Benjamin Graham’s Net Current Asset Value Approach
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By Wayne A. Thorp, CFA
O
utside o Warren Buett, perhaps no other investor is as well-known as his mentor Benjamin Graham. Considered by most to be the ather o value investing and oten credited as the creator o the stock analyst proession, Graham’s value-oriented investing methodologies have been the topic o countless articles and academic studies. In act, AAII tracks three dierent Graham methodologies at the Stock Screens area o AAII.com. However, his original stock selection approach has not garnered the same attention as his later concepts. Graham developed and tested the net current asset value (NCAV) approach between 1930 and 1932. According to private investing rm Tweedy, Browne Company: “The net current asset value approach is the oldest approach to investment in groups o securities with common selection characteristics o which we are aware.” Graham reported that the average return, over a 30-year period, on diversied portolios o net current asset stocks was about 20%. An outside study showed that rom 1970 to 1983, an investor could have earned an average return o 29.4% by purchasing stocks that ullled Graham’s requirement and holding them or one year. The topic o two “First Cut” columns by John Bajkowski in the AAII Journal (September 2007 and April 2009), the NCAV approach is more ully explained in this CI Online Exclusive, highlighting how you can use computerized stock screening tools to identiy stocks meeting Graham’s Graham’s criteria.
edition o “Security Analysis,” which he coauthored with David Dodd. In the book, (net) current asset value is dened as: “current “curr ent assets alone, minus all liabilities and claims ahead o the issue.” The common denition o NCAV is: NCAV = current assets – [total liabilities + preerred stock]
Current assets consist primarily o cash and cash equivalents, receivables, and inventories. Basically, these are assets that are already cash or are
sheet. In contrast, NCAV deducts total liabilities (current and longterm) rom current assets. However, Graham used the terms interchangeably. Compared to book value, the NCAV method is a more rigorous standard. Book value can include intangible assets, many o which may be impaired in some manner. FurFurthermore, book value includes land, property and equipment, which are ignored altogether by NCAV. However, over time, the on-the-book value o such assets is more than likely not an accurate representation o their actual worth.
“From 1970 to 1983,
NCAV & Market Value
an investor could have
In “Security Analysis,” the authors note that net asset value, or book value, seemingly was o little importance to investors looking at “indus“industrial companies,” citing the act that stocks can sell at high multiples or at mere ractions o book value. Investor reasoning was that share prices, by and large, are driven by a company’ss earning power and company’ dividend payments, which in general have no close relationship to the asset value (excluding utilities and nancial rms). Thereore, investors and speculators alike had, or the most part, come to ignore asset value. Beginning in the 1930s, ollowing the market crash o 1929, Graham and Dodd noticed a large number o stocks selling below their current asset value, meaning that the share price o a company is less than the per share value o current assets. During this period, the low prices to net asset values were primarily driven by poor earnings, which in turn drove stock prices down. Perhaps not surprisingly, according to Graham and Dodd, the market greeted these stocks with uncertainty and indi-
earned an average return o 29.4% by purchasing stocks
that ulilled Graham’s requirement and holding
NCAV Dened Graham rst discussed net current asset value (NCAV) in the 1934
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them or one year.” convertible into cash within a relatively short period o time (usually less than a year). Net current assets exclude not only the intangible assets but also the xed and miscellaneous assets. In addition, Graham believed that preerred stock belongs on the liability side o the balance sheet, not as part o capital and surplus. In “Security Analysis,” preerred stock is dubbed “an imperect creditorship position” that is best placed on the balance sheet alongside unded debt. Net current assets dier rom working capital in that working capital is current assets less current liabilities, thereby ocusing only on the current segments o the balance
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erence. The number o companies trading below current asset value again spiked during the post-war period rom 1947 to 1950. However, this time, high earnings orced working capital levels above lagging stock prices. However, the market once again ignored these “bargain issues.” Graham and Dodd pointed out, however, that when stocks trade below the company’s current asset level they are, in eect, trading below the company’s liquidating value. Assuming a company’ company’ss working capital is conservatively stated, it is reasonable to assume that most companies can be sold o or at least the value o these assets. Furthermore, they elt it was also reasonable to expect that the company’ss remaining assets— company’ plant, property, equipment and other miscellaneous assets—would etch enough to oset “shrinkage” in current assets resulting rom converting them into cash. Using net current assets as a proxy or liquidating value, Graham and Dodd were able to create an actual relationship between the market price o a stock and the realizable value o a company’ company’ss assets. When they ound companies trading well below their liquidating values, they bought them in bulk.
