Graham Net-Nets: Outdated or Outstanding?

I have written briefly on Graham’s Net-Net Strategy before (here) with backtest being run by Jae Jun from Old School Value. Having read Montier’s research article – Graham Net-Nets: Outdated or Outstanding?, I believe that a more in-depth article should be written on the topic of net-nets.

With a net-net strategy, it is really ‘cigar butt investing’ as how Buffett termed it. Essentially, it is akin to searching for cigar butts on the street to get one or two last puffs from it. While that last few puffs may not offer much of a smoke, this ‘bargain find’ will make that puff all profit. In Montier’s article he did not go into the details of his research methodology, however, I would believe as with most backtests, it would consist of the usual procedures and standard biases would have been taken into account. More importantly, some of Montier’s findings got me quite interested.

Montier’s Findings:

  1. Over the period of 1985-2007, buying a global basket of net-nets would have generated a return of over 35% p.a. versus an equally weighted universe return of 17% p.a.
  2. The net-nets portfolio contains a median universe of 65 stocks per year.
  3. There is a small cap bias to the portfolio, with the median market cap of a net-net being USD21m.
  4. He found roughly 175 net-nets globally, with over half of these in Japan.
  5. Defining total business failure as stocks that drop more than 90% in a year, then the net-nets portfolio sees around 5% of its constitutes witnessing such as event. In the broad market only about 2% of stocks faces such a scenario.
  6. The net-nets portfolio suffered only three down years compared to six for the overall market.

What got me interested are points 5 & 6 of the above-mentioned findings.

With net-nets, we are buying company’s whose theoretical liquidation value far exceeds that of their market cap. Yet, we do see that 5% of the portfolio of companies would suffer a permanent loss of capital compared to the 2% of the overall market.

Ben Graham Net-Nets: Outdated or Outstanding?

Given such the higher statistics of a permanent loss of capital, Montier pointed as to why the net-net strategy still works today, despite being widely known. Investors are known to look at the performance of individual stocks in their portfolio rather than the portfolio in entirety, this is known as ‘narrow framing’.



However, the reverse can be said for the number of down years for each portfolio. Montier observed that comparing the number of years of negative returns, the broad market suffers 6 years of down years compared to the 3 for the net-nets portfolio.

Whether Graham’s Net-Net Strategy is outdated or outstanding, I believe most would have the answer now. However, one has to understand the limitations of such a strategy. As stated, such companies are usually the small to micro-cap stocks that is not available for individuals managing a much larger capital. Otherwise, the biggest challenge for most I would say would be overcoming our bias of such stocks and look at our portfolio in aggregate terms.