Exploring Graham's Net-Net Working Capital Strategy, Part 3: The First 6 Months

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Includes: ABIO, ADVM, ALBO, BNTC, CBYL, CHMA, CMRX, CYCC, DNAI, EBIO, ECYT, EGT, GIGM, GRVY, INFI, IOT, MATN, MCUR, MDGL, MEIP, MIRN, MSN, NEOT, NRXGQ, NURO, NVCN, OGXI, OIIM, OPTT, PCO, QLTI, RBCN, RELL, SGNL, SKLN, SPRT, TAIT, TKAI, TNXP, TOSYY, TTPH, VSTM, WILC, ZFGN
by: David Chopin

Summary

In March of this year, I began testing Benjamin Graham's famous "net-net working capital strategy."

I used a hypothetical $210,000 to invest in 21 equally-weighted deep value opportunities.

September 15th of this year marks 6 months since the portfolio's inception.

Graham's strategy is living up to the hype, returning 33% in only six months.

Understanding Net-nets

In my first article, I defined what a "net-net" stock is and identified some companies which qualified as net-net opportunities. Essentially, net-nets are ugly companies. Like really ugly companies. They're "I wouldn't touch you with a thirty-nine-and-a-half-foot-pole" companies. Net-net investing strategy involves buying companies that trade for less than the cash that should be realized during a liquidation. Deep value investors use two formulas, net current asset value (NCAV) and net-net working capital (NNWC) to calculate a company's liquidating value. Investing in failing companies doesn't make sense to some investors, but it is important to remember that shares of any company become attractive when trading at low enough of a price. The calculations for identifying net-nets are simple, but I recommend reading my first article in this series if you are unfamiliar with them.

Understanding Net-net Working Capital

Net-net working capital is a formula used to estimate the cash a company could realize if it were to undergo a complete liquidation. It involves discounting some of the subject company's current assets based on their liquidity. The formula for calculating NNWC is as follows:

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Portfolios which are composed entirely of companies trading for less than their NNWC have historically outperformed major market indices. A back test done by Jae Jun at Old School Value showed that a portfolio consisting of 20 equally weighted, annually-rebalanced NNWC positions returned about 19.37% annually between 1999 and 2014 (vs. just over 5% for the S&P 500). Another study done by Tobias Carlisle, Sunil Mohanty, and Jeffrey Oxman revealed that portfolios composed of net-net stocks outperformed the NYSE by about 22% between 1984 and 2008. Although net-net portfolios have consistently blown away market indices, the strategy is not utilized by many professional investors. Because many of the stocks which qualify as net-nets have such a small market capitalization or are very thinly traded, fund managers with over $1 billion in AUM would struggle to utilize a net-net portfolio. Because of this, smaller and more individual investors have a great advantage over some of the investing pros. Deep value investment strategies give small investors an edge, and I believe investors with a long-term outlook could benefit greatly from adopting a deep-value strategy.

The Portfolio

On March 15th of this year, I invested a hypothetical $210,000 among 21 equally weighted companies trading below their net-net working capital. This portfolio will be rebalanced on an annual basis, meaning on March 15th of 2017 I will sell all of my original positions and redistribute the cash equally among any number of newly-identified NNWC opportunities. Below is a snapshot of the annually-rebalanced portfolio.

And the performance of those positions:

