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Tuesday, May 20, 2014

Balance Sheet Investing Strategy: A Review of Graham net-net

Source: http://klse.i3investor.com/blogs/kcchongnz/52382.jsp

Balance Sheet Investing Strategy: A Review of Graham net-net

“If you are shopping for common stocks, choose them the way you would buy groceries, not the way you would buy perfume.”

The reason I was interested in this investing strategy is because plenty of academic research has shown that this strategy has yielded very good results in the US market. One of the nearest-to-pin disciples of Graham, Walter Schloss purely followed this strategy and has yielded wonderful results with CAGR of 21.3% compared to 8.4% of S&P for a period spanning five decades as shown below:

http://klse.i3investor.com/blogs/kcchongnz/50988.jsp

Comments on Graham net net investing strategy

So far the response to this strategy from the i3investors forumers has been lukewarm at best as shown from some of the comments below:

“investors should look into investing in businesses that can generate wealth from their existing assets and grow, not from the view of how much they will get if the company liquidate their existing assets”

“KC, what is the likelihood that Kuchai will trade closer to its net asset value in the future ? For me, looking at these type of Graham net net there must be some catalyst that would unlock its value or else we could be stuck very long time holding them with significant opportunity cost.”

“The market always discounts potential value trap at required rate of return on equity. You may invest in value play based on Balance Sheet but ultimately it is FCF that counts when determining fair value.” maker

It is understandable as this strategy of investing is a very boring strategy. Few people are interested in investing by looking at the balance sheet (shit?). Revenue and profit growth, directors frying their shares, big contracts awarding, striking oil etc are always the prevailing themes.

So what is this Graham net net strategy of investing? Here is a review.

Graham net net strategy

Graham net-net is an estimation of the liquidation value of a company as shown below.

Net Net Working Capital = Cash and short-term investments + (0.75 * accounts receivable) + (0.5 * inventory) – total liabilities

It's the lowest form of valuation you could possibly do because it ignores everything about the business and just focuses on tangible assets. The formula states that;
• cash and short term investments are worth 100% of its value
• accounts receivables taken at 75% of its stated value because some might not be collectible
• take 50% off inventories, due to discounting if close outs occur.

So if one buys the stock with market capitalization below the Graham net-net value, he would very sure make money eventually. This was what Graham said.

“The idea here was to acquire as many issues as possible at a cost for each of less than their book value in terms of net-current-assets alone – i.e., giving no value to the plant account and other assets. Our purchases were made typically at two-thirds or less of such stripped-down asset value. In most years we carried a wide diversification here – at least 100 different issues.”

What is my experience in Graham net net investing then? My experience is indeed too short a time frame. Nevertheless I will still provide some non-statistically significance figures here just as a guide.

My experience in Graham net net investing strategy

I started this strategy of investing about a year ago as a “diversification” from my earnings based “Magic Formula” of Greenblatt. Here is the results as shown in Table 1 in the appendix below at the close of today’s market of some of the net net stocks picked throughout the past one year.

The net net portfolio set up within the past one year returned 34.6%, more than twice the return of the broad market of KLCI of 16.0%. It is really not bad at all for a safe balance sheet investing strategy. Heads I win, tails I don’t lose (much).

I have hence decided to continue this safe strategy of investing for the near future in view of the prevailing market conditions and the position of the swing of the investment pendulum.

K C Chong (19th May 2014)

Appendix
Table 1: Return of net net portfolio as on 19th May 2014
Graham net net return

No.
19/05/2014
Ref price
Now
Dividend
Gain/loss
return
1
Daiman
2.630
3.480
0.120
0.97
36.9%
2
KSL
2.020
2.170
0.000
0.15
7.4%
3
Plenitude
2.100
2.910
0.060
0.87
41.4%
4
Insas
0.630
1.200
0.010
0.58
92.1%
5
PMCorp
0.150
0.220
0.000
0.07
46.7%
6
Hexza*
0.635
0.755
0.050
0.17
26.8%
7
Prkcorp
2.820
3.590
0.000
0.77
27.3%
8
Kuchai
1.200
1.450
0.000
0.25
20.8%
9
KESM
2.040
2.520
0.030
0.51
25.0%
10
FACB
1.260
1.530
0.000
0.27
21.4%

     

Average
1.55
1.98
0.03
0.46
34.6%

KLSE
1627
1887
0.000
260
16.0%

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