Net-net stocks

Graham's most famous quantitative technique is also his most extreme expression of the margin-of-safety idea. You'll rarely use it today, but working through it teaches the logic in its cleanest form.

How do net-net stocks work?

The idea. Ignore earnings, growth, moats, management. Ignore the going concern entirely, and look only at what the business would be worth if it stopped tomorrow and was wound up. Graham's conservative liquidation proxy:

Net Current Asset Value (NCAV) = Current Assets − Total Liabilities

Look how severe that is. He takes only current assets (cash, receivables, inventory, the things that turn into cash within a year) and subtracts all liabilities, current and long-term. Every fixed asset gets zero value. The factories, the land, the equipment, the brands, the entire long-term asset side of the balance sheet count for nothing. It's a deliberately brutal, worst-case number. Think of it as roughly what a creditor would expect from a hurried liquidation, with the illiquid items haircut even then.

The rule. Graham would buy only when the price was at or below two-thirds (≈67%) of NCAV:

Buy if: Market Cap ≤ ⅔ × NCAV     (equivalently, price per share ≤ ⅔ × NCAV per share)

Think about what that means. You pay 67 cents or less for a dollar of current assets net of every debt, and you get all the fixed assets and the whole operating business for free, or for less than free. Here the margin of safety isn't an estimate. It's arithmetic. Even if the business is worthless as a going concern, its liquidation should return more than you paid. Graham insisted on two more safeguards:

• Diversify heavily. Hold a basket of 20 to 30+ net-nets, never a concentrated bet. Any one of them might be a value trap that erodes to nothing. As a group, the statistics of buying below liquidation value worked. It's a statistical strategy and not a business-by-business conviction strategy, which sets it apart from everything Buffett later did.
• Watch for the melting ice cube, the value-trap risk. NCAV is a snapshot, and a loss-making business consumes its net current assets over time. Cash burns, receivables sour, inventory goes obsolete. A stock at ⅔ of an NCAV that's shrinking 20% a year isn't cheap at all, because the discount evaporates as fast as you earn it. Your defence is to prefer net-nets that are at least roughly break-even, so they aren't haemorrhaging cash, and to hold the diversified basket so the winners (re-rating, buyout or liquidation) outweigh the melters.

Why are net-nets so rare today?

Why they worked, and why they're now rare. Net-nets were abundant in Graham's formative decades. The wreckage of the 1930s and the neglected corners of mid-century markets threw up hundreds of companies trading below liquidation value. Fear was everywhere, information was scarce and slow, and nobody was analysing small companies. Then markets became more efficient, information became instant and screening became trivial. Any beginner can now run "price < ⅔ NCAV" on a screener in ten seconds, so the obvious sub-liquidation bargains were arbitraged away. Today a broad-market net-net screen usually returns a short list dominated by three unappetising categories: real melting ice cubes (deservedly cheap, burning cash), tiny illiquid micro-caps, and companies in structural decline or with governance problems.

They still turn up in bear-market troughs, in neglected Japanese and Korean small-caps and in Indian micro-caps after a crash. And the logic remains a permanent tool. A business trading below its net cash is worth a look, and India's post-crash small-cap universe offers a few from time to time. But the era when a diversified net-net basket was a core strategy for serious capital is gone. That fact is itself the seed of the Graham-to-Buffett evolution. As the cigar butts ran out and the capital grew, the deep-value practitioner had to find safety somewhere other than a cheap balance sheet.

You'll find a full net-net screen in the worked examples. There you compute NCAV for a synthetic company, apply the two-thirds rule and, most important, use the cash-burn check to tell a real bargain from a melting ice cube. The arithmetic of NCAV and the arithmetic of dying, taken together, are the trap Graham's diversification was built to survive.