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And finally, It doesn't take a lot of time. A glance every quarter at the companies' balance sheets to make sure there are no substantial changes to NCAV and that's it. The Ground Rules For this portfolio, as it is a mechanical strategy, we must have our rules of engagement clearly spelled out before we begin. I have largely adopted Wendl's suggestions for basic construction. All stocks must have a market cap greater than 10 million dollars at the time of purchase.
Only stocks traded on major exchanges will be considered. We will sell all positions when their price is equal to their NCAV. This will doubtless lead to tears on occasion as a stock shoots well past NCAV shortly after we have sold it. At the end of a year, stocks still trading under NCAV will be retained. No stock will be held for more than two consecutive years.
Qualitative Considerations These will be looked at in an attempt to avoid being burned. This is particularly true with the current rich valuation level of the broader market. The stocks trading below NCAV right now in the US are mostly the dregs of the dregs, not the ample fare we might have had in previous years.
Wendl demonstrates that focusing on PEs below 10 improves results. Low share issuance. Some NCAV stocks issue massive amounts of shares to help keep afloat. I don't like ownership dilution. No Chinese stocks, due to fraud concerns.
We want to avoid having them eat up our opportunity aka their NCAV. Has real business operations. Many companies trading below NCAV are research companies with no products or revenue. The Portfolio In no particular order here are the picks, and believe me it is slim picking right now. The below are simply the result of a quick screen coupled with a look at the qualitative factors. Many qualitative factors could not be completely satisfied. I need to be sure the strategy suits my mentality before committing more heavily.
This has forced me, as you will note, to leave a portion of the portfolio in cash for the time being. Conclusion I'm excited to see how this goes and how it matches up against the broader market. As I mentioned, I am new to this style of investing, so let me know if I've made some grievous errors, or share any suggestions you may have in the comments. I plan to make a competing public portfolio of stock picks inspired by the Buffettology book series in the near future. So stay tuned. Editor's Note: This article covers one or more microcap stocks.
Please be aware of the risks associated with these stocks. The idea of a net-net first appeared in Graham and Dodd's edition of Security Analysis. Today not as many net-nets exist in the US, most are smaller cap stocks with questionable businesses. Many market historians claim net-nets don't exist anymore, or are out of reach for most investors.
While the US market isn't full of net-nets a variety do exist worldwide with the biggest concentration in Japan. Japan's current market is similar to what the US was like in the s. Many companies in Japan trade below NCAV, companies with solid business models, long histories of profits, and sound management. There are always a number of reasons investors try to justify why a company is selling below NCAV but whatever the reason it seems strange.
Forget the financial markets and for a moment imagine a local business with one location on a sparsely travelled secondary road. The owner has run the business for years and has done ok for themselves, but the business isn't growing, and the location is in need of updates. The owner has been prudent and saves most of the excess cash and has no debt. Now imagine walking into the business and offering to purchase the entire business for less the cash and inventory and receivables.
The owner would laugh you out of the place, but this is what many net-nets are like. The wallpaper needs to be replaced, the seats need new cushions, and the pictures from the s need to go. Some net-nets are the equivalent of walking into the local business and offering to buy the company for less than the cash on hand. Making an offer like this would be insulting no matter how marginal the business is.
Yet in the financial markets stocks trade like this every day, and even worse investors somehow trick themselves into justifying these low valuations. The premise of Graham's original net-net investment thesis was that a reasonable company shouldn't be worth less than NCAV.
In Security Analysis Graham discusses that a prudent net-net investor should prefer companies that are profitable and that do not exhibit an eroding NCAV. Based on the Graham criteria it should be fairly simple to value a net-net. When the price eventually rises above NCAV sell the stock.
While this is a simple and sound strategy the truth is the market doesn't evaluate companies based on their asset values. This is why companies sell below book value or NCAV in the first place. The market is earnings and future focused.
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The simple fact is that if any mechanical strategy worked reliably, it would become widely used, resulting in market disturbance that defeated the strategy! The reason I posted was that I feel sure that the idea of having some of his principles applied to a mechanical strategy would have Graham spinning in his grave. If you study his work carefully, you will find that his emphasis on "thorough analysis" which doesn't just mean looking at a few figures is the key message he is trying to "sell", alongside the need to forma reasonable valuation metric for a stock and then buying it when it appears cheap vs that metric and selling when it doesn't.
That is the philosophy I try to! You will also find that Graham suggested using quality managed funds for those that don't have the time or inclination to do their own "thorough analysis". As you read further in his works, you will find that Graham's through analysis includes a careful study of the company's history, to help you judge the likely trajectory of its earnings and balance sheet.
