Ben Graham Net Nets Updated

Friday, Jan 06 2012 by
7
Ben Graham Net Nets Updated

One of the most enduring investment strategies for ‘deep value’ investors was defined by Ben Graham way back in (at least) the 1940′s.  The approach was to buy shares in companies where the market cap was less than the value of the company’s current assets minus all of its liabilities.

This was a simplified rule-of-thumb guesstimate of liquidation value.  The assumption was that any haircut taken on current assets (like inventory) in an orderly liquidation would be more than offset, on average, by returns from the sale of fixed assets like property and equipment.

So why would anyone want to invest based on a guess of the liquidation value of a company?  Graham cited three key reasons:

  1. Earnings power would rise in the future to the point where investors would value the company at a higher level.  Graham conjectured that this might occur because such a poor industry may see other firms exiting first, leaving more customers for those who can stick it out or; management find a way to generate sufficient earnings by dropping underperforming products, becoming more efficient or some other means.
  2. A sale or merger in which the buyer would likely pay at least liquidation value.
  3. The company is liquidated, fully or partially, and shareholders gain from the value released by selling off the company’s assets.

There have been many studies into these net-net stocks and as far as I know, they have all shown a high degree of outperformance, in the medium and long term.

But it isn’t an easy strategy to follow.

As I mentioned before in Merry Christmas 2011, I abandoned my own portfolio of low price to books stocks because I found it difficult to hold a large portion of my pension in a group of weak and economically underperforming companies.  Another problem is the tiny pool of stocks that fit the investment criteria.  It’s highly uncommon for any company other than a house builder to have enough current assets to pay off all current and non-current liabilities.  At the moment my net-net screen shows only 16 companies listed on the main FTSE indices (i.e. not the Alternative Investment Market, which typically can’t be held in an ISA) which are valued at less than their net-net value, and only 6 companies that are valued below 2/3rds of their net-net value, which was the most that Graham would pay.

When Graham’s investment company used net-nets as their main strategy for some 20 years or so, he typically held over 100 positions.  The reason for this high degree of diversification was the inherent uncertainty in any given net-net stock.  By being so diversified the volatility and returns of the overall portfolio were more acceptable to his clients.

So to reduce volatility to a level that could be lived with by most people Graham invested in over 100 companies at a time, but that’s going to be very difficult if there are only 6 available to select from.

Another problem with net-net stocks is the bid/ask spread.  Because many of these companies are small and unloved, they don’t attract much trading on the stock market.  This means that the difference between the bid and the ask price can be 10% or more.  That may not sound like much but if the average holding period is one year then a stock with a 10% spread needs to gain 10% just to break even.  Seeing as 10% is the about average return from the stock market over time (including dividends) that’s a big handicap to carry.

Still, I have an enduring fascination with simple mechanical strategies and net-nets are one of the simplest and one of the best.  I think that with a few tweaks the strategy could be usable for those who are interested, without having to hold only a handful of these highly volatile and often miserable stocks.

Buy liquid, unlevered companies

The first point to note is that there isn’t anything magic about having enough current assets to cover all liabilities.  The real point is that companies that do have that balance sheet structure are typically highly liquid (quick ratio over 1) with little leverage and very often have net cash.  The reason that good liquidity and low leverage are important is that it helps the company to survive whatever problems are currently causing the share price to be so low.  Turnarounds are a lot easier if the company has lots of cash and little debt.

Not only that, but in The Price To Book Effect In Stock Returns: Accounting For Leverage, Stephen Penman found that in some cases lower leverage leads to higher returns.

Buy low price to book companies

The second point is that net-nets are trading well below book value and even tangible book value.  Low price to book stocks are the standard academic definition of ‘value’ stocks and they have a history of outperformance in the long term.

Hold lots of companies for long periods

Another point of note is that several studies have looked at returns of net-nets and low price to book stocks and found that they outperform the market, on average, for years after they are selected.  For example, in Testing Benjamin Graham’s Net Current Asset Value Strategy in London, Ying Xiao and Glen Arnold show that net-nets beat the market by up to 19.7% a year, over 5 holding years.  In Tweedy, Browne’s What Has Worked In Investing, various studies show excess returns over 3 and 4 years.

