor worth paying attention to for his value-based fundamental approach, excellent research and long-term focus. Since its inception, Greenlight has returned an average of 29% annually.
Conclusion
One might wonder why Graham’s strategy is not more popular among professional investors since the evidence for strong outperformance is undeniable. One of the reasons is its lack of scalability. Huge funds with billions of dollars under management cannot implement this approach with such 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 even be a problem for smaller private investors. Of course, if your playground is global, you will have more stocks to choose from. Roughly speaking, if you have less than $1 million under management, you can use a solely NCAV strategy. If you have over $10 million, it can be only part of your overall strategy.
Start a free 7-day trial of Premium Membership to GuruFocus.
