Testing Graham’s Net Current Asset Value Strategy, Part 1

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Testing Graham’s Net Current Asset Value Strategy, Part 1

Postby SHARK » Fri Apr 13, 2018 10:29 pm

There have been various studies analyzing the performance of Benjamin Graham's strategy of purchasing stocks trading below net current asset value (NCAV). These stocks are also called net-nets. Graham developed and tested this criterion in the early 1930s and first described his net current asset value rule for stock selection in the 1934 edition of "Security Analysis."
The common definition of net current asset value is:

NCAV = current assets - (total liabilities + preferred stock)

The first studies and the majority of examinations were done in the U.S. Later, other studies were conducted in major international markets. Although there were many differences across each study, a general conclusion was that stocks meeting Graham's net current asset value criterion outperform a broad market average. In addition, the outperformance has been superior most of the time.

Various studies conducted over the years

In the "Intelligent Investor," Graham provides evidence to illustrate the power of his net-net approach. Graham tested his strategy by buying one share of each of the 85 companies that met his net-net criteria on Dec. 31, 1957, holding them for two years.

Graham was not content with just buying companies trading at prices less than their net current asset value. He required a greater margin of safety, buying only stocks trading at prices less than two-thirds of their net current asset value. The gain for the entire portfolio in that period was 75%, against 50% for the S&P 500's 425 industrials. What was more remarkable was that none of the stocks showed significant losses, seven held about even and 78 showed appreciable gains.

Henry Oppenheimer, professor of finance at State University of New York at Binghampton, examined the returns to Graham's net current asset value strategy over a 13-year period from Dec. 31, 1970 to Dec. 31, 1983. Oppenheimer's study assumed that all stocks meeting the investment criterion were purchased on Dec. 31 of each year, held for one year and replaced on Dec. 31 the following year by stocks meeting the same criterion on that date.

Oppenheimer used the same two-thirds margin of safety of net current asset value as Graham. The total number of researched net-net stocks was 645. The smallest annual sample was 18 stocks and the largest was 89. Oppenheimer found the average return over the 13-year period he examined was 29.4% per year compared to 11.5% for the NYSE Amex index. A $10,000 investment in the net current asset value portfolio would have increased to $285,197. In comparison, a $10,000 investment in the market would have increased to just $41,169.

Carbon Beach Asset Management founder Tobias E. Carlisle, who is known for his books "Deep Value", "Quantitative Value"(co-authored with Wesley Gray) and "Concentrated Investing" (co-authored with Allen C. Benello and Michael van Biema), tested the performance of Graham's net current asset value strategy with Jeffrey Oxmanin and Sunil Mohantyn of St. Thomas University. They continued the examination from the end of Oppenheimer's data in December 1983 to Dec. 1, 2008.

The net current asset value strategy returned, on average, 35.3% every year for 25 years. It outperformed the market by an average of 22.4% per year and a comparable Small Firm Index portfolio by an average of 16.9% per year. The lowest net-net selection was only 13 stocks in 1984 and the highest number of net-nets, 152 stocks, were found in 2002.

Joseph D. Vu published his examination of the performance of Graham's net current asset value strategy in the Financial Review in 1988. His study, "An Empirical Analysis of Benjamin Graham's Net Current Asset Value Rules," was conducted to provide evidence that the net current asset value rule established by Ben Graham in 1930 was still profitable in the 1970s and 1980s. Vu researched return of net-net stocks in U.S. markets from April 1977 to December 1984. Stocks meeting Graham's criterion returned, on average, 38.5% every year, compared to 32.1% for the market index.

Famous value investors Joel Greenblatt ( Trades , Portfolio ) and Richard Pzena (Trades, Portfolio), together with money manager Bruce L. Newberg, published their findings in the The Journal of Portfolio Management in 1981. Greenblatt and his co-authors argued that the only way the small investor can beat the market is by looking for undervalued stocks.

