Why net-net investment strategy is still viable — but in short term
• Local firms Balwin, Bell Equipment, EMD, ELB, Ellies, Lewis and Primeserv meet criteria
G raham had this concept of value to a private owner: what the whole enterprise would sell for if it were available. And that was calculable in many cases,” said Charlie Munger.
“Then, if you could take the stock price and multiply it by the number of shares and get something that was one-third or less of sellout value, he would say that you have got a lot of edge going for you.
“Even with an elderly alcoholic running a stodgy business, this signifies excess of real value per share working for you, which means that all kinds of good things can happen to you.
“But he was, by and large, operating when the world was in shell shock from the 1930s, when for a long time thereafter Ben Graham could run his Geiger counter over this detritus from the collapse of the 1930s and find things selling below their working capital per share and so on … At any rate, the trouble with what I call the classic Ben Graham concept is that gradually the world wised up and those real obvious bargains disappeared. You could run your Geiger counter over the rubble and it wouldn’t click.”
That is only partly true. There are still companies that will set off Graham’s Geiger counter. The big question is whether they are bargains.
Graham first discussed net current asset value (NCAV), which he defined as current assets minus all liabilities and claims, in the 1934 edition of Security Analysis.
It differs from working capital in that it deducts total liabilities (as opposed to current liabilities) from current assets. It seems, however, that Graham used the terms interchangeably.
So in the 1949 edition of his book The Intelligent Investor, he defined a “bargain share” as a common stock that could be bought at no more than twothirds of its working capital value, “provided the earnings record and prospects were reasonably satisfactory”.
Graham went on to define net-net working capital as cash and short-term investments plus 75% of accounts receivable plus 50% of inventory minus all liabilities. (On the assumption that the full value of inventory and accounts receivables would not be collected.)
The basic idea is to look for companies trading below their liquidation value, where you can sell off their assets, pay off their liabilities and still make a profit.
Can such a strategy still work over long periods of time in today’s markets?
In 2018 Quant Investing looked at three research papers that suggest it does.
The first paper, published in 2010 and titled “Ben Graham’s Net Nets: Seventy-Five Years Old and Outperforming”, concluded that the NCAV rule continues to show considerable performance in generating excess returns.
The second paper, published by the same authors and titled “Deep Value Investing and Unexplained Returns”, looked at the returns generated from a net-net strategy implemented from 1984 to 2008, and concluded that, “After controlling for a variety of risk factors and firm characteristics, and imposing several filters, we find a remaining significant excess return.”
In the third paper, titled “Testing Benjamin Graham’s Net Current Asset Value Strategy in London”, the authors took the NCAV of a firm and divided it by the total market value (MV) of the stock. Companies with a NCAV-MV ratio higher than 1.5 were counted as net-net stocks. Meaning that if the firm was to go bankrupt and liquidate all its current assets, they would fetch more than 50% of their current market value.
Examining stocks listed on the London Stock Exchange from 1981 to 2005, the authors concluded that those with an NCAV-MV greater than 1.5 display “significantly positive market-adjusted returns” over five-year periods.
Possible explanations from Quant Investing as to why these strategies might produce excess returns include:
● Risk. Since these stocks are more risky than average stock, they must compensate by providing higher returns than average stock.
● Liquidity. Firms selling below their NVAC are often small and hard to easily transact, therefore need to offer a higher return to compensate for higher risk.
● Long-term reversal. Stocks that have performed poorly in the past three to five years will likely do well in the future.
● Financial distress. The market overreacted to recent poor performance and underpriced these stocks.
● Low analyst coverage. Assuming a positive association between less analyst coverage and higher returns, it may be that investors have a harder time finding net-net companies.
● Low trading volume. Stocks with low trading volume generate higher returns than stocks with a higher volume. Partly because of the low liquidity but also because institutional investors have a harder time taking a big position, firms selling below their liquidation values are too few in number and have too low of a market value to make a difference in the returns of big money managers.
Whatever the reasons, given the evidence that net-net strategies produce excess returns, the question is: is there the potential to build a net-net portfolio in the local market?
Based on Reuters data and taking the NCAV-MV approach, as at the end of last week 10 firms meet the net-net criteria: Balwin, Bell Equipment, Delta EMD, ELB, Ellies, Esor, Hulamin, Lewis, Mazor and Primeserv.
Whether they meet the “earnings record and reasonably satisfactory prospects” required by Graham is another matter. Some don’t. Delta, Hulamin and Mazor have negative earnings. Esor has been suspended.
And, according to Investopedia, even those that do have satisfactory prospects may still not be a great long-term investment. “In the short term, a net-net stock may make up the gap between current assets and market cap, but over the long term an incompetent management team or flawed business model can ruin a balance sheet.
“So a net-net stock may find itself in that position because the market has already identified long-term issues that will negatively affect that stock. For example, the rise of Amazon has pushed retailers into net-net positions and some investors have profited in the short term. In the long term, however, many of those stocks have gone under or been acquired at a discount.”
THE TROUBLE WITH WHAT I CALL THE CLASSIC BEN GRAHAM CONCEPT IS THAT GRADUALLY THE WORLD WISED UP
EVEN THOSE THAT DO HAVE SATISFACTORY PROSPECTS MAY STILL NOT BE A GREAT LONG-TERM INVESTMENT