by David Sterman
Benjamin Graham and David Dodd, widely considered to be the fathers of modern investing philosophy, had a deep affinity for value stocks. They taught disciples such as Warren Buffett to assess companies in the most pessimistic possible scenarios. This makes sense. These men wrote their famous book, Security Analysis, in 1934, when companies were liquidating at a fast pace during the Great Depression.
One of their favorite techniques was Net/net investing. This looks at what a company would be worth in a time of absolute distress. Specifically: what would a company have left if you piled up its cash, inventory and accounts receivable, paid off its liabilities and returned the funds to shareholders? (Graham and Dodd applied a slight discount to the value of inventory and accounts receivable, but I am not-- because companies do a much better job these days of writing down those assets to reflect realistic expected values than they did back in the 1930s.)
As you might imagine, these companies are cheap for a reason. They're not operating at peak performance. So you don't want to measure them by current metrics such as operating cash flow.
Instead, you want to see if their business models hold any long-term appeal, since you're basically getting the business for nothing (or in this case, less than nothing).
Digging into the balance sheet
To truly find a "net/net" investment, you need to have accurate numbers on the balance sheet. Avatar Holdings (Nasdaq: AVTR), a real estate developer focused on Florida and Arizona, is a good test case. The company is sitting on more than $300 million in unsold homes, far above the company's stock value. This figure is the cost incurred to acquire the land and build on it. Are those homes still worth that much? Clearly not. Then again, you have to assume real estate in those states will improve eventually. In the meantime, Avatar has more than $150 million in the bank, which is more than enough to ride out the current crisis.
The real estate crisis brought shares down from $80 in 2007 to $20 by 2009, where they sat ever since. But the recent market rout has pushed shares all the way down to $10, moving this squarely into net/net category.
A worthless business?
As noted earlier, you have to look at what these businesses might be worth in a different economic climate and not simply what they look like right now. Case in point, micro-cap stock Gencor Industries (Nasdaq: GENC), which is struggling from very weak demand for asphalt and other road-building materials. State and federal government finances are in bad shape, and a rising number of projects are on hold. This can only last so long because we'll again need to invest in repairs of existing roads and the construction of new ones.
Gencor, back in "normal" times, earned an average of $2 a share from fiscal (September) 2005 through fiscal 2008. It's a hopeful sign the company just announced a solid boost in quarterly sales and a decent profit. Fiscal third quarter sales rose 81% to $23 million and a $1.5 million loss a year ago was boosted to $1.5 million in this third quarter. This is money that goes to the balance sheet, pumping up an already-considerable net cash balance. Cash exceeds the entire value of the company, which should provide major downside protection in these challenging times.
Risks to consider: The challenge for these companies is to preserve their asset base during this economic slowdown. Money-losing quarters have a way of eroding cash and book value.
All of these stocks require a good deal more research because they tend to operate off-the-radar and clearly have challenges that need to be understood. But the extremely low values assigned to their businesses imply that any operational rebound would quickly bring investors back into the fold.
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.