By holding an investment for a longer period the average returns from each position are larger, which can help mitigate some of the negative effects of wide spreads.

So one possible interpretation of net-nets for the 21st century would focus on low price to book, highly liquid, low leverage companies, holding quite a large number of positions for multiple years.

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I like to keep things simple so I came up with this list:

Net cash

Only invest in stocks that are net cash, i.e. they have enough assets that they can turn into cash within a ‘short’ period of time to cover all borrowings.  This is a measure of leverage, but it is also a reasonable indicator of liquidity.  If you look at companies that are net cash they tend to have quick ratios close to and usually over 1.

Low price to book

Very simple this one.  Low price to book stocks have a history of outperformance.  Net-nets are low price to book stocks so that’s what I’m after.  Sort the universe of stocks by price to book at start with the lowest.

Price to sales ratio of less than 1

This is the only point where I really digress from the net-net spirit.  At these levels you can pick up some funny companies, like pharmaceutical firms that don’t actually sell anything or just make losses every year… or house builders that aren’t doing anything or other firms that are in hibernation mode or other companies that are so inefficient they cannot even generate a fraction of their book value in sales.  I want the companies in the portfolio to be actual trading companies so a price to sales ratio of less than 1 is a simple rule of thumb to make sure that the company is actually doing something.

Hold 60 companies, equally balanced, for 5 years each

60 companies should give the investor enough distance from each individual company so that any horror stories (or even success stories) that emerge shouldn’t over excite or over depress.  A detached alertness is what is required and this many positions should help.

Holding each stock for 5 years is in line with previous studies and should allow the average to outperform the market while reducing trading costs from the more typical 1 year holding period.  For example, in Testing Benjamin Graham’s Net Current Asset Value Strategy in London, the average 60-month buy and hold return was 254% which would not be affected to a huge extent by a single 10% trading cost.  Compare that to flipping positions every year and even if your investment returns 30% a year it’s running uphill against a 10% or even 5% spread each year.  The difference over time is enormous.

Flip investments monthly

I like a fixed investment schedule as it helps me to avoid the delusion that I can time the market.  By investing on a fixed schedule it also mechanises the optimisation of the portfolio, calmly and gradually over the long term.  I’m not saying that any portfolio is optimal, but if you’re consistently moving a portfolio towards value then good things are more likely to happen.

So basically I’d buy say French Connection today and hold it until January 2017, at which point I’d sell it regardless of where it was or what happened in between and replace it with another of my 21st century net-nets.

It may sound daft, but in the long term these ‘blind watchmaker’ strategies seem to have a nasty habit of working.

Over the next 60 weeks I’ll be loading a new model portfolio up with these stocks, 1 a week plus a post on each one when possible; followed by a switch to monthly trading once it’s fully invested.

For those who love the unloved, this could be interesting.

 


Filed Under: Value Investing, Graham,

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This article is for information and discussion purposes only and nothing in it should be construed as a recommendation to invest or otherwise. The value of an investment may fall and an investor may lose all their money. Any investments referred to in this article may not be suitable for all investors.  Investors should always seek advice from a qualified investment adviser.


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11 Comments on this Article show/hide all

Edward Croft 7th Jan '12 1 of 11

http://www.stockopedia.com/share-prices/french-connection-LON:FCCN/

Net Net Bargain of the day? French Connection comes up quite pretty on the page, momentum grim, sentiment obviously grim vs retail sector at the moment. Everyone seems to love the Toast catalogue at the moment although its a v small part of the biz. I know nothing about the newsflow of late, but seems worthy of a closer look given the value situation.

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UK Value Investor 7th Jan '12 2 of 11

In reply to Edward Croft, post #1

French Connection has been good to net-net watchers over the last few years. If you got in at under 50p in 2009/10 then there were pretty fast 100% gains on the cards. I actually managed to do quite badly last time (16% gain in about 18 months), getting in during Feb '09 and out in Nov '10, which of course was moments before the explosive 100% gain to well over 100p.