I hope and expect that Pro tools will help with this but it would be wise to go back to source to check any key figures - and, as Graham advocates, to investigate any accounting adjustments that have been made. I applaud Stockopedia for their efforts on these screens c'mon guys, let's have the beta, at last! Graham considered preferred stock to be a liability, so these are also subtracted.
This is then divided by the number of shares outstanding. NCAV is similar to working capital , but instead of subtracting current liabilities from current assets, total liabilities and preferred stock are subtracted. NCAVPS is a key metric for value investors and is arrived at by subtracting a company's total liabilities including preferred stock from its current assets and dividing the total by the shares outstanding.
But Graham believed that by comparing the net current asset value per share NCAVPS with the share price, investors could find bargains. Essentially, net current asset value is a company's liquidation value. A company's liquidation value is the total worth of all its physical assets, such as fixtures, equipment, inventory, and real estate.
It excludes intangible assets , such as intellectual property, brand recognition, and goodwill. If a company were to go out of business and sell all its physical assets, the value of these assets would be the company's liquidation value.
So a stock that is trading below NCAVPS is allowing an investor to buy a company at less than the value of its current assets. And as long as the company has reasonable prospects, investors are likely to receive substantially more than they pay for. One such strategy, defensive stock investing , means the investor will purchase stocks that provide stable earnings and dividends regardless of what is going on in the overall stock market and economy.
These "defensive stocks" are especially appealing because they protect the investor during times of recession, giving the investor a cushion to weather downturns in the markets. Examples of defensive stocks can often be found in the consumer staples, utilities, and healthcare sectors.
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Does Benjamin Graham's Net Current Asset strategy (or Net Net strategy) still work?
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I call this the "cigar butt" approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the "bargain purchase" will make that puff all profit. Below Working Capital In the following video — which comprises of two clips from the and Berkshire Hathaway Annual Shareholder Meetings respectively — Buffett defines a "cigar butt" stock as one "selling well below working capital", which is a little different from Graham's definition of NCAV stocks.
Buffett also says here that the "cigar butt" approach works well on a small scale, and that Berkshire Hathaway itself was one. Buffett has repeated, on multiple occasions over the years, that one of the main reasons Berkshire Hathaway moved towards more qualitative investing was because the "cigar butt" approach — despite being effective — did not scale to the kind of figures they had to work with; especially in their later years.
Watch Video. I'm a big believer in just doing what works -- what has been shown to work, when using a little bit of critical thinking, through academic or institutional studies. I'm a value investor because of the track-record that value investing has, and I'm a net net stock investor specifically because of the returns that the strategy has shown. When developing my net net stock strategy I dove into all of the academic, peer reviewed, studies I could find in order to dissect the strategy to see what worked.
During my research I came across an interesting little tidbit in Oppenheimer's study of net net stocks. Oppenheimer looked at the performance of net net stocks from to , a period that represented significant fluctuations in the stock market. Near the end of the paper Oppenheimer mentions that there is no real difference between NCAV stocks of profitable and unprofitable companies. In fact, he suggests that, if anything, NCAV stocks of unprofitable companies did slightly better than the rest.
Obviously this finding is not significant enough for you to go out and purposefully look for unprofitable net net stocks. What is significant, however, is the fact that unprofitable NCAV stocks did not underperform versus their peers. Oppenheimer's study strongly suggests that you will pass up high quality investment opportunities if you screen out money-losing firms.
Warren Buffett would have agreed. One of the most well known of his earlier investments was a firm called Dempster Mills. Dempster wasn't profitable, yet Warren Buffett bought it anyways. As a result, a profitability requirement never made it onto the list and 17 of the 18 positions that I've held over the last 3 years have been NCAV stocks of money-losing companies. I don't recommend that investors screen out money making net net stocks, stocks of profitable companies that are trading below NCAV, but I don't think excluding money-losing net net stocks will add to your portfolio returns, either.
The great returns shown by my net net stocks portfolio show how well money-losing net net stocks can perform. PLCC had very large losses in , followed by a string of money losing years since then. Take a look at the graph below: Despite losing money since , the stock remained buoyant somewhere below its NCAV and eventually popped up to NCAV on a bit of good news. The rest of my money-losing net net stocks returned, on average, better results.
While it is true that money-losing NCAV stocks can be great investments, I'm convinced that this isn't true for all of them. My ideal candidate is a company that had been reasonably profitable but then stumbled big time. Companies that face large business problems typically start facing losses.