Ticker Initial price per share ($) Price per share as of September 15 close ($) Overall return
EBIO 0.49 3.87 689.8%
OPTT 2.11 7.29 245.5%
MEIP 1.18 1.76 49.2%
NEOT 0.71 1.05 47.9%
BIOD 0.35 0.414 18.3%
SPRT 0.85 0.847 -0.4%
VSTM 1.36 1.35 -0.7%
MATN 0.70 0.651 -7.0%
SGNL 0.55 0.51 -7.3%
TTPH 3.98 3.69 -7.3%
CYCC 0.47 5.09 -9.8%
ECYT 3.35 3.02 -9.9%
NURO 1.73 1.52 -12.1%
ABIO 3.71 2.98 -19.7%
ADVM 4.87 3.76 -22.8%
QLTI 2.24 1.55 -30.8%
RBCN 0.90 0.61 -32.2%
SKLN 0.257 0.168 -34.6%
CBYL 0.71 0.461 -35.1%
OGXI 0.83 0.515 -38.0%
NRXGQ 0.46 0.045 -90.2%
Overall 32.99%
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The stellar performance of this portfolio can be attributed almost exclusively to the performance of Eleven Biotherapeutics (NASDAQ:EBIO), which has seen its shares appreciate nearly 700%. Although EBIO's performance has been more than satisfactory, it does raise some concerns about the NNWC method. A portfolio identical to the annually-rebalanced NNWC portfolio but excluding a position in EBIO actually returned -0.77% over the six month period. The fact that the portfolio's performance was so dependent upon the performance of EBIO illustrates the nature of net-net investment: most of the positions will fail but a few positions should appreciate so much that it more than compensates for the poor performance of the remaining positions.

The annually rebalanced NNWC portfolio vs. the S&P 500 Click to enlarge

The annually-rebalanced NNWC portfolio vs. the S&P 500

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The annually-rebalanced NNWC portfolio (excluding EBIO) vs. the S&P 500

In addition to the annually-rebalanced portfolio, I created a monthly-rebalanced NNWC portfolio. The monthly-rebalanced portfolio began with the original 21 NNWC companies seen in the other portfolio, but it has been rebalanced on the last trading day of each month as opposed to on an annual basis. The monthly-rebalanced NNWC portfolio has returned 32.20% (almost as much as the annually-rebalanced portfolio) but has drawn much of its gains from positions other than Eleven Biotherapeutics. To compare, the monthly-rebalanced NNWC portfolio returned 20.55% when excluding the BIO position (vs. 0.05% for the annually-rebalanced when excluding the EBIO position).

Annually-rebalanced NNWC Portfolio Monthly-rebalanced NNWC Portfolio
Including EBIO 32.99% 32.20%
Excluding EBIO 0.05% 20.55%
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The above chart illustrates that the monthly-rebalanced NNWC portfolio was far less dependent upon the performance of one stock. In fact, when rebalancing on a monthly basis, the portfolio drew its gains from numerous stocks.

The main issue with adopting a monthly-rebalanced NNWC strategy is, of course, high brokerage charges for making so many trades. Although it is relatively unorthodox, I believe a disciplined investor who utilizes limit orders through a commission-free broker, like Robinhood, could benefit greatly from the monthly-rebalanced NNWC strategy while reducing downside risk.

Attempting to Fine-tune the Strategy

While 6 months is hardly a long enough period to draw conclusions about an investment strategy, I believe we can begin to look at the data and start identifying trends and statistics within the annually-rebalanced portfolio. I will be comparing the discount to NNWC among positions, how quickly each position's discount to NNWC is diminishing, and the performances of high revenue vs. low revenue companies.

I will be comparing high revenue companies to low revenue companies because companies with a price to sales greater than 1 are more likely to play out in a binary fashion, i.e., either seeing their price rebound above their NNWC or slowly dwindle away until their shares are worthless. On the other hand, companies with a price to sales less than 1 may see their price fluctuate less than those with a price to sales greater than 1. This is because net-nets which trade for less than their annual sales generally have a legitimate, albeit failing, business. These companies are likely to see their prices rise above their NNWC due to improvement in earnings or changing of company management, as opposed to a potential buy-out scenario.

*"Purchase price will be below NNWC for:" assumes that the company's NNWC will change in accordance to the average of the following four quarters. For example, if a company lost an average of $0.30 worth of NNWC in the past four quarters, we will assume that the company will continue to lose $0.30 of NNWC per quarter.