o the working-capital alone— disregarding all other assets—and i the earnings record and prospects are reasonably satisactory, there is strong reason to believe that the investor is getting substantially more than his money’s worth.” Graham’s need or a “margin o saety” shines through in this example. First o all, he isn’t interested in the total assets o a company company.. Instead, he is only interested in the most liquid assets on the balance sheet. In “The Intelligent Investor,”
“Security Analysis,” they suggested two possible reasons why buying stocks below current asset value may ail: 1) Changing intrinsic value; or 2) Market behavior behavior.. The “market-behavior problem,” as they termed it, relates to the act that there is nothing that says that a stock price must adjust to the value an analyst places on it. The authors also argue that intrinsic value is always changing based on the development o the business—earnings, dividends, etc. Thereore, Thereore, i a company trading below current asset value loses money or substantially reduces its working capital, its intrinsic value will likely be less than it was when it was initially evaluated evaluated.. As a result o this decline in intrinsic value, the stock may no longer be undervalued and, in act, may now be overvalued. Graham and Dodd elt that, given the market’s reaction to stocks selling below net current asset value, investors were avoiding these issues or ear that the companies’ prospects were so poor that working capital would decline in the uture. However, However, in analyzing companies that were selling below current asset value in 1932, 1933, 1938, and 1939, Graham and Dodd discovered that the market’s indierence was misplaced. They concluded that: “…stocks selling below working capital and showing a air record o earnings and dividends are likely to be ‘bargain’ issues and are likely to turn out to be unusually satisactory purchases.” To oset the potential o investing in individual stocks that turn out to be unprotable, Graham suggested holding at least 30 stocks at a time.
“Using net current assets
as a proxy or liquidating
value, Graham and Dodd were able to create an actual
relationship between the
market price o a stock and the realizable value o a
Buying “Bargain Issues” In the 1949 edition o his book “The Intelligent Investor,” Graham oered this denition o a “bargain issue”: “To be as concrete as possible, let us suggest that an issue is not a true ‘bargain’ unless unless the indicated value is at least 50 percent more than the price.” He goes even urther when it comes to stock price relative to a company’s net current asset value: “…i a common stock can be bought at no more than two-thirds
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company’s assets.” Graham points out that a business should be worth to any private owner at least the amount o the working capital, since the business ordinarily would be expected to etch that much at liquidation. Furthermore, Graham wasn’t satised with merely buying rms trading at less than net current asset value. He required an even greater margin o saety and only looked at stocks whose prices were less than two-thirds o net current asset value.
Risks o “Undervalued Stocks” Graham and Dodd were keenly aware that some investments in lowprice-to-NCAV stocks would ail. In
Screening on NCAV Table 1 summarizes the Graham Table approach to NCAV stock selec-
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Table T able 1. The Graham NCAV Stock Selection Process in Brie Philosophy and Style The Graham net current asset value approach is one o the oldest documented stock selection methodologies, dating back to the 1930s. Net current asset value, o r NCAV, NCAV, looks at current assets minus total liabilities and preerred stock. Graham also termed NCAV a company’s “liquidation “liquidation value.” value.” His rationale was that this was the minimum value a company would be able to garner i its assets were sold o. Graham purchased large numbers (rom 30 to as many as 100) “bargain” issues to limit the risk o any one individual issue.