But the potential is certainly still there for big gains IF you can time it right.

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Edward Croft 7th Jan '12 3 of 11

In reply to UK Value Investor, post #2

It's true that there are hardly any decent sized net-nets in the market. We count 27 in total but all but a few are sub £10m mCap companies which suffer from the spread issues you mentioned above.

There are though a few larger stocks trading in our other Ben Graham bargain screen - the net current asset value (NCAV) screen http://j.mp/zy2341 - but the list is mostly populated with housing companies of which few investors seem to be willing to take a gamble at present - Barratt, Bellway, Taylor Wimpey.

Anyone want to share any thoughts on UK housebuilders? Mortgage market in pieces, but massive undersupply of housing creates a good structural underpinning for the industry in this country vs US etc.

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dangersimpson 9th Jan '12 4 of 11

The problem with retailers as 'Net Nets' is usually their accounting period. There is a reason that most retailers have a financial year that ends on 31st January and that's because its the point in the financial year where they have the most cash & the least inventories.

One of the keys is to look at the net finance income as well as the cash levels so for FCCN they had £34.1m on 31st Jan 2010 but only generated £0.2m of Net Finance Income c0.6% return. Now interest rates are pretty low but still the cautious investor would probably want to reduce the cash level by say 50% to get a more realistic average cash level over the year.

Part of the idea of investing in 'net nets' is the limited downside - you could shut the company down and receive your investment back. However it's not clear that could be done with a retailer even if you did it on the 31st January the cost of exiting leases and discounting stock to sell may leave little left for the shareholder.

Of course, all things being equal, net cash is always better than net debt and FCCN are pretty cheap on an earnings and dividend basis so as long as the Christmas trading has been ok and they've recovered from the poor start to the winter period they are probably a good buy - however its been a mixed bag for retailers this year so it's a hard one to call whether FCCN have been a winner or loser in the short term.

Now one year's Christmas trading is pretty irrelevant to someone who has a mechanical 5-yr holding period so it's probably a mistake to overanalyse the short term trading environment however I think it's also a mistake to think that a 'net net' retailer has Graham's Margin of Safety since the nature of the business means that it's unlikely that it has.

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marben100 9th Jan '12 5 of 11

In reply to UK Value Investor, post #2

For anyone interested in French Connection (LON:FCCN) , I'll just mention that I understand they're presenting at next Mnday's "Mello Monday" event. Watch this space for further details!

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marben100 9th Jan '12 6 of 11

In reply to Edward Croft, post #3

Anyone want to share any thoughts on UK housebuilders?

The situation with housebuilders is a perfect illustration of Ben Graham's real teaching: you have to look a little beyond mere numbers and decide whether those numbers are plausible. Stock screeners are a very valuable starting point, but once you've used the screener to identify potential candidates for investment, the real work begins!

If you look at, say, Barratt Developments (LON:BDEV) 's results, the problem becomes apparent. Current assets are dominated by £3.3bn of inventories and current assets less all liabilities are £1.6bn. Those inventories comprise mainly a land bank of £2.2bn and construction work in progress of £1.0bn. Moreover, there is very little fixed asset protection as TANGIBLE fixed assets are only £0.3bn (only tangible assets have any value in a liquidation).

So, if there were, say, a 20% decline in land/construction project values, that would reduce the current assets less all liabilities figure from £1.6bn to less than £1.0bn - roughly equal to the current market cap.

As it happens, that's not too bad a margin of safety (another important Graham concept), so could be worth a closer look... However, the forecast dividend for this year is tiny and I don't foresee housebuilding recovering any time soon (not until house prices correct properly and homes become affordable for ordinary people, assuming realistic interest rates, not the present unsustainably low ones), so maybe one for the watchlist, rather than immediate investment?

Regards,

Mark

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Edward Croft 9th Jan '12 7 of 11
1

In reply to marben100, post #6

The situation is a perfect illustration of Ben Graham's real teaching: you have to look a little beyond mere numbers...

That's not striclty true Mark.  Granted, Ben Graham invented the profession of  Security Analysis (and he wrote the book), but he was also the market's first quant.   He generally advocated buying widely diversified portfolios of bargain issues and used a shotgun rather than rifle approach when doing so.

