This article was written by Evan Bleker, a net net stock evangelist and author of the deep value website Net Net Hunter. His sole mission in life is to help small private investors realize the best possible returns by investing in Ben Graham’s famous net net stock strategy. Click here for more information.
Are you having a tough time investing?
You may be falling into the same investment trap many other small investors have stumbled into.
There are millions of individual investors globally but most of them underperform the market by a wide margin on average each year. In fact, despite the time and effort spent trying to select outstanding stocks, most individual investors would have been better in a plain vanilla bond portfolio!
Reasonably intelligent investors who are willing to put in even a minimum amount of work into select stocks can do better than that. Being an over-active investor, buying expensive stocks relative to value, and having a weak emotional temperament are all commonly cited reasons for weak performance, but there’s one simple change that would definitely boost your returns over the long run.
A Short Introduction About Me
I started investing way back in 2002 after the tech bubble burst and most stock market and technology gurus were put out of work. In that environment it seemed especially prudent to look back at the long term record of anybody you wanted to learn from. Over the previous 5 years, billions of dollars had been made and destroyed in dot com, and I definitely did not want the same thing to happen to me over the next 5 years.
When it comes to long term track records, people such as Warren Buffett, Ben Graham and Walter Schloss are about as good as it gets. It didn’t take long for me to dive head first into books on Warren Buffett and eventually his shareholder letters. I learned a tremendous amount about investing, and how to think about markets. I grew tremendously as an investor.
I Slipped Into The Trap That Most Retail Investors Fall For…
Reading what the pros have written can be very rewarding but there’s a problem. It didn’t take long for me to realize that I lacked the skill and experience needed to use Buffett’s contemporary investment strategy — a phenomenon I’ve called slipping into The Warren Buffett Trap. But, it wasn’t until after dissecting books by Bruce Greenwald and David Dreman that I began to realize that I had narrowed my scope of potential investments to a pool of maybe 500 to 750 stocks.
At first glance, that doesn’t seem like an issue. There’s no way I could fit that many stocks into my portfolio, after all, and there must be some great picks in a group of 500 firms. Actually, it’s not until you work through the consequences of limiting your pool of investment candidates that the error really comes into focus.
Professional managers are usually very intelligent but the size of the portfolios they’re charged with managing limits their investment options. The average mutual fund had just under $1 billion USD invested in 2011, and it’s definitely grown since. Regulatory and liquidity issues making owning more than 10% of a given company problematic so most managers aim to take a smaller stake in any company they invest in.
But, given the amount of money that needs to be invested and the amount of work needed to properly research and keep track of a single stock, most managers want to limit the number of positions they have to between 25 and 50 stocks. Keeping the 10% restriction in mind, that means investing in firms larger than $200 million USD in market capitalization, at minimum. Larger funds are at an even greater disadvantage. A fund with $20 billion USD under management (a pretty common occurrence in 2016) would be limited to market caps of around $2 billion or greater.
Since there are over 14 000 mutual funds in existence, you can see how competition gets fierce the higher up the market cap ladder you step. At a certain market cap, companies are extremely well researched and the price-to-value discrepancy value investors look for becomes much smaller. In essence, by concentrating on large companies your ability to make market beating returns shrinks dramatically.
1 Simple Change to Boost Your Returns over the Long Run
That’s why I prefer to fish for attractive value stocks where the pros can’t follow. By concentrating my research on the smallest companies, I dramatically improve my ability to find solid value on sale for next to nothing. This is nothing new — Alvin Chow pointed this out in 2014.
But, this investment strategy doesn’t just make intuitive sense, the superior performance of tiny value stocks has been well documented. One of the best places to see this is in the landmark paper, “What Has Worked In Investing,” that Tweedy, Browne put together in 1992 and updated in 2009.
Incase you’re new to value investing, Tweedy, Browne is what we would call a “Classic Graham” or “Deep Value” firm. They’re one of the original Superinvestors identified by Warren Buffett in his “Superinvestors of Graham-and-Doddsville” speech so they definitely know something about value investing. In the paper, Tweedy, Browne highlights a number of studies that cover a wide range of popular value investment strategies and their associated returns.
Let’s start with American stocks, since they’re so well researched by academics and industry professionals. Tweedy, Browne begins their discussion of small capitalization stocks by pointing to a study conducted by Rolf Banz. When looking at stocks in general over the 54 year period, Banz found that the smallest firms recorded a much higher stock return when compared to the largest publicly traded companies. The outperformance amounted to 3.2% compounded each year, or a 36% premium in return over the largest companies.
It’s worth noting that the Brandes Institute, a fantastic value firm in its own right, confirmed this relationship between company size and return. In their words, “Although global small caps have shown cyclical relative returns, they generally have delivered long-term outperformance vs. large caps.”
When looking at specific value strategies, the relationship becomes even more pronounced. Low PE stocks and Low Price to Book firms show much better returns among the smallest market capitalizations when compared to larger companies.
When it comes to Low PB companies, the lower the Price to Book value, the higher the associated return. Fittingly, the firms with the largest discounts to book value also happen to be the smallest companies relative to market cap.
And this tiny market cap phenomenon holds over a wide range of countries, as well. Smaller firms in the UK, France, Germany, Canada, Australia and Japan all show better returns than their larger peers over a long period of time.
For a more detailed look at Tweedy, Browne’s findings, you can access their paper here.
When it comes to small investors, though, this is only the start. Your greatest strength as a small investor is your ability to take advantage of your small portfolio size by adopting much better value strategies, strategies that the pros just can’t use. Take the king of value investing strategies, for example, Ben Graham’s classic net net stock strategy.
Essentially, net net stocks (or NCAV stocks) are Low PB stocks but where the company’s long term assets have been excluded from the book value calculation. The resulting value is known as the company’s net current asset value (NCAV) and is a very good approximation of a firm’s real world liquidation value. By buying companies trading below their NCAV, Graham found that he was able to beat the market by a wide margin for decades. In fact, while Graham developed the strategy during the 1930s he was still advocating it as his choice investment strategy just before his death in 1976.
The returns associated with a well-selected net net stock portfolio dwarf those of more common value investing strategies, which is likely one reason Alvin and the rest of the guys here at Big Fat Purse adopted the strategy for their own investing. A well selected net net stock portfolio has been shown in academic studies to beat the market by 15% or more compounded per year going back over 60 years. That’s a long term CAGR of 25%+, numbers the pros can only dream of!
Just like other value strategies, the returns associated with net net stocks increase with each step down the market cap ladder. Take a look:
Are you shooting yourself in the foot as an investor?
By focusing on larger companies, you’re inevitably making investing much harder than it has to be. Not only are you choosing to compete against professional money managers, investors with a lot more time, experience, credentials, and hired help than you have, you’re also giving up much more profitable investment strategies that you could be using.
Understanding your inherent advantage as an investor is key to wracking up great returns over the course of your life. If you’re managing only a few million dollars or less, do yourself a favour and start focusing on the smallest areas of the market.
Start earning a 25%+ compound rate of return by adopting Ben Graham’s favourite investment strategy, net net stocks. For more information, click here.