Universe o Stocks No restrictions. By their nature, however, the stocks typically passing this screen are small-capitalization stocks, or even micro-caps.
Primary Criteria Bargain price with a margin o saety: Price no more than twothirds the company’s net current asset value.
Secondary Factors •
•
“Reasonably satisactory” earnings record and prospects: Companies that are losing money or have an erratic earnings history are likely to see their intrinsic value decline, making them less undervalued or potentially overvalued. “Sound nancial condition”: As a test or nancial strength, Graham suggests looking or companies with total stockholder’s equity (common and preerred equity) greater than the total o current liabilities and long-term debt.
Stock Monitoring and When to Sell •
•
Graham held large numbers o companies trading below their net current asset value to mitigate individual company risk, suggesting as many as 30. His Graham-Newman und held as many as 100 o these issues at a time. When he bought a stock trading at 67% o its net current asset value, he would hold it until he had a 50% gain on it or until he had held it or two years.
tion. Now that we have dened the screening process. Thereore, we problems with the company itsel or his requirement or buying stocks created a custom eld that deducts problems with its industry. Graham based on net current asset value, we total liabilities and preerred stock admitted that not all stocks chosen turn our attention to nding stocks rom current assets (all rom the in this manner will have excessive that meet that requirement. The latest scal year) and divides this by returns, which is why he stressed the easiest and quickest way to identiy the average number o shares outneed or adequate diversication. In companies sharing similar nancial standing over the last scal year. (See an article published in 1975 or a characteristics is by using either a Table 2 or the ormula.) seminar, Graham states that the portWeb- or sotware-based screening Using this custom eld and reolio at his investment rm Grahamtool. We used AAII’s Stock Investor quiring that the latest weekly closing Newman oten included more than Pro undamental stock screening and price is not more than 66.7% o net 100 bargain issues at a time. research database to develop our current asset value per share, we arIn order to winnow our group even Graham NCAV screen. As o January rive at 456 companies as o January urther, and to potentially weed out 22, 2010, the Stock Investor database 22, 2010. some o the duds, some qualiying consisted o 9,874 companies traded Even though we have eliminated lters are required. on U.S. exchanges. over 95% o the companies in the Graham’s NCAV approach begins current database, we still have Protable Operations by identiying stocks trading at a over 400 candidates rom which to In “The Intelligent Investor,” discount to the company’s net current choose. Furthermore, many o these Graham suggests buying stocks that asset value per share; specically, at companies are cheap or a reason— are priced below net current asleast one-third below net asset value. perhaps either because o underlying sets only i the company’ company’ss “earnings “earnings We are not aware o any screening Table 2. Graham NCAV Custom Fields or Use With AAII’s Stock Investor Pro services that allow you to screen or Custom Field Name Formula this specic criNet Curr Assets per per Shr Y1 ([Current assets Y1]-[Total liabilities liabilities Y1]-[Pre Y1]-[Preerred erred stock stock Y1])/[Shares Y1])/[Shares Average Average Y1] terion. However, Total Equity Y1 [Equity (common) Y1]+[Preerred stock Y1] Curr Liab + LT Debt Y1 [Current liabiliti liabilities es Y1]+[Long Y1]+[Long-term -term debt Y1] with Stock Investor Pro, you can create Stock Investor Pro subscribers can download a text le o these elds at www.aaii.com www.aaii.com/ci/201002/c /ci/201002/customelds ustomelds.txt .txt or cutting custom elds that and pasting into the Custom Field Editor. you can then use in
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Table T able 3. Translating Style Into Screening: The Graham NCAV Approach Low NCAV Graham looked or stocks trading or less than two-thirds o the company’s net current asset value, which he dened as current assets less total liabilities and preerred stock. Most screening services will not allow you to screen on this value. As a proxy, you can screen or companies with low price multiples such as price-to-book-value ratio or price-to-sales ratio. You can also use variables such as the current c urrent ratio or quick ratio to identiy companies with high levels o liquid assets relative to liabilities.