To start, they used Graham's traditional net-nets formula to screen for bargains. After using this, Greenblatt went further in an attempt to remove bad stocks from the list. To accomplish this goal, the authors added the price-earnings ratio to their NCAV screening criteria. Using both Graham's net current asset value and the P/E ratio, Greenblatt tested four different portfolios and compared them to the OTC and Value Line's own value index from April 1972 to April 1978. This period was characterized by an extreme amount of volatility.

Stocks with a market cap of less than $3 million were discarded from the study. Stocks were sold after a 100% gain or two years had passed, whichever occurred first.

The returns of the four portfolios were following:

Portfolio 1 returned 20.0% per year.
Portfolio 2 returned 27.1% per year.
Portfolio 3 returned 32.2% per year.
Portfolio 4 returned 42.2% per year.

Inspired by the study, Greenblatt founded hedge fund Gotham Capital, which returned an average 40% per year from 1985 to 2006. Gotham's stellar performance came from deep-value and special situations investing and the maintenance of an extremely concentrated portfolio.

Victor J. Wendl, president ofWendl Financial, published a book, "The Net Current Asset Value Approach To Stock Investing," where he analyzed how the net current asset value method performed over the 60 years from 1951 to 2009. Stocks were included in the portfolio if the current trading price was below 75% of the net current asset value calculation. Stocks were held between one and five years. In summary, longer holding periods gave weaker results.

The study also showed that, in general, the more undervalued a stock is relative to its net current asset value, the higher the future return. Additional criteria, like low P/E ratios and dividend yields were also studied. The net current asset value portfolio (return 19.89%) beat both the S&P 500 index (return 10.67%) and Wilshire Small-Cap index (return 11.20%) by a wide margin.

Chongsoo An, John J. Cheh and Il-woon Kim published their own study in Journal of Economic & Financial Studies in February 2015. The study period was from Jan. 2, 1999 to Aug. 31, 2012. The results were compared to the performance of the S&P 500.

In their study, stocks were divided in three different portfolios:

Portfolio 1: Net Current Asset Value/Market Value > market pricex1
Portfolio 2: Net Current Asset Value/Market Value > market pricex2
Portfolio 3: Net Current Asset Value/Market Value > market pricex5
The final sample size for each portfolio, respectively, was 84 companies, 32 companies and 10 companies. The portfolios were rebalanced yearly.

The annualized returns of the three portfolios are:

Portfolio 1: 17.17%
Portfolio 2: 17.78%
Portfolio 3: 18.34%
The performance of S&P 500 during the same period was 2.91%. As the stock holding period decreased from one year to six months, and finally to four weeks, returns generally decreased and could not beat the market anymore.

These results are not just limited to the United States.

Famous value investor and behavioral finance expert James Montier examined the performance of net-net stocks on a global basis. He purchased a portfolio of net-net stocks in all developed markets globally over the period of 1985 to 2007. The returns of this investing strategy were impressive. An equally-weighted basket of net-nets generated outstanding average returns of 35% per year versus market returns of 17% per year. The net current asset value strategy worked well at the global level. Within regions, these stocks outperformed the market by 18% in the U.S., 15% in Japan and 6% in Europe.

In the first study outside of the U.S., J.S. Bildersee, J.J. Cheh and A. Zutshi tested the strategy in the Japanese market from April 1975 to March 1988. The study was published in Japan and the World Economy in 1993, entitled "The Performance of Japanese Stocks in Relation Their Net Current Asset Values."

In order to maintain a sample large enough for cross-sectional analysis, Graham's criterion was relaxed so that companies are required to merely have a net current asset value-market value ratio greater than zero. The study's net current asset value portfolio returned 20.55% and the market index returned 16.63% annually over the same period. Not a big difference, but it was obviously a difficult period in Japan. The Nikkei index peaked at the end of 1989 and never recovered.

