For investors keen to identify the ultimate value stocks there is no shortage of investment philosophy and advice to put to the test – and among the most famous are the models formulated by the father of Value Investing - Benjamin Graham. With an approach that emerged from the grim days of the Great Depression, Graham’s techniques have gone on to become a vital tool for value hunters. Within his earliest work, Graham came up with a stringent value test that assesses a company based on the value of its current assets minus its total liabilities. It is a demanding screen to pass especially when market valuations are high, but research has shown that Net Current Asset Value – or NCAV stocks as they are known – offer investors significant potential gains.
Graham and his now legendary books, "Security Analysis" and "The Intelligent Investor" are firmly embedded in the foundations of conventional investment theory. For anyone that isn’t familiar with him, it is worth referring to the views of an equally high profile value investor for guidance – Warren Buffett – who credited his professor for shaping his well known and hugely successful investment philosophy:
Graham began penning his investment philosophy with the publication of Security Analysis in 1934, which was followed by the more accessible guide The Intelligent Investor in 1949. In The Intelligent Investor, Graham sets out two detailed screens for potential investors, one for “Defensive Investors” and another more demanding test for “Enterprising Investors.” As the original ‘quant’ on Wall Street, he aimed to invest purely on the basis of the undervaluation of bargain stocks, seeking safety from individual bankruptcy risk by diversifying his portfolio with a large numbers of companies – he suggested 30. While his legacy has tended to be dominated by his later work, the earlier formulas, in particular NCAV, remains a vital tool in identifying these undervalued stocks.
NCAV for deep value
NCAV is a deep value screen that values a company based on its current assets – think cash and cash equivalents, money it is owed and inventories – minus its total liabilities. The essence of the model is to identify bargain stocks that are trading at such a low price that they are unlikely to slip further. In the worst case, you would be able to liquidate the company and still emerge with a gain. To add even more comfort, Graham built in a 33% margin of safety, so in his basket of undervalued stocks he would only buy companies that were trading under 66% of their NCAV.
As an aside, Graham developed an extension of this screen, commonly known as Net Net Working Capital, which assumed that in the event of a liquidation an investor was not guaranteed a 100% return on liquid assets. So he made allowances for that. No surprises that this screen is an even more demanding test for bargain stocks.
But does NCAV work for UK stocks, you might ask? In a fascinating 2007 research paper, Ying Xiao and Glen Arnold at the Centre for Economics and Finance Research at Salford Business School, found that between 1981 and 2005 London-listed stocks with a market cap / NCAV ratio of less than 0.66 displayed “annualised return[s] up to 19.7% per year over five holding years.”
Despite the formula being comparatively straightforward, the task of applying it to come up with a basket of stocks is not easy because so many companies fail the test. However, using the screening products soon to launch with Stockopedia PRO, we have done the maths. Among those on the list is Ceres Power (OTC:CPWHF), an AIM listed fuel cell technology company with plans to introduce a mass market domestic combined-heat-and-power boiler that will not only heat your home but also generate electricity that you can sell back to the grid. With a market cap of £14.6 million, Ceres boasts net current assets of £24.6 million, giving it a price-to-NCAV score of just 0.59. Its cash position was bolstered two years ago with a £31.4 million share placing but hopes of introducing the new product this year were postponed following problematic trials and the subsequent departure of its CEO. Nevertheless, a full launch is expected in the first half of 2014 but the company has said it is planning to raise more cash before then. This raises questions about how quickly it will be burning through its cashpile but on current numbers at least, it’s an NCAV stock.
House-builders have been a common occurrence on bargain stock screens since the economic downturn began wreaking havoc in British mortgage lending. On Graham’s NCAV screen Barratt Developments (OTC:BTDPF) and Telford Homes (LON-TEF) are the two main contenders, with peer group companies Bovis Homes (OTC:BVHMF), Bellway (OTCPK:BLWYY) and Taylor Wimpey (OTCPK:TWODF) falling just short of the stricter criteria. With net assets of £2.93bn and a market cap of £850 million, FTSE 250 quoted Barratt easily earns a place on the NCAV screen with a score of 0.55. Shares in the company have traded within a relatively narrow range of between 76p and 119p for the last 12 months – well down on the three year high of 184p in September 2009 and just a fraction of the 720p peak they hit in January 2007. Like its peers, Barratt has focused on optimising selling prices, improving efficiencies and building its land bank. Supply/demand trends for new homes appear to favour house-builders in the long term – but the underlying mortgage market needs to be repaired first.