Satisactory Earnings Graham did not specically outline any qualiying lters he applied to the low-price-to-net-current-asset-value universe. He did suggest, however, only buying such stocks i the earnings record and prospects were satisac tory. To To this end, we eliminated companies that have had negative earnings over the trailing 12 months or or any o the last our scal quarters. Most screening services should allow you, at a minimum, to screen or positive positi ve earnings over the last year.
Positive Cash Flow Since it is possible or companies with positive earnings to still have problems paying their bills, we also require that companies have positive operating cash fow over the last 12 months and or each o the last our scal quarters. Operating cash fow, generally speaking, is what a company has let
record and prospects are reasonably satisactory.” As we mentioned earlier, one way a company’s intrinsic value alls—thereby making an apparently undervalued stock less undervalued—is by losing money. To To this end, we require companies to have positive earnings per share rom continuing operations or the trailing 12 months as well as or each o the last our scal quarters. This lowers the total number o passing companies rom 456 to 17. A company with positive earnings can still have problems paying its bills i it does not generate sucient cash rom its normal operations. This could orce it to liquidate assets to meet its obligations. Thereore, Thereore, we also require that companies have positive operating cash fow over the last 12 months and or each o the last our scal quarters. Operating 4
ater deducting operating expenses rom revenues (although it is typically calculated by making adjustments to net income). Many screening services should allow you, at a minimum, to screen or positive operating cash fow over the last year.
Financial Strength All else equal, companies that have strong balance sheets are less likely to ail than those that do not. Thereore, as a test o nancial strength we look or companies where the value o equity (common and preerred) exceeds the value o current liabilities and long-term debt. While it is unlikely you will nd a screener oering these exact variables, you should be able to screen or such items as debt-to-equity to eliminate those companies with high levels o debt relative to some asset or equity measure.
Additional Filters We also excluded non-U.S.-based companies and stocks trading as American depositary receipts (ADRs) on U.S. exchanges. This is to avoid issues related to diering accounting standards and potential withholding taxes on dividends. Finally, stocks in the nancial sector are excluded because their nancial statements are not directly comparable to other industries. While most screeners will not allow you to exclude ADRs or stock based in a specic country, you should have better luck being able to exclude specic industries or sectors.
cash fows are just that—cash generated rom the operations o a company. Generally speaking, cash rom operations is dened as revenues less all operating expenses. Adding these criteria to our Graham NCAV screen lowers the number o passing companies to ve.
Strong Balance Sheet Having isolated companies with minimum levels o protability and operating cash fow, we shit our attention back to the balance sheet. NCAV is a balance-sheet-based metric and companies with positive NCAV have current assets that exceed the total value o their total liabilities and preerred stock. For another test o nancial strength, we look to the 1975 seminar materials in which Graham suggests comparing a company’ company’ss total
equity to liabilities and debt: Stock equity (including preerred stock) ≥ current liabilities + debt
For this lter, we had to create two custom elds within Stock Investor: I nvestor: The rst totaled the value o a company’s common and preerred equity or the last scal year and the second is the sum o a company’s current liabilities and long-term debt (see Table Tabl e 2 or the ormulas). Requiring that a company’s total equity be greater than or equal to its current liabilities and long-term debt did not eliminate any additional companies, so ve companies still remain. Lastly, we excluded non-U.S.-based companies and stocks trading as American depositary receipts (ADRs) on U.S. exchanges. This is to avoid issues related to diering accounting Computerized Investing
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Table 4. Graham NCAV Criteria or Use With AAII’s Stock Investor Pro Data Category
Field
Custom Fields Fields** Custom Fields* Income Statement - Annual Income Statement - Quarterly Income Statement - Quarterly Income Statement - Quarterly Income Statement - Quarterly Cash Flow - Annual Cash Flow - Quarterly Cash Flow - Quarterly Cash Flow - Quarterly Cash Flow - Quarterly Company Inormation Company Inormati Inormation on Company Inormation
Net Curr Assets per Shr Y1 >= Total Equity Y1 >= EPS-Continuing 12m EPS-Continuing > EPS-Continuing Q1 > EPS-Continuing Q2 > EPS-Continuing Q3 > EPS-Continuing Q4 > Cash rom operations 12m > Cash rom operations Q1 > Cash rom operations Q2 > Cash rom operations Q3 > Cash rom operations Q4 > Country Equals ADR/ADS Stock Is False Sector Not Equal
Operator
Factor
Compare to (Field, Value, Industry)
0.667
Price (In Price and Share Statistics data category) Curr Liab + LT Debt Y1 (In Custom Fields* data categor category) y) 0 0 0 0 0 0 0 0 0 0 United States Financial
*See Table 2 or inormation on creating Custom Fields.
