The Enterprising Investor's Bargain Hunting
Systematically find undervalued stocks through quantitative screening and special situations
For the enterprising investor willing to devote significant time and effort, Graham outlined specific strategies for finding bargain securities. These include companies selling below their net working capital (the 'net-net' approach), companies temporarily depressed by bad news, companies in unpopular industries, and special situations such as mergers, spin-offs, and reorganizations.
The enterprising approach is fundamentally different from the defensive approach. It requires substantial research, the ability to act independently of the crowd, and the patience to wait for results. Graham emphasized that the enterprising investor's advantage comes not from superior prediction of the future but from superior identification of present-day discrepancies between price and value.
Graham's quantitative criteria for the enterprising investor were more demanding than for the defensive investor. He sought companies with low P/E ratios relative to their historical range, prices below net current asset value, and earnings yields significantly higher than the prevailing bond yield. He recommended diversifying across at least 10 such situations and allowing one to three years for the value to be realized.
- The best bargains are found where other investors are not looking or are afraid to look
- Quantitative cheapness provides a margin of safety that protects against qualitative errors
- Diversification across bargain situations compensates for the inevitable failures among them
- Patience is required — bargain stocks may take one to three years to reflect their true value
- The enterprising investor's edge comes from effort and discipline, not from prediction
- Screen for quantitative cheapnessUse mechanical screens to identify stocks trading below their net current asset value (current assets minus all liabilities), at P/E ratios in the lowest decile of the market, or at significant discounts to book value. Cast a wide net with strict quantitative criteria.
- Verify financial soundnessAmong the cheap stocks identified, eliminate those with dangerously high debt, declining revenue over multiple years, or accounting red flags. Cheapness alone is not sufficient — the company must be financially sound enough to survive until the value is realized.
- Assess the reason for undervaluationInvestigate why the stock is cheap. If it is cheap because the business is genuinely dying, pass. If it is cheap because of temporary problems, industry-wide pessimism, or investor neglect, proceed. The best bargains are stocks that are cheap for reasons that are likely to resolve themselves.
- Build a diversified basketPurchase at least 10 to 20 qualifying stocks, spreading across different industries. No single position should be large enough to cause significant portfolio damage if it fails. The statistical advantage of this approach works on a portfolio basis, not on any individual stock.
- Set time and price targets for realizationFor each position, establish a target price at which you will sell (typically near intrinsic value) and a maximum holding period (Graham suggested two to three years). If a stock has not appreciated within the holding period, sell it and replace it with a new bargain. This prevents dead money from dragging portfolio returns.
Graham's most famous bargain strategy was buying stocks trading below their net current asset value — meaning the investor paid less than the company's liquid assets minus all debts. Even if the company were liquidated, the investor would receive more than the purchase price. Graham held diversified portfolios of 20-30 such stocks at a time.
Graham practiced this approach at Graham-Newman Corporation for over twenty years, achieving remarkable returns. He found that mechanical screening for cheap stocks, combined with adequate diversification, produced results superior to most professional money managers. His success was not based on predicting which companies would turn around, but on the statistical certainty that a diversified portfolio of deeply undervalued stocks would produce above-average results.