Wednesday, June 27, 2007

Net/Nets Any Good? And Where Are They All?

The net current assets investment selection criterion calls for the purchase of stocks which are priced at 66% or less of a company's underlying current assets (cash, receivables and inventory) net of all liabilities and claims senior to a company's common stock (current liabilities, long-term debt, preferred stock, unfunded pension liabilities etc. etc.).

So if a company's current assets are $100 per share and the sum of current liabilities, long-term debt, preferred stock, and unfunded pension liabilities is $40 per share, then NCAV would be $60 per share.

Notice how long-term assets aren't in the equation. I.e. intangible assets and in particular, real estate and equipment are not included. Nor is any going value ascribed to prospective earning power from a company's sales base. That's a high bar to begin with, Graham then adds another hurdle to clear; he would not pay anymore than 66% of $60, or $40, for the stock.

Since most companies have negative NCAVs you have a thin field to begin with but when you're fishing only for stocks at 66% NCAV you can often end up with no companies on the field at all, especially in bull markets like now, albeit one that is starting to look a little weary.

So why go for the 66% level, why not shoot for 80%? That is an option but Graham's reasoning was if you go for firms trading so cheap that there is little danger of them falling further, it's pure margin of safety investing. Still 80% may be a tempting level but we'll come to that later.

What about the other equally important component of investing - knowing when to sell? Given that a lot of NCAV companies tend to be shot to pieces or heavily out of favor the safest strategy (if you're not going to do much detailed analysis of the companies you are buying) is to sell once the company hits its 100% NCAV.

So how did Graham run this strategy back in the day? Luckily for him he started doing this shortly after the Great Depression so there were tonnes of companies that fitted the bill. In fact, at one point he apparently had up to 100 of these companies in his portfolio.

Now I don't know if this is true and what those 100 stocks were, but assuming this is correct I would imagine that's a diversified bunch of companies he had in there. You can diversify away most company specific risk with about 15-20 stocks upwards if you are picking stocks purely using some kind of filter system - so 100 names seems pretty diversified to allow for duds that would blow up on you. Graham reported the average return, over a 30-year period, on a DIVERSIFIED portfolio of NCAV stocks was about 20% per annum.

As some of you may also have noticed though the key word in Graham's portfolio returns is diversified (in case you hadn't noticed I capitalized the word). Graham himself recommended buying a large number of stocks to diversify the risk. The NCAV strategy in Graham's day was thus essentially a forerunner to Greenblatt's Magic Formula system; there will be some real gems in there but if you're not doing a whole load of homework on them best to buy the basket as the stocks on average should give you a decent bang for your buck, actually Greenblatt mentions NCAV in passing on this video... http://merlin.gsb.columbia.edu:8080/ramgen/video3/admin/alumni/Reunion_2006/Reunion_4-8-06_Greenblatt.rm.

That seems to roughly chime with this post over at Cheap Stocks - http://stocksbelowncav.blogspot.com/2007/01/top-10-netnets-four-years-later-we.html
They report a 33.5% return on a basket of the biggest 10 Net/Nets by market cap back in Feb 2003, but there were a few duds in there - with one halving in value and one essentially flat. Standard deviation for the group was a hefty 78.7%, i.e. if you bought just one of these stocks you probably shouldn't expect a return anywhere near 33.5%!!

The biggest risk is the company folding and a complete wipeout of its stock price. Stocks that get down to NCAV territory probably didn't get there because management were on the top of their game. Indeed, there's a real risk some of them will go up in smoke even with your 66% selection criteria.

How real a prospect is that?
Well, I did a google search on NCAV stocks and found an article on the subject over at http://iamamazing.wordpress.com/2006/12/19/the-problem-with-netnets/ This was published seven months ago on Dec 19 2006. It turns up four NCAV candidates;
1. Dominion Homes (DHOM)
2. CET Services (CETR)
3. TransNet Corp. (TRNT)
4. Taitron Components (TAIT)

I decided to take a look at what these stocks did since then... and of those CET Services seems to have imploded. Auditors gave the company a going concern qualification back in April, and it is being delisted from the American Stock Exchange. I haven't poked around into the balance sheet of this company - it may have some pretty decent stuff to give out in the event of a liquidation but that's the stuff of bankruptcy investing, which is a different ballgame.

So of the four names seven months ago one is up in smoke, that's means in order to get a 20% return, like Graham's portfolio had, the other three names are gonna have to be absolutely on a roll over the next five months. Who knows, they may well be, then again they may well join CET in going belly up.

With a lack of candidates (i.e. less than 10 companies at the very least) the 66% NCAV basket buying strategy can be downright dangerous. So how many 66% NCAV are there are out there today?
One place to look is over at http://www.grahaminvestor.com/screens/grahams_result

That yields as of today June 13, two candidates! Relaxing a bit to 80% gives us five names, still not a whole load, and then once we start going above that... well there don't seem to be much of a margin of safety folks if you're just going on a pure stock screen based portfolio.

As it stands NCAV screens for the U.S. market, or screens for stocks trading around or near to it, looks like a good idea generator rather than anything else. That is you need to have a proper look at the names thrown up and judge if the actual companies themselves are decent bets as I suspect buying the basket of 10-15 trading at or nearest to NCAV probably won't be great. Of course, I have no proof of that unfortunately, it's just a hunch. It would be interesting to see a study of how buying a basket of 10 plus Net/Nets at 80% NCAV perform over a one-year plus period. Does anyone know of such a study or some fund that does this kind of strategy?

Finally, the lack of 66% NCAVs may just suggest the market is expensive. After all, the post at Cheap Stocks infers there was a fairly decent wad of them back in 2003. So if there is a market meltdown, which may not be so unlikely, then we could end up with a whole load of 66% NCAV companies and you could snap up 15 plus stocks and sit it out without a load of effort.

Actually, one place which may be fertile hunting ground would be small cap and retail shares in Japan, which have been having an appalling time over the past 18 months after a high-flying internet conglomerate there called Livedoor imploded in a most likely politically-motivated investigation into the company's business practices. The Mothers Index there is down 68% from its lifetime high on January 16th.

But to invest in small cap Japanese stocks you will probably need to have a Japanese brokerage acct - not the easiest thing for non-residents and if you don't read and speak Japanese finding these stocks may be a bit of a beeatch.

Thoughts and comments welcome!

1 comment:

ekram said...

Hi Eddie Bravo,

My name is Ekram. I was reading your post about Graham's net-nets at http://valetudoinvesting.blogspot.com/2007/06/netnets-any-good-and-where-are-they-all_27.html

Actually, I have worked the returns for stocks quoting at or below ncav for the Indian markets for the last 10 years.

Additionally, I have also looked at how Grahams Earnings Yield portfolio would have worked and how his Net cash (net of all liabilities)would have worked.

I have the results in a pdf file.

If interested, give me your email id so that I can forward it to you.
my email id is: ekramcal@gmail.com

Regards
Ekram