standards and potential withholding taxes on dividends. Finally, stocks in the nancial sector are excluded because their nancial statements are not directly comparable to other industries. Adding the nal three lters eliminated two additional companies, leaving us with three companies passing our Graham NCAV screen. Table Tabl e 3 summarizes the lters or the screen and Table 4 shows the criteria as used in i n Stock Investor Pro.
Analysis,” Graham and Dodd write that they used this number as a buy and sell signal: When the number was large (many rms selling on the NYSE below their net current asset values), the market had reached a buy range; when the number was very small, the market was dangerously high. During the Depression years, when the market was vastly oversold, Graham ound such issues to be plentiul. However, the bull market that began in 1949 led to such a dearth o these same stocks that Graham and his partners dissolved the Graham-Newman investment rm in 1956.
Passing Companies Table 5 lists the three companies Table passing the Graham NCAV screen as o January 22, 2010. The number o companies selling at a sub-currentasset basis will rise and all depending on the market. In I n “Security
Due Diligence At this point, I eel it is extremely
important to stress that the listing in Table 5 is not intended to be a buy or recommended list. Stocks meeting the Graham NCAV screen require additional due diligence beore adding them to your investment portolio.
Current Financials By their nature, most companies trading below NCAV are very small in terms o market capitalization and trading volume. O the 456 companies whose price is two-thirds or less o NCAV, almost 90% trade on the Over the Counter Bulletin Board (OTCBB) (OTC BB) or on the pink sheets. Since such an overwhelming number o the current low-price-to-NCAV stocks trade over the counter, we chose not to exclude them. When companies trade over the
Table T able 5. Companies Passing the Graham NCAV Screen
Company Name (Exchange: Ticker)
Price-to- PriceEPS Curr Net toGrowth Liab & Current Book P/E Rate LT Debt to Price Assets Value Ratio (3 Yr) To Tott Equity ($/Sh) (X) (X) (X) (%) (%)
BGI, Inc. (O: BGII) 0.01 GSI Group Inc. (USA) (O: GSIGQ) 0.06 China Dashe Dasheng ng Biote Biotechnolo chnology gy Co. (O: CDBT) 0.79
0.07 0.12 0.46 0.4 6
0.05 0.09 0.09 0.0 9
0.1 2.1 0.3
0.0 (-23.6) na
17.4 13.1 9.6
Market Cap ($ Mil) 0.1 32.9 1.8
Price as % o 52-Wk High (%) Description 20 53 5
sweepstakes gaming lasers & motion devices wellness well ness prod prodss
Exchange Key: O = over the counter. Source: AAII’s Stock Investor Pro/Thomson Reuters. Data as o 1/22/2010.