Next, is MBL (LON-MUBL), which until recently ran a very successful music and DVD distribution business. Last year a key customer, the supermarket group Wm Morrison, caused chaos by cancelling its contract with the group, which in turn triggered a very rapid disintegration of the bulk of MBL’s operations. Between 2010 and 2011 the groups net assets were slashed from £35.9 million to £13.6 million, but with a tiny market cap of £1.9 million, the company comes near the top of Graham’s screen with an NCAV of 0.19. MBL hasn’t ruled out further divestments as it seeks to stabilise its remaining operations. CEO Trevor Allan has stressed that the company is committed to recovering and to be fair the MBL board was apparently making efforts to diversify shortly before last year’s disastrous events.
Elsewhere, Bluestar Secutech (LON-BSST), the Chinese security surveillance business, produced a second successive year of increased revenues and profits in 2011 on the back of increasing demand from the banking and government security markets. With net assets of £24.4 million and a market cap of £12.5 million, BlueStar scores a price-to-NCAV of 0.56. Closer inspection reveals that within the company’s £29.6 million of current assets, £21.3 million is attributable to trade and other receivables – in other words, money that the company is owed. BlueStar has conceded as much – claiming that despite many of its customers being banks, it normally takes it many months to get paid. It is a similar story at another Chinese business software company, Geong (LON-GNG) which, with net assets of £17.9 million and a market cap of £7.89 million, has an NCAV of 0.48. Pre-tax profits and margins improved substantially last year at GEONG as the implementation of a software-as-a-service model took effect. Total current assets came in at £23.2 million, within which trade and other receivables totalled £4.8 million and accrued income – amounts due from customers on the achievement of milestones but not yet invoiced until completion of the project – totalled £11.4 million. High Accounts receivable (or cash not received from sales) can be a red flag on company accounts, and combining that with the opaqueness of foreign listed AIM stocks accounts can make the risk in these stocks high.
Meanwhile, June 27 turned out to be one of the hottest days of 2011 in the UK, adding insult to injury for shareholders of solar panel component maker PV Crystalox (OTC:PVCRF), which saw its share price halve in value on the same day. Huge concern about demand in the photovoltaic market led PV to issue a warning that if conditions persisted it could be forced into a second half loss. With £95.6 million of net assets and a market cap of £32.3 million, PV Crystalox scores a price-to-NCAV of 0.45. Despite having stripped down costs, increased shipments and significantly boosted profits, the company continues to be unsettled by issues over demand and major pricing pressures in the market.
Finally, American oilman Steve Remp has been a regular fixture on the Alternative Investment Market for several years, bringing joy and heartbreak to investors in Ramco Energy and later turning his attention to renewable energy. His near legendary deal making ability saw SeaEnergy (OTC:SEYXF) pick up acreage in a government-led offshore wind development auction in early 2010. He then sold that arm of the company to Repsol in June this year for £38 million. With a focus on renewable energy services, a 24.68% interest in Lansdowne Oil & Gas (LON-LOGP) and other potential exploration projects, SeaEnergy is a speculative prospect. With net assets of £28.5 million and a market cap of £16.9 million, the company scores 0.77 on the NCAV list, just outside Graham’s strict criteria – but justifies its place as a stock for the oil & gas investment crowd.
So house-builders, speculative energy stocks and Chinese AIM stocks - NCAV investing is certainly not for the faint-hearted but when investing in a portfolio of NCAV stocks, it seems that the benefits on average tend to outweigh the occasional disaster. In the words of the great man himself, NCAVs are “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.” Still, anybody investing in such issues must be extremely careful that they don’t expose themselves to stock specific risks as the risk of complete loss of capital in an individual stock is so high. Graham himself recommended a diversified portfolio of at least 30 of such issues, which is counsel that all but the most foolhardy would be wise to listen to.