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Legend Gurus: Cigar-butt Net-Net Checklists (Everything you need to know)

Graham's net-net criteria post-1970

From various articles and publications written either by or about Graham in the 19705, we can put together a concise set of criteria:

  • margin of safety

  • profitable over the most recent 12-month period

  • reasonably good future prospects

  • sell at no more than a 100% gain

  • maximum holding period of three years

Astute readers will note the inclusion of mechanical sell rules in the set of criteria. Near the end of his life, Graham made it very clear that investors were to set strict sell rules consistent with their purchase criteria. Specifically, investors were to sell a stock after a 50-100% gain, or two to three years had passed.


Graham stayed true to his principle of ensuring a solid margin of safety throughout his career. Even towards the end of his life, Graham was cautioning investors to ensure that a stocks per-share value was at least 50% more than its quoted price.


Buried deep within The Intelligent Investor, Graham walks readers through a winnowing of the Standard & Poor's stocks guide. In the process, he briefly mentions finding dozens of net-nets. To shrink the number to a manageable group, he suggests eliminating firms that show a loss over the previous 12 months. While it's unclear which other criteria Graham would have adopted when putting together a high-quality net-net portfolio, he clearly favoured profitable firms.


Interestingly, while Graham shifted to favouring a simple quantitative approach to stock selection, he retained what are arguably the most qualitative selection criteria he ever used. In September 1974, he gave a talk titled The Renaissance of Value. During the talk, he discussed a couple of approaches designed to provide investors with good returns. While discussing net-nets, he specifically identified good future prospects as a major criterion.

Buffett' cigar-butt scorecard


  • priced below net-net working capital

  • strong defensive characteristics as determined by balance sheet ratios


  • very cheap price relative to net-net working capital

  • good management

  • decent industry prospects

  • very cheap price relative to earnings

  • other assets that significantly increase value

  • activists intent on improving the firm

  • activists intent on helping investors realize value

  • strong earnings growth

  • strong asset value growth

The core criteria specified here are the criteria that Buffett would demand as a basic requirement for purchase. When selecting net-nets, he'd simply pass on firms not meeting these basic stipulations.

Ranking criteria, on the other hand, are features that Buffett would prefer in an investment. Each has been selected from Buffett's early writings, whether stated directly or alluded to in examples. While none of these criteria are necessary for a solid investment, each of Buffett's early known investments included at least one of these characteristics. It's also fair to assume that the more of these factors that the criteria had in place, the better the stock was as an investment.

Peter Cundill's net-net selection criteria

Cundill's strategy seemed to be lifted straight from Graham and Dodd's Security Analysis. Writing in 1995, Cundill outlined his investment framework this way:

"I'm searching for securities that trade below their seeming

liquidation value. The framework is really the one set by Benjamin

Graham. He took the current assets less all the liabilities, including

preferred shares, at their liquidation value and divided that number

by the number of shares outstanding. If the price of the security is

less than that, you examine the business."

Cundill's personal diary reveals a strong preference for detailed analysis to establish fair values, while incorporating qualitative aspects that would influence the investment. In this respect, his philosophy was very similar to Buffett's.

Cundill's quantitative checklist

Soon after taking over the value fund, he noted in his diary the investment checklist that would help him earn outstanding returns:

"Based on my studies and experience, investments for the Venture

Fund should only be made if most of the following criteria are met:

  • The share price must be less than book value. Preferably it will be less than net working capital less long-term debt.

  • The price must be less than one half of the former high and preferably at or near its all time low.

  • The price earning multiple must be less than ten or the inverse of the long-term corporate bond rate, whichever is the less.

  • The company must be profitable. Preferably it will have increased its earnings for the past five years and there will have been no deficits over that period.

  • The company must be paying dividends. Preferably the dividend will have been increasing and have been paid for some time.

  • Long-term debt and bank debt (including off-balance-sheet financing) must be judiciously employed. There must be room to expand the debt position if required."

While most are simple to understand, why demand an inverse PE ratio that's less than the corporate bond yield?

The lower a firm's price to earnings ratio, the more attractive the investment, all else being equal. The inverse of the PE ratio, known as the earnings yield, allows an investor to compare a firm's income to the income of other assets. Cundill's PE of 10 amounts to an earnings yield of 10%, while a PE of 20 equals an earnings yield of 5%.

Investment yields tend to move in sympathy with changes in the prime rate, so when the prime rate is high, so are investment yields. In fact, yields may rise to such an extent that a PE of I0 is merely average rather than cheap. In these situations, Cundill's PE of 10 requirement would not specify a cheap stock. If interest rates rose even higher, Cundill would demand a greater earnings yield (or lower PE) and would use a corporate bond yield as a benchmark. If corporate bond yields were 20%, as they were in Canada in the early 1980s, Cundill would aim to buy companies with earning yields of 20% or higher (PEs of 5% or lower) This would ensure that he'd be buying at a lower valuation relative to earnings.

But Cundill didn't just seek firms priced cheaply relative to earnings; he also use earnings records to screen for higher-quality investments. All three gurus presented here considered growth an important factor. Growth, without a corresponding deterioration in operating ratios, leads to higher valuations and increasing stock prices. Cundill's preference for sustained profitability also meant buying firms that were less affected by business challenges to help him select more stable businesses, which provided him with additional downside protection.

Firms suffering large business problems are in a much trickier spot if their balance sheets are overloaded with debt. As Cundill wrote in The Financial Times Global Guide to Investing, "(a] strong balance sheet with very little debt gives you the margin of safety. Even if the business is deteriorating, as long as it's not too badly, that allows you to fight another day," since the business is less likely to slip into bankruptcy. When facing a crisis, management also have a much easier time righting operations if they're free from the worry of covering interest or principal payments.

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