Friday, October 12, 2007

It's Still Boring in Net/Net Land;The Homebuilders are Clogging our Initial Net/Net Screen

Something strange began happening a few months back when we ran our net/net screen. The list of companies trading below their net current asset value was chock full of homebuilders. It’s not surprising in one sense, due to the troubles in the housing markets, homebuilders have been pounded: 50, 60, even 70% drops. As a company’s market cap falls, and net current assets don’t fall as much, the relationship between net current assets and market cap decreases, increasing the likelihood of trading below NCAV.

But, despite the screens we run, we don’t typically include homebuilders on our net/net list. Why? It’s a data issue. More on this later.

Many readers have inquired over the years as to how we come up with our list of net/nets. It is not as simple as running a stock screen and printing the results, although that is where the process begins. All you need to start here is data, namely the ability to add and subtract the components of the NCAV formula, and compare them to market cap. This is quite easy to do with some of the big name market data providers. The hard part is digging into the data to verify that the companies actually meet your desired screening criteria. (The harder part is trying to distinguish between a "cigar butt", and company with possibilities.)

There are a number of issues that can arise in the initial screening process, we’ll name a couple. First, there can be a lag in the fundamental data. Some data providers don’t get around to crunching the numbers on the micro-caps—typical net/net candidates—until well after the financial statements are actually released. So you can end up with older balance sheet data, compared to current market cap data. This can be very misleading. So, we’ll actually dig into the latest SEC filings, and verify the data manually. Second, data screening tools are not always 100% accurate. We’ve found many cases over the years where screening tools reveal net/nets that upon further inspection don’t actually meet the screening criteria. We’re not sure why this happens, but the bottom line is that stock screening tools are not foolproof.

Back to the Homebuilders
The reason we typically ignore homebuilders is because of the way they classify accounts on their balance sheets. Typically, these companies have “unclassified” balance sheets, which means that they don’t distinguish between current and non-current assets—essential data in the net/net methodology. But in the data standardization process that some equity fundamental data providers employ, homebuilder balance sheets are re-classified into current and non-current assets and liabilities. Given this fact and recent price action, it’s of little surprise that these companies are initially screened as net/nets.

This is no knock on the data providers themselves. One that follows this process is Bloomberg, which probably has the best Equity Fundamental product in the business.

We’re just not comfortable applying the net/net methodology to homebuilders. They are an entirely different animal in terms of valuation and structure. Inventories are typically relatively large relative to total assets; while this account is typically a current asset for companies in most industries, we're not sure this applies to homebuilders--especially now.

In any event, as the markets continue to head upward (at least for now), we're not finding many worthy net/net candidates these days. Stay tuned though, the markets have a unique ability of doing the unexpected.

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