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by Evan Bleker,

Want to achieve the highest compounded returns possible? Few investors will say no to that question. But many of the same investors still don't optimize the strategy that they've chosen.

Mechanical Investing: a Simple Way to Make Big Profits

As founder of Net Net Hunter, it's no secret what strategy I've opted for. Net net stocks consistently outperform pretty much all other investing styles since at least the 1920′s. Eventhough Graham himself suggested that investors should expect a minimum 20% return from net net stocks over the long term, some of us strive to do better.

Getting better results with mechanical value investment strategies really comes down to stacking the odds even further in your favor. Mechanical value investing styles exist because it takes advantage of systematic market anomalies - little quirks in the market where the odds of success are in the investor's favor.

Many value investing strategies are extremely profitable, such as Graham's net net stock strategy, but it can be improved upon. Improving my NCAV strategy came down to dissecting a number of academic studies and white papers that examined net net stocks. The main goal of the papers is to check the returns produced by Graham's net net strategy. However, I was able to dig up additional nuggets of wisdom tucked within the pages which I want to share with you.

One Easy Way You Can Increase Your NCAV Portfolio Returns

One of the easiest ways to increase your net net portfolio returns is to screen out companies with a lot of debt. One of my favorite papers is titled What Has Worked in Investing by legendary investment firm Tweedy Browne. In the paper, Tweedy Browne tests returns of low price-to-book portfolios, ranking them from the highest to the lowest in terms of price-to-book ratio. On the very bottom rung, Tweedy Browne includes a basket of net net stocks.

The idea is to pit the portfolios against each other and the S&P 500 to see how each portfolio fares.

Let's take a look:

Tweedy Browne examined the historical returns from stocks which were priced low in relation to book value and from stocks which were selling at 66% or less of net current asset value.

All 7,000 public companies in the Compustat database, including the Research File of companies which had been acquired, merged or declared bankrupt subsequent to an assumed historical selection date, were screened to identify those companies with a market capitalization of at least $1 million and a stock market price of no more than 140% of book value on April 30 in each of 1970 through 1981.

For each of these twelve portfolio formation dates, the investment returns for all stocks were computed for 6 months, 1 year, 2 years and 3 years after each selection date. These stocks were ranked according to price in relation to book value and sorted into nine price/book value groups and one group comprised of stocks selling at less than 66% of net current asset value.

The average results for all stocks in each of the ten groups were compared to the results of the Standard & Poor's 500 Stock Index (S&P 500) over each of the holding periods. A total of 1,820 companies were culled from the Compustat database. The results of this price/book value and net current asset value study are presented in Table 4. Tweedy Browne p. 5.

The average result of the net net stock portfolios over the 11 year period was stunning. While the S&P 500 climbed 9.1% from 1970 to 1981, net net stocks returned 28.8% on average.

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Tweedy Browne's study is great because it gives you a clear baseline from which to judge the effect of eliminating net nets with too much debt from an investor's portfolio. We can also compare the effect this technique has on NCAV portfolio returns versus the effect of eliminating debt-heavy companies from regular low price-to-book portfolios.

To test, Tweedy Browne gets rid of the most debt-laden companies.

...using the same methodology over the same period, examined the historical returns of the stocks of

(i) unleveraged companies which were priced low in relation to book value and
(ii) unleveraged companies selling at 66% or less of net current asset value in the stock market.

The sample included only those companies priced at no more than 140% of book value, or no more than 66% of net current asset value in which the debt-to-equity ratio was 20% or less. The results of this study of unleveraged companies which were priced low in relation to book value and net current asset value are presented on the following page in Table 5. pg 6

The result is extraordinary. Instead of the 28.8% returns net net stocks gained during the original study, net net stocks returned 34.9% on average per year - 6 percentage points higher! - after companies with too much debt were screened out. To put that into perspective, the S&P 500 averaged roughly 10% per year. Just by screening out companies that had debt-to-equity ratios over 20% Tweedy Brown was able to boost gains by roughly 60% of the S&P 500's yearly return.

Now, I doubt that eliminating debt-heavy companies will yield this large of an advantage over a typical net net stock portfolio each and every year. Variance in individual company returns will guarantee that your results dance around this number most years rather than hit it. That said, given the violently volatile 11 year period in which this study took place, Tweedy Browne's paper does provide a solid idea of what investors can expect on average if they use this technique.

The rest of the low price-to-book portfolios saw an average gain of roughly 2% a year, much lower than the average gains seen by the NCAV portfolios.

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Why Does Screening Out Companies with Too Much Debt Boost Returns?

Debt acts as a double-edged sword. When times are good, debt can give a huge boost to a company's earnings. A company can take on a large debt load to buy more retail space or another factory, capitalizing on strong demand. Debt can even be used to buy back stock if shares are priced low enough, thereby increasing shareholder value.

When times get tough or if management misjudges how much they can sell, debt becomes a huge handicap. A company that would have otherwise sailed through a lull in sales may find it incredibly hard to survive. Not only does debt require bill payments that a company might not have money for, covenants may have also been placed on the debt by lenders, allowing lenders to demand their money back any time these covenants are breached.

Other covenants may erode shareholder value. For example, some covenants may require specific assets to be liquidated, even at distressed prices, or share buybacks to be halted. Even if covenants don't exist on the debt, just being forced to make debt payments ties management's hands in terms of what reinvestment decisions it can make or which divisions it can afford to keep funded.

If management is restricted from making decisions when the going gets tough then the company's future may not be as bright as it otherwise could have been. Management may be forced into making less than ideal decisions. And none of this touches on the fact that debt can eliminate firms entirely from being takeover candidates.

This really gets to the heart of why low debt-to-equity ratios probably matter so much in net net stock investing. Debt is never a nice thing to acquire, but firms shopping for a corporate acquisition may be at the point where they don't feel comfortable taking on additional debt. Since a large number of net net firms are bought by other firms, this can put a huge damper on net net stock portfolio returns.

When boosting mechanical returns, sometimes it's the little things that count.

When it comes to maximizing investment returns, little things really add up. Eliminating companies with too much debt is just one simple way to boost portfolio returns but there is definitely more you can do. That's why eliminating debt-heavy companies is just one piece of my investment scorecard. When it really comes down to it, it's amazing that not only has such a profitable investment strategy lasted for so long in the public eye, but also that you can actually improve the returns on offer by making such a simple change to how you pick stocks.

Source: One Easy Change To Squeeze The Most Out Of Your Net Net Stock Portfolio