Quoting from the Intelligent Investor...

Net Current Asset Issues - the idea here was to acquire as many issues as possible at a cost for each of less than their book value in terms of net current assets alone. ...  Our purchases were made typically at 2/3 or less of such stripped down asset value.  In most years we carried a wide diversification here - at least 100 different issues.

So I'm not sure you can dispel the pure screening approach to Graham investing quite so easily.  And w.r.t. timing in out of favour sectors...

If he [the Enterprising Investor] followed our philosophy in this field, he would more likely be the buyer of important cyclical enterprises - such as steel shares perhaps - when the current situation is unfavorable, the near term prospects are poor, and the low price fully reflects the current pessimism.

 

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marben100 9th Jan '12 8 of 11

In reply to Edward Croft, post #7

Hi Ed,

I think Graham is widely misunderstood. Yes, he lays a great deal of emphasis on quantitative calculations - but he also emphasises the need to look deeply into the figures you're basing your calculations on, for example what "exceptional items" are truly exceptional, before conluding that a "bargain issue" is really a bargain.

Unfortunately, I haven't been able to find the perfect quote from his books to make my point, (though I do seem to remember one, where he emphasised there were no shortcuts to hard and detailed work), but I think this will suffice from the final summary of "Margin of Safety", the closing chapter of "The Intelligent Investor":

 

 

...The first and most obvious of these principles is "Know what you are doing - know your business". For the investor this means: Do not try to make "Business profits" out of securities - that is returns in excess of normal interest and dividend income - unless you know as much about security values as you would need to know about the value of merchandise that you proposed to manufacture or deal in.

I have no doubt that he would consider the reliability of a figure forming a key component of current asset value as essential to computing the margin of safety. Cash, for example is a much sounder number that something with an uncertain value such as building plots.

 

One of my favourite investments right now is a Hong Kong quoted business, Regent Pacific (HK:0575). It has no debt and most of its assets comprise listed securities and cash. Therefore I can compute an accurate NAV on a daily basis. Unless there is an error in my arithmetic, I can be pretty comfortable that the NAV is reliable. So when I can buy shares in that business at a discount of nearly 50% to NAV (after payment of the usual annual special dividend), that's what I call a true bargain with a massive margin of safety. ;0)

Cheers,

Mark

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Edward Croft 9th Jan '12 9 of 11

In reply to marben100, post #8

I have no doubt that he would consider the reliability of a figure forming a key component of current asset value as essential to computing the margin of safety

I'm sure he would!   But then again if you had a basket of 100 stocks you wanted to buy that were all net nets would you be able to do the due dil on every single one? Graham or one of his analyst team may have, but you'd still have had 'satisfactory' returns if you bought the basket.

For what its worth, I'm not arguing for housebuilders here - more defending the quantitative approach... I don't think the housebuilders are particularly cheap at the moment - certainly on a PE basis they are at a premium to the market which is most undeserved. http://j.mp/xQMvQo

re. Regent Pacific...  that's one of your Dattels picks isn't it ?

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marben100 9th Jan '12 10 of 11

In reply to Edward Croft, post #9

Regent Pacific...  that's one of your Dattels picks isn't it ?

Yup. Another Dattels/Mellon special (predates Polo). ;0)

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carmensfella 9th Jan '12 11 of 11

French Connection wil actually be presenting to us all at the Mello Morning After event next Tuesday at 11am with Silverdell on at 10am just before and breakfast drinks and nibbles from 9.30am at FinnCap HQ which is 60 new Broad Street and all are welcome.

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My name is John Kingham and I'm the editor of UK Value Investor, an investment newsletter for defensive and income-focused value investors. That means I write about buying large, successful companies with long track records of profitable dividend growth, and buying their shares at low valuations and with high yields. My website includes a unique stock screen and a model portfolio which is managed using a checklist-based investment strategy.  The goal of the strategy is to produce a portfolio which combines a high yield and good capital growth with low risk, and which is easy to maintain in just a few hours each month. more »


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