Everybody is looking for stocks that will increase in price but few investors focus on increasing the value of their entire portfolio.
Ironic, isn’t it?
A rising stock can make you money but it’s your portfolio returns that increase your net worth. You really have to look at your portfolio as a whole to be a successful investor — and that’s why I focus so much on playing probabilities.
Probabilistic investing means putting together a portfolio based around some criteria that has been shown to yield solid average yearly returns in the past. It means seeking out a base rate, a rate of return typical of specific types of stocks, and then putting together a portfolio of those stocks with the goal of trying to mirror that base rate. This could mean building a portfolio based around low PE, PB, or PCF stocks.
If you’re like me, however, and you want the highest possible returns than it means putting together a portfolio of NCAV stocks and then leveraging additional criteria to boost your returns.
…when it comes to growing your own net worth through investing, limit your downside and the upside will take care of itself.
Instead of putting together a portfolio of stocks that stack the odds of great returns in their favour, however, many people look for lottery type stocks. They focus on trying to find stocks that will increase in price in dramatic fashion and don’t pay much attention to the downside risk.
Benjamin Graham, obviously, understood this to be a serious mistake. According to both Benjamin Graham and Warren Buffett, safety should be a primary concern when investing since risk leads to losses which in turn erode your overall returns and can even leave you broke.
When it comes to my own investments, my philosophy is focused as much on avoiding losses as it is on seeking out high potential opportunities. When I invest, I follow Warren Buffett’s two rules religiously:
- Never lose money, and
- never forget rule #1.
Only after I judge that a stock is unlikely to lead to losses do I focus on the upside potential. Screening out firms with specific characteristics helps decrease the chances that you’ll suffer large losses on any stock in your portfolio.
Ultimately, when it comes to growing your own net worth through investing, limit your downside and the upside will take care of itself.
How to Adapt Benjamin Graham for Safety and Profit
I think everyone should use a checklist when putting together a great classic Benjamin Graham portfolio. A checklist will help you avoid mistakes by focusing your attention on key factors that you might otherwise gloss-over.
I’ve put together a NCAV investment scorecard to assess the investment merit of each net net stock I come across. My checklist has been put together based on a detailed study of Benjamin Graham and an analysis of a number of different studies that examine the returns of various NCAV stock portfolios. While I’ve focused on Benjamin Graham to form the base of my portfolio, it’s hard to argue with the data that’s come out of these scientific studies. As a result, my criteria reflects a blend of Benjamin Graham and findings in contemporary scientific studies.
Let’s run through my NCAV investment scorecard briefly before we see how I would apply it to a specific stock:
Core NCAV Criteria
- Not Chinese – There have been many reverse takeover scams that have left investors with large losses. Most Chinese net nets have been penalized in the market due to allegations of fraud. Ultimately, who knows what the asset value of these companies are.
- Low Price to NCAV – The cheaper you buy your stocks the fewer paper losses you’ll suffer and the greater your ultimate returns will be. Even if any one of your cheap net nets doesn’t bounce back up to full NCAV you can still make money.
- Low Debt-to-Equity – Debt can be a huge benefit to a company when times are good, but destroy a company when it runs into problems. Debt-free troubled companies can’t go bankrupt.
- Adequate Past Earnings or Catalyst – I want to invest in firms that have run into major, yet solvable, problems. Companies with a history of barely scraping by could stay valued below NCAV for a very long time. Obviously this doesn’t matter if there’s a catalyst on the horizon that will either move the stock price or increase profitability.
- Past Price Above NCAV or Catalyst – This is a good way to tell whether you’re buying into a perennial net net or not. I want to see a company that has traded above its NCAV sometime in its recent history, sometime in the past 5 years. The same catalyst clause applies here, as well.
- Existing Operations or Liquidation – When investing in tiny companies, sometimes management will sit on a big bank account “managing” it while they collect large salaries. This is a great way to erode shareholder value slowly while making themselves rich. Avoid Avoid Avoid.
- Not Selling Shares – If a company is using equity financing when the firm’s shares are drastically undervalued then it’s destroying value, destroying your potential for capital gains, and indicating that it’s in a very difficult spot with few options. Why else would management choose to destroy value like that?
Key Quantitative NCAV Criteria
- Large Current Ratio – A larger current ratio is an insolvency buffer. I want the firms I invest in to be able to cover their current liabilities as easily as possible. A larger current ratio also means that the firm’s balance sheet can erode to a greater degree without having a large impact on the firm’s NCAV.
- Small Market Cap – Tiny firms are correlated with large outperformance so I want to stick with smaller firms. Large net nets may have serious problems since there are more large institutional investors who can purchase them but haven’t.
- Low Price to Net Cash – I like situations where the firm is trading below net cash (cash less ALL liabilities) since these firms are paying me to buy stock. The value of cash is also highly certain, since $1 usually equals $1 while other assets might be worth more or less than stated value.
Key Qualitative NCAV Criteria
- Financial/regulated/ADR/Real Estate/closed fund – Avoid. I generally understand these less than I do retail or manufacturing companies so I stay away from them. This will change as my circle of competence shifts.
- Company is Buying Back Stock – This is a great sign because it displays management’s confidence in the business’s future, plus increases the NCAV per share for remaining investors.
- Insider Ownership – If management’s money is on the line then they will have an incentive to realize the maximum shareholder value.
- Major/Minor Insider Buys Vs. Sells – I look for insider buys because I see it as a vote of confidence while I don’t like to see management cash out at deflated prices. While buys are a stronger signal than sells, both are important.
- Burn Rate – The rate at which the firm’s NCAV is eroding provides a good estimate of the amount of runway you have left before your deep value stock isn’t much of a bargain anymore. I want a small or positive burn rate.
- Catalyst – A catalyst isn’t necessary but it is a bonus. I like situations where shareholder value will be unlocked sooner.
If you want a more detailed discussion of some