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Benjamin Graham is widely considered as the father of value investing, with disciples including Walter Schloss, Charles Brandes, Irving Kahn and most notably Warren Buffet. Graham is perhaps more famously known for penning two of the most influential and acclaimed investing classics: Security Analysis and The Intelligent Investor, the latter which Warren Buffet described as “the best book about investing ever written”.
Today I will be looking at one of Graham’s famous proven stock picking strategies, which is the Net-Net Strategy. Essentially the strategy is derived from a valuation technique that determines the value of a company in the event that it has to liquidate and sell off all of its assets. The practicality in looking at liquidating value comes from the logic that if the price of a stock sells persistently below its liquidating value, then either 1) the price is too low or 2) the company should be liquidated. As succinctly put by Graham:
“Very few companies turn out to have an ultimate value less than the working capital alone, although scattered instances may be found.”
“It is clear that these issues were selling at a price well below the value of the enterprise as a private business. No proprietor or majority holder would think of selling what he owned at so ridiculously low a figure.”
Net Current Asset Value
To determine the liquidation value is relatively straightforward. Graham described it in detail in Chapter 15: Stock Selection for the Enterprising Investor of The Intelligent Investorunder Bargain Issues, or Net-Current-Asset Stocks:
“The idea here was to acquire as many issues as possible at a cost of each of less than their book value in terms of net-current assets alone-i.e., giving no value to the plant accounts and other assets. Our purchases were made typically at two-thirds or less of such stripped-down asset value.”
The formula Graham was referring to in the excerpt is as follows:
Net-Asset Current Value = Current Assets – Total Liabilities
The value derived will give an estimate of the value of the company if it were to liquidate all of its assets effectively. However, as Graham observed that not all current assets may be perfectly liquid (e.g. inventories may not be able to be sold off), to improve margin of safety he added another requirement: the company was to have a NACV that was at 2/3(66%) or less of their current market cap.
As such, if the discounted net current asset value is still lower than current market value it will imply that the investor is paying for only the company’s working assets (at a discounted value no less) and gifted with the fixed assets (property, land etc.) for free! Hence to Graham these stocks are deemed to be undervalued with a large margin of safety.
Net-Net Working Capital
Another derivation by Graham of this technique is known as the Net Net Working Capital strategy, which Graham explained in Chapter 43: Significance of the Current Asset Value in the Security Analysis as:
Net Net Working Capital = Cash and cash equivalents + Account Receivables * 0.75 + Inventory * 0.5 – Total Liabilities
The formula is derived from Graham’s observations on % of liquidating value to stated book value:
Table source: Security Analysis, Chapter 43: Significance of the Current Asset Value
So, What’s The Catch?
You may wonder then, if net-net stocks are so predictably profitable, then why has their value not been recognised? These stocks inspire such low confidence from the market for good reason: they are often small caps with persisting business issues that investors deem their survival to be unlikely; it is not uncommon to see net-net companies operating at a loss or experience a huge drop in earnings.
However, it is important to remember that the net-net strategy is not focused on a company’s profitability and operations but rather in its assets. Thus you are more concerned about the stock valuation rather than the business model or economic moat of the company. Hence, if the price of the company is low enough the margin of safety provided will afford multiple positive catalysts such as company liquidation, share buybacks, acquisition and recovery in operations for the share price to grow with limited downside.
Nevertheless, there are some risks associated with this strategy that investors should look out for. Graham repeatedly emphasised that “Our experience with this type of investment selection-on a diversified basis-was uniformly good.” Given that net-net stocks are usually penny stocks, they are usually highly volatile and illiquid. Hence it will be wise to approach this as a portfolio strategy rather than a stock-picking strategy.
Furthermore, investors should exercise as much discrimination as possible in deciding net-net stocks besides the company’s liquid asset position e.g. to look for positive signals such as consistent dividend payments or high average earning power in the past and to avoid companies that are losing current assets at a rapid rate or are mired in high debt.
Investors should also recognize that the net-net strategy is a deep value play for the long term; in the short and mid-term net-net stocks may not see recovery in prices and may even fall if poor business situation persists.
In Singapore market’s context, it can be noted that quite a number of net-nets are S-chips. Be wary of Chinese companies when employing the strategy as given their history of corporate governance issues such companies may be in a false net-net position.
A Timeless Strategy
In The Intelligent Investor, Graham proved that the return of purchasing one share each of 85 net-net companies on 31 December 1957 and holding it for two years was 75 per cent, which was 25 points higher than the benchmark S&P’s 425 industrials over the same period.
Since then, prominent studies, some as recent as a decade ago have proven time and time again that Graham’s net-net strategy will outperform the US market in the long-term:
Table from: http://www.valuewalk.com/2015/02/benjamin-…
International studies from Japan and the UK have also shown this to be the case:
Table from: http://www.valuewalk.com/2015/02/benjamin-…
To see whether the strategy also applies to the Singapore market, I ran a simple backtest of a portfolio of 13 stocks that I was able to identify that has net-net status with Stock Price/NCAV < 0.667 on 30th June 2008 with equal weighting. Note that the test does not account for dividends or reinvestment of returns. The results are as follows:
Data from Capital IQ Database
Compared to benchmark STI Index, which managed to generate annualized returns of around 3% less dividend (data from SPDR ETF Index), the result has shown that it is likely that the net-net strategy is also able to outperform the Singapore market on a long term basis.
Net-Net Stocks in SGX
Using the screener on Capital IQ there are currently 14 SGX stocks as of Jul 2017 that fulfills the net-net criteria of Stock Price/NCAV < 0.800. The companies are as follows:
Data from Capital IQ Database
Having done a quick screen of the list, there are three stocks that have been displaying positive signals which I find intriguing:
Kingboard Copper Foil Holdings Limited is an investment holding company. The Company has two operating divisions, which are polyvinyl butyral (PVB) business and license business. PVB business includes manufacturing and trading of PVB and related products, and License business includes earning license fee income from its licensed assets
Hengxin Technology Limited is an investment holding company principally engaged in the production of radio frequency coaxial cables for mobile communications.
China Sports International Limited is an investment holding company. The Company is engaged in the design, manufacture and sale of sports fashion footwear, and design and sale of sports fashion apparel. It offers its products under the brand name YELI. The Company operates in two segments: footwear and apparels and accessories
Please cast your vote on your favourite stock (pick 1 out of 3) in the comments below before the market opens tomorrow (12 July) at 9am!
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