Company Stats

Eleven Biotherapeutics

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$0.49 $1.40 35% -$0.30 3 quarters Yes
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Ocean Power Technologies (OPTT)

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$2.11 $2.92 72% -$1.55 0 quarters Yes
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MEI Pharma, Inc. (MEIP)

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$1.18 $1.48 80% -$0.17 1 quarter Yes
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Neothetics (NEOT)

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$0.71 $2.28 31% -$0.96 1 quarter Yes
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Biodel Inc. (BIOD)

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$0.35 $0.55 64% -$0.05 4 quarters Yes
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Support.com, Inc. (SPRT)

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$0.85 $1.15 74% -$0.05 6 quarters No
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Verastem (VSTM)

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$1.36 $2.71 50% -$0.22 6 quarters Yes
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Mateon Therapeutics, Inc. (MATN)

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$0.70 $1.09 64% $0.00 N/a Yes
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Signal Genetics, Inc. (SGNL)

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$0.55 $0.99 56% +$0.16 N/a Yes
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Tetraphase Pharmaceuticals (TTPH)

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$3.98 $5.41 74% -$0.49 3 quarters Yes
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Cyclacel Pharmaceuticals, Inc. (CYCC)

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$0.47 $0.50 94% -$0.09 0 quarters Yes
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Endocyte, Inc. (ECYT)

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$3.35 $3.95 85% +$0.38 N/a Yes
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NeuroMetrix, Inc. (NURO)

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$1.73 $2.49 69% +$0.83 N/a No
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ARCA biopharma, Inc. (ABIO)

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$3.71 $4.44 84% -$0.17 4 quarters Yes
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Avalanche Biotechnologies (ADVM)

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$4.87 $9.22 53% -$1.63 2 quarters Yes
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QLT Inc. (QLTI)

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$2.24 $2.62 85% -$0.08 4 quarters Yes
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Rubicon Technology, Inc. (RBCN)

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$0.90 $1.80 50% -$0.12 7 quarters Yes
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Skyline Medical Inc. (SKLN)

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$0.257 $1.01 25% +$0.99 N/a Yes
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Carbylan Therapeutics (CBYL)

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$0.71 $1.99 36% +$0.73 N/a

Yes

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OncoGenex Pharmaceuticals Inc (OGXI)

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$0.83 $1.21 69% +$0.05 N/a Yes
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NephroGenex (OTCPK:NRXGQ)

Price at purchase NNWC at purchase Price/NNWC at purchase Avg. quarterly change in NNWC/share Purchase price will be below NNWC for*: Price to sales >1?
$0.46 $0.79 58% -$0.24 1 quarter Yes
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Observations

Discount to NNWC

The results of past net-net studies have shown that there is a positive correlation between the discount to liquidating value and the returns generated by net-net stocks. I will divide all of my position into quintiles and compare their performance:

  1. Price/NNWC of 0-20%
  2. Price/NNWC of 21-40%
  3. Price/NNWC of 41-60%
  4. Price/NNWC of 61-80%
  5. Price/NNWC of 81-100%

Historically, a larger discount to liquidating value has correlated to higher returns, except for the 0-20% quintile (stocks in this category actually have drastically underperformed).

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The results of our NNWC study is somewhat consistent with what we have seen historically. The second lowest quintile yielded the highest returns, a result consistent with historical net-net studies. However, the third lowest quintile performed far worse than the fourth lowest quintile. The most expensive stocks did yield negative returns, as we may have expected, but they were not the worst performers. As the study continues we may gather more consistent data.

Longevity of NNWC

The idea behind this data set is that net-nets who are seeing their NNWC dissipate at a lower rate will yield more satisfactory returns. I have not heard of any study looking at this quantitatively, but I feel it could highlight some tendencies of net-nets that we, as investors, can exploit. The theory is that companies who have a larger amount of NNWC compared to how quickly it is dissipating and to its price per share will be less likely to see their prices decrease over the course of their investment.

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The data is not consistent with the hypothesis. Companies who had more NNWC relative to the rate at which it was dissipating actually saw their prices decrease more over the course of their investment. Over a longer period of time we may see a pattern occur, however.

Pharmaceuticals vs. Other

Naturally, many of the companies which qualify as net-nets are pharmaceutical companies who are failing for whatever reason (generally failure to receive regulatory approval for drugs). This experiment will hope to make clear whether or not a solely pharma net-net portfolio would perform better than a general net-net portfolio.

