Benjamin Graham's Net-Net Stocks

By Puah Soon Lim

Cigar Butts Anyone?

Recognized as the father of securities analysis, Benjamin Graham argued for investing in stocks that were significantly undervalued relative to their intrinsic worth. Among the most widely adopted strategies of his is the cigar butts approach (also known as the Net-Net approach). This strategy alone brought him high profits in the 1930s to 1956. Buffett also successfully implemented this strategy during his Buffett Partnership years from 1956 to 1969.

The key measure of this approach is the ratio NCAV/MV which is the balance sheet current assets minus all the firm's (current and long-term) liabilities divide by market capitalization. Long-term assets (e.g. intangible assets and fixed assets) values are not counted. An undervalue investment will be one that has an NCAV that is above the market capitalization of the stock. In his classic book The Intelligent Investor, Graham recommended for a margin of safety to be built into this evaluation. He called for the purchase of stocks at a price that is 2/3 or less of the NCAV.

Graham found that companies satisfying the NCAV/MV strategy were often priced at significant discounts to estimates of the value that stockholders could receive in an actual sale or liquidation of the entire corporation. Thus, the NCAV/MV rule, in theory, not only protects capital from a significant permanent loss but also generates a portfolio of stocks with excellent prospects for advancement in price.

“It is clear that these issues were selling at a price well below the value of the enterprise as a private business. No proprietor or majority holder would think of selling what he owned at so ridiculously low a figure. In some ways, practically all these bargain issues turned out to be profitable and the average annual result proved much more remunerative than most other investments’ Graham (2003).”

Search

Given this criteria, I made a search on stocks that are listed in Singapore and Malaysia and applied the NCAV/MV test.

Results: You may download the spreadsheet of the results through this link: NCAV/MV Results (20 Mar '18).

Among the over 700 stocks that are listed on the SGX, I found 85 which have an NCAV/MV ratio that is greater than one. (i.e. Net current assets after paying off all of the liabilities is still greater than the market capitalization.) Among these 85, there are 64 which fulfilled Graham’s margin-of-safety rule of ⅔ NCAV. What is interesting is that from a Net Cash perspective, there are 25 companies that have a NetCash/MV that is greater than one and even after building in a ⅔ margin of safety, we are still left with 16 companies.

Across the causeway in Malaysia, the result is a little bit different. I was expecting to find more since there are more stocks to start with. However, there are actually fewer cigar butts in Malaysia right now than Singapore. Among the over 900 stocks that are listed on the BURSA, I found only 48 which have an NCAV/MV ratio that is greater than one. (i.e. Net current assets after paying off all of the liabilities is still greater than the market capitalization.) Among these 48, there are 24 which fulfilled Graham’s margin-of-safety rule of ⅔ NCAV. From a Net Cash perspective, there are only seven companies that have a NetCash/MV that is greater than one, and after building in a ⅔ margin of safety, we are only left with only 3 companies.

The Argument from Efficient Market Hypothesis

If you are a proponent of the efficient markets hypothesis, you might argue that investors rationally push down a stock’s price to below NCAV with the expectation that the corporation will continue to waste resources thereby draining the company of much of its shareholder wealth over time. However, Graham reasoned that the majority of these value stocks would survive and produce good returns because of the potential for one of a number of catalysts.

These catalysts could come from:

• Earning power improvement. This could come about in three ways: a general improvement in the industry – entry and exit dynamics mean that low industry profitability is frequently not as persistent as many market pessimists believe - and; a change in the company’s operating policies – management running a company with such a low stock price relative to assets either respond voluntarily to take corrective action or they (or their replacements) are forced to by stockholders, such as adopting more efficient methods or abandonment of unprofitable lines. A new product to drive revenue growth.
• Sale or merger - A sale or merger with another corporation that could employ the firm’s assets would take place. It would pay at least the liquidation value.
• Complete or partial liquidation - Complete or partial liquidation could release value. The management of a corporation selling at below liquidation value needs to provide a frank justification for continuing to operate.

What is your thought about cigar butts? Please share with me your insight on our Facebook page. 

Source: Capitalcube

Disclaimer: Please be sure to do your own research prior to making any investment decisions. This article is not a recommendation to buy or sell any security and is strictly the author's opinion.