Value Investing Congress Blog

If you’ve ever perused the Cheap Stocks website (http://stocksbelowncav.blogspot.com), it’s obvious that we are enamored with one of Ben Graham’s most fascinating (to us, anyway) investment techniques, that being the pursuit of companies trading below their net current asset value.  Indeed, we’ve taken some liberties with Ben’s formula, a necessary evil in this day and age.  (Ben’s formula sought companies trading at less than 2/3 NCAV, while we typically look for less than one times NCAV).

We’ve researched and written about the concept for years (yours truly published a handful of pieces on the subject during my time at Bloomberg), but only recently took it a step further.  In February, we rolled out The Cheap Stocks 21 Net Net Index, the first index of companies trading below net current asset value (that we are aware of, anyway).

It’s been an interesting experiment to date, and since inception the index is up 7.54% percent versus
-.38% for the Russell Microcap Index, the closest benchmark to this combination of down and outs, ne’er do wells, and potential bankruptcy candidates.  Don’t get us wrong, there are probably some gems in the mix, but companies don’t typically trade so cheaply relative to assets unless there’s either a very good reason, or the market is just not paying attention.  Nonetheless, the concept of building a “passive” index of net/nets is at the very least intriguing.

Below is more about this index, its construction and constituents:

The Cheap Stocks 21 Net/Net Index is a market cap weighted index comprised of companies that met the following criteria at index inception on Tuesday, February 12th, 2008:

•Market Cap is below net current asset value, defined as:
Current Assets – Current Liabilities – all other long term liabilities (including preferred stock, and minority interest where applicable)

•Stock Price above $1.00 per share

•Companies have an operating business; acquisition companies were excluded

•Minimum average 100 day volume of at least 5000 shares (light we know, but welcome to the wonderful world of net/nets)

*Index constituents were selected by market cap. The index is comprised of the “largest” companies meeting the above criteria.

The Index is naïve in construction in that:

•It will be rebalanced annually, and companies no longer meeting the net/net criteria will remain in the index until annual rebalancing.

•Only bankruptcies, de-listings, or acquisitions may result in replacement

•Does not discriminate by industry weighting—some industries may have heavy weights.

Cheap Stocks 21 Net/Net Index Constituents and Weights (%, rounded):

Adaptec Inc(ADPT)18.72%
Computer Systems

Audiovox Corp(VOXX)12.20%
Electronics

Trans World Entertainment(TWMC)7.58%
Retail-Music and Video

Finish Line Inc(FINL)6.30%
Retail-Apparel

Nu Horizons Electronics(NUHC)5.76%
Electronics Wholesale

Richardson Electronics(RELL)5.09%
Electronics Wholesale

Pomeroy IT Solutions(PMRY)4.61%
IT

Ditech Networks(DITC)4.31%
Communication Equip

Parlux Fragrances(PARL)3.92%
Personal Products

InFocus Corp(INFS)3.81%
Computer Peripherals

*Renovis Inc(RNVS)3.80%
Biotech

Leadis Technology Inc(LDIS)3.47%
Semiconductor-Integrated Circuits

Replidyne Inc(RDYN)3.31%
Biotech

Tandy Brands Accessories Inc(TBAC)2.94%
Apparel, Footwear, Accessories

FSI International Inc(FSII)2.87%
Semiconductor Equip

Anadys Pharmaceuticals Inc(ANDS)2.49%
Biotech

MediciNova Inc(MNOV)2.33%
Biotech

Emerson Radio Corp(MSN)1.71%
Electronics

Handleman Co(HDLM)1.66%
Music- Wholesale

Chromcraft Revington Inc(CRC)1.62%
Furniture

Charles & Colvard Ltd(CTHR)1.50%
Jewel Wholesale

*Renovis was acquired on 5/5/08; the allocation to that company in our index model remains in cash

Jonathan M. Heller, CFA

*The author does not have positions in any of the companies mentioned. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. The author will not trade any of the securities mentioned (buy, sell, short) for at least two weeks following the date of this post.

Considering Net/Nets
by Jonathan M. Heller, CFA

We’ve been enamored by one of Ben Graham’s somewhat little known investment techniques, the evaluation of companies trading below their Net Current Asset Value (NCAV), for many years.  This is reflected by our research, and one of the primary focuses on our Cheap Stocks website.  Graham’s technique involved the hunt for firms that traded at such low valuations to assets that they seemingly include an inherent safety net or moat, terms that warm the value investor’s heart.

For those willing to do some digging and research, the application of a modified version of Graham’s formula—he would only consider companies trading at less than 2/3 of NCAV (extremely rare these days)—using one times NCAV as a threshold can typically uncover names worth further research.

The Formula

In order to determine if a stock is trading below its NCAV, the company’s market cap is compared to the result of the following formula:

Current Assets –Current Liabilities- All Long Term Liabilities (including Preferred Stock and Minority Interests if applicable)

If the company’s market cap is indeed greater than the result of this formula, you may have identified a net/net.  Even if that’s the case, your work and research has only just begun.  To blindly invest based on the formula alone would be imprudent.  Upon further examination, many companies meeting the NCAV criteria are cheap for very good reasons.  Perhaps its inventories are not only bloated, but also worthless, the company lacks adequate cash, and is one step away from bankruptcy.  Or, its last available financial data is up to 3 months old, and a negative material event has yet to be reflected within the numbers.  Most are not profitable, and it’s important to identify a potential catalyst—if one exists—for a return toward profitability.

There are a whole host of reasons that companies appear to be cheap, but are instead one step away from bankruptcy.  Sometimes, however, you can discover hidden gems, unnoticed because of lack of market or institutional interest in the smallest of the small publicly traded companies—the microcaps, the typical size of most net/nets.

Liquidity Issues
When investing in micro caps, liquidity is often an issue.  Companies may trade infrequently, and have very wide bid/ask spreads.  When evaluating these, it is imperative to be aware of daily trading volume, current spreads.  Placing a market order can be very dangerous, so limit orders should be considered.

Asset Quality
The composition and quality of a company’s current assets is also an important factor in assessing an individual net/net.  All else being equal, the greater the amount of cash and marketable securities as a percentage of current assets, the better—especially if the company is not burning through its cash rapidly.  In terms of true value, it goes downhill 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—short of fraudulent accounting, that is.

Long Term Assets for Free
It is important to note non-current assets, or long-term assets such as land, property, plant and equipment, which are not included in the NCAV calculation.  They are completely ignored, but may have great value—another potential source of value to consider.

The Current Market Environment
When we first began researching net/nets, in the late 1990’s/early 2000’s, there were hundreds of companies that met the criteria—very typical in bear markets.  Some were fairly big names:  Circuit City was on the list in 2003, for instance, before being “re-discovered”, posting good numbers and appreciating considerably.  But when the markets are in bull territory, the rising tide lifts all boats, and the number of net/nets shrinks.  Despite recent market volatility, and threat of a bear market, the ranks of net/nets are still fairly thin these days.

A search using Bloomberg data conducted Tuesday, January 22, revealed an initial, unscrutinized list of just 25 potential net/nets with market caps greater than $10 million, just 4 of which had market caps greater than $100 million:  Slim pickings to say the least.

Conclusion
While the net/net area currently reveals few names, it’s an interesting area of the market to keep an eye on, especially for more sophisticated individual investors.  Tread lightly however, don’t acquire names without adequate research, and be aware of the risks.

Jon Heller, CFA, is a financial analyst and value investor in Philadelphia. He blogs regularly at stocksbelowncav.blogspot.com.