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The data suggests that the pharmaceuticals performed better than the other net-nets, but the presence of an outlier makes it hard to draw conclusions. For comparison, the pharmaceutical net-nets had a median return of -9.8% while the other net-nets had a median return of -9.7%.

NNWC Opportunities Today

I have recently made screens for companies trading below both NNWC and NCAV. They can be found here: Student Investing Guide Net-net Screens

These screens show the ticker symbols of companies qualifying as net-net opportunities along their top sides. The screens also show a detailed view of the inputs used in each company's analysis. Hopefully the more detailed view helps those wanting to learn more about the deep value process understand how each value was calculated.

Pendrell Corporation (PCO)

Probably my favorite net-net opportunity today, Pendrell Corp. presents a unique situation which offers low downside and considerable upside. Pendrell, formerly ICO Global Communications, is a company which engages in the business of licensing and selling intellectual property. The company generates revenue by licensing their inventions to other companies, or filing lawsuits against companies who, they believe, have infringed upon their patents. Although it trades at a price/NNWC of only about 85%, Pendrell saw positive cash flow last quarter due to the licensing of memory and storage patents to Toshiba Corporation (OTCPK:TOSYY). In addition to the IP business, Pendrell is sitting on a large sum of cash, about $170 million, which they hope to use for a strategic acquisition or partnership in order to provide them with more reliable cash flow and greater potential for growth. Pendrell's plan is to acquire a business through which they can monetize over $2.5 billion worth of net operating losses (NOLs). If Pendrell can manage to monetize this asset, we can expect the share price to appreciate considerably. Austin Newsom has written a couple of great articles summarizing the investment thesis.

Mirna Therapeutics (MIRN)

Mirna Therapeutics is another net-net which offers tremendous upside. Mirna is a biopharmaceutical company which is developing a pipeline of microRNA therapeutics that are capable of reducing the proliferation of cultured cancer cells. Their main drug, MRX34, is in a phase 1 trial and has shown promising signs of tumor shrinkage, but the presence of serious adverse events (SAEs) have raised concerns about whether or not the FDA will put a clinical hold on the drug. The company currently trades at about 68% its NNWC and could be a more speculative play for investors to consider.

Chiasma (CHMA) and ProNAi Therapeutics (DNAI)

Chiasma and ProNAi are both healthcare companies which I believe have considerable upside. I summarized each company in my previous article. Chiasma and ProNAi trade at 66% and 45% NNWC, respectively.

Other Companies Trading Below NNWC

Benitec Biopharma Ltd. (NASDAQ:BNTC), Chimerix Inc (NASDAQ:CMRX), Emerson Radio Corp. (NYSEMKT:MSN), Entertainment Gaming Asia Incorporated (NYSEMKT:EGT), G. Willi-Food International, Ltd. (NASDAQ:WILC), GigaMedia Limited (NASDAQ:GIGM), GRAVITY Co., Ltd. (NASDAQ:GRVY), Income Opportunity Realty Investors, Inc (NYSEMKT:IOT), Infinity Pharmaceuticals, Inc. (NASDAQ:INFI), Macrocure (NASDAQ:MCUR), Madrigal Pharmaceuticals, Inc. (NASDAQ:MDGL), Mateon Therapeutics Inc, Neovasc Inc. (NASDAQ:NVCN), O2Micro International Limited (NASDAQ:OIIM), Richardson Electronics, Ltd. (NASDAQ:RELL), Taitron Components Inc. (NASDAQ:TAIT), Tokai Pharmaceuticals (NASDAQ:TKAI), Tonix Pharmaceuticals Holding Corp. (NASDAQ:TNXP), Zafgen, Inc. (NASDAQ:ZFGN)

Conclusion

While mechanical deep-value investors have preferred rebalancing annually or every 30 months, my results have led me to believe that a more frequent rebalancing period could benefit investors. We are living in a time when commission free trading is available to investors and although it does not offer some of the resources the major brokers do, I believe a disciplined and smaller investor could find alpha using a market strategy that was never feasible until recently.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.