Ying Xiao and Glen C. Arnold from Salford Business School examined the net current asset value-market value strategy in London. The research period was from January 1980 to December 2005. Portfolios were formed annually in July. To be included in the sample for the year, companies had to have data for NCAV in December of t-1 and at least one return observation in the post-formation period. The six-month lag between the measurement of NCAV and return data allowed for a delay in the publication of individual companies' accounts, thus ensuring the financial statements are public information before the returns are recorded. Only those stocks with two-thirds of net current asset value are included in the portfolios. The holding periods for the portfolios ranged from one year to five years. A one-year holding period returned 31.19% against the market's 20.51%. Two years returned 75.11%, three years 126.27%, four years 191.62% and five years 254.02%. One million pounds ($1.2 million) invested in equally weighted net current asset value portfolios starting on July 1, 1981 would have increased to 432 million pounds by June 2005. By comparison, one million pounds invested in the entire U.K. market would have increased to 34 million pounds by end of June 2005. A huge difference in the long term.


A review of the studies clearly show that regardless of the differences in methodology and the markets where these studies were conducted, stocks meeting Graham's net current asset value criterion outperformed a broad market average - and notably. Not only did the strategy return continued superior performance, it also had fewer losing years.

In the next part of this series, we will look at different value investors in their practical work using Graham's method.
Price is what you pay. Value is what you get.”

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Re: Testing Graham’s Net Current Asset Value Strategy, Part 1

Postby SHARK » Sat Apr 14, 2018 3:41 pm

Understanding Net Nets
Net net stocks are not just cheap stocks.

Cheap stocks reference anything where the current stock price is lower than the underlying intrinsic value.

Net net stocks are dirty, trodden, haven’t had a bath in 10 years types of stocks.

It’s a value investing technique where the stock is valued purely on its current assets.

Accounts receivables
subtract debt
In fact, Graham basically said that net nets are stocks that are priced for liquidation.

Here’s how he described how to calculate the net net value.

Working capital (current assets less current liabilities) then subtract any debt not included in current liabilities.

What Graham is describing is the NCAV (Net Current Asset Value). You can see that he’s not talking about book value because he values intangibles and other non current assets as zero.

When people mention net nets, they usually mean NCAV. But I use NCAV as well as NNWC and you can see the difference below.

Calculating the NCAV (Net Current Asset Value) for Stocks
The formula to calculate NCAV is simple and the idea is to find stocks where the NCAV is higher than the market price.

NCAV = Current Assets – Total Liabilities

To get a per share value, simply divide by the number of diluted shares outstanding.

NCAV per Share = (Current Assets – Total Liabilities) / Shares Outstanding

Graham’s criteria for buying NCAV stocks was if the stock price was 2/3 of the NCAV.

e.g. If the NCAV per share was $10, then Graham wanted to buy it when the stock price was at $6.66.

More on that later.

Calculating the NNWC (Net Net Working Capital) for Stocks
NNWC is a very close cousin to the NCAV but the difference is that NNWC is a fire sale liquidation calculation.

NNWC stands for Net Net Working Capital and the formula is as follows.

NNWC = Cash and short-term investments
+ (0.75 x Accounts Receivable)
+ (0.5 x Total Inventory )
– Total Liabilities

Then divide by shares outstanding to get the per share value.

NNWC per Share = NNWC / Shares Outstanding

The big difference is that NNWC looks purely at liquid and tangible asset value. It doesn’t include any prepaid expenses or even deferred taxes that NCAV does include.

Accounts receivables are marked down for doubtful accounts and inventory gets a 50% off haircut and to reflect a rapid fire sale.

When Circuit City was going through its liquidation, they didn’t try to sell what they had left at 10% or even 20% off.

Prices were marked 50% and more because it just had to be cleared.

The key distinction however is that liquidations are very rare in the market. There are a lot of costs associated with liquidating and it takes a long time to fully unwind.

So NNWC is more of a theoretical number to help you see how conservative the valuation is.
Price is what you pay. Value is what you get.”

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