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counter, they are not required to counter, le reports with the SEC. Financial analysis is only as good as the nancial data on which it is based, so it is imperative to have current nancial data compiled ollowing accepted accounting principles. When we look at our passing companies, red fags begin to appear. First o, we nd that BGI Inc. (BGII) has not led a 10-Q or 10-K since 2006. Next, we learn that GSI Group (GSIGQ) is in bankruptcy and led or Chapter 11 protection in November 2009. This highlights the need to invest in a well-diversied collection o low-price-to-NCA low-price-to-NCAV V stocks to mitigate the risk o any one individual issue. Furthermore, GSIGQ’ss latest 10-Q and 10-K GSIGQ’ reports date back to 2008. Lastly, China Dasheng Biotechnology’ Biotechnology’ss latest 10-Q dates to March o 2009 and its most recent 10-K is or the period ending June 30, 2008. Since this data is what led to these companies passing the screen in the rst place, I would be hesitant to act on them unless I could nd more recent nancial data.
Liquidity When a company’s stock trades over the counter, it usually means that the company is too small to meet exchange listing requirements. Looking at the three companies that passed our Graham NCAV screen in Table Table 5, we see that the market caps or these companies range rom $100,000 (yes, that is one hundred thousand dollars) or BGI Inc. to almost $33 million or GSI Group Inc. Even AAII’s Shadow Stock Portolio, which invests in micro-cap stocks, sets a minimum market cap foor o
$17 million. Low market-cap stocks oten also have low trading volume, sometimes making it dicult or even an individual investor to accumulate a meaningul number o shares without moving the stock price. In this case, we borrow a rule used with the AAII Shadow Stock Portolio: The average daily number o shares traded should be our times the amount needed or the position. Otherwise, it may be too dicult to get in and out o the position quickly. For example, i I had $5,000 to invest in China Dasheng Biotechnology (CDBT), I would be able to buy 6,330 shares at its January 22, 2010, closing price o $0.79. Thereore, I would like to see CDBT trade at least 25,000 shares a day (specically 25,320, or 6,330 × 4). At the Scottrade Web Web site, we nd that the 10-day average trading volume or CDBT is 74,300. When looking at illiquid, lowtrading-volume trading-volum e stocks, we oten nd higher bid-ask spreads—the amount by which the ask price exceeds the bid. This is essentially the dierence between the highest price that a buyer is willing to pay or a stock and the lowest price or which a seller is willing to sell it. Outside o the commission your broker charges, the bid-ask spread is the cost o buying or selling the stock; the higher the spread, the higher the cost o buying or selling. For BGII, with its zero 10-day average trading volume, its spread was 100% the aternoon o January 28 ($0.0055 bid versus a $0.011 ask). That means that i I were to buy this stock, the price would need to rise 100% in order or me just to break even. Realistically, I
Wayne A. Thorp, CFA, is editor o Computerized Investing and AAII’s nancial analyst. Follow him on Twitter @CI_Editor.
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would be hesitant to buy a stock with a bid-ask spread o more than 2%. Looking at CDBT that same aternoon, its bid price was $0.48 and the ask price was $0.50, or a percentage spread o 4.2%.
Conclusion Benjamin Graham made a successul career out o buying lowpriced stocks that oered him a “margin o saety.” However, the simplicity o his methodology is equally impressive. Even he was aware o this, as he commented in the 1973 edition o “The Intelligent Investor,”: “It always seemed, and still seems, ridiculously simple to say that i one can acquire a diversied group o common stocks at a price less than the applicable net current assets alone—ater deducting all prior claims, and counting as zero the xed and other assets—the results should be quite satisactory.” Despite the simplicity o his approach, it seems that, or the most part, the market ignored the stocks Graham most coveted. To be able to go against the mood o the market takes conviction and aith in your approach, both o which Graham had in great quantity. Furthermore, Furthermore, Graham achieved his impressive track record by investing in bulk, which allowed him to all but eliminate the risk o individual issues. The number o stocks meeting this requirement will ebb and fow with the movement o the market. Currently, the number o companies is low, refecting the impressive run in the market over the second-hal o 2009. With such a small number o candidates, it is important to limit your risk in individual stocks. Furthermore, as our analysis illustrated, not all companies that end up passing the Graham NCAV are worthy investi nvestment candidates.
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