Saturday, February 01, 2003

Ben Graham is considered to be the father of value investing, and although his principals seemed antiquated during the bubble, they still have application in today's market. Graham's focus on having a margin of safety in investments is as meaningful today, as when he first put pen to paper.

One of Graham's strategies focused on identifying companies trading below their "Net Current Asset Value", which is defined as:
Current Assets minus (Current Liabilities+Preferred Equity+Long Term Debt + Other Long Term Liabilities)

The product of this equation is then compared to a company's market capitalization. In cases where market cap is less than net current assets, you may (the operative word is may) have found a bargain. Why? Because net current asset value does not even consider the value of long-term (or non-current assets) such as property plant and equipment, land, long term investments. Therefore, buying a company trading below its NCAV is like getting the rest of the assets for free.

Graham preferred companies trading at less than 2/3 of their NCAV, which allowed a greater margin of safety. Word of warning though, companies may be trading at these levels for good reason. They may be in trouble, and Graham was very clear on this point in his writings. Howevever, the analysis of such companies is still well worth the effort.

In building this web page, the intent is to educate readers about this investment technique, the ins and outs, what to look for in NCAV companies, and why. As the concept is further explained in the coming weeks, short research reports on companies meeting the criteria will be also be posted.

Unfortunately there have not been many studies (outside of Graham's research, that is) on the success or lack thereof of buying companies trading at less than their NCAV. One, by Professor Joseph Vu of Depaul University from (1988) found that buying these companies, then selling two years later beat the market by 24 percent.

Tweedy Browne, an investment management firm (these guys are the real deal, excellent value managers), publishes a booklet titled "What Has Worked In Investing", which also references the NCAV strategy, saying that it's research "indicated that companies satisfying the net asset value criterion have not only enjoyed superior common stock performance over time, but also have often been priced at significant discounts to "real world" estimates of the specific value that stockholders would probably receive in an actual sale or liquidation of the entire corporation."

The bottom line is that you will not find many well known companies meeting the criteria. The large majority will be small companies, with market caps below $100 million. Analysts typically don't follow these companies, institutions don't own them, so they don't generate much press. Some are fallen technology companies, chock with cash, but unfortunately, that cash is being burned very quickly, and the companies are not profitable. You can also find companies that are making money, have great balance sheets, and a potentially positive future. This is where the analysis comes in.

The composition and quality of a company's current assets is an important factor as to whether you are truly getting a bargain. All else being equal, the greater the amount of cash and marketable securities as a percentage of current assets, the better. In terms of true value, it goes down hill quickly for the other current asset accounts. Accounts receivable, for instance, must be collected in order for value to be realized, and there are no guarantees this will happen. Inventories may be worth pennies on the dollar if they needed to be quickly converted into cash, plus there are storage and maintenance costs. Cash, on the other hand, has a fixed value. What you see is what you get.

Thats exactly what this strategy demands. Even if you uncover a true gem, it may take a long time for the market to realize a company's true value. You may find a company with tremendously undervalued assets (remember, if you buy a company below it;s NCAV, you essentially get the long term assets for free), but you should also look for a potential catalyst. Look for companies who have positive earnings (many NCAV companies do not), who have the potential to increase earnings in the future. Loads of cash, along with in-demand products will buy these companies time to make their strategies work. While, those that are bleeding red ink, and have little cash may be headed to bankruptcy.

Since most NCAV companies are small, and have relatively low trading volume, the bid/ask spreads can be huge. Always use limit orders when buying or selling. A market order placed for a thinly traded issue can really hurt when buying or selling.

Read the 10K, know what business the company is in, know its financials, and don't be afraid to call the company for more information. Don't buy if you can't explain the business in one sentence. This strategy is risky, so do your homework.

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