Introduction and data set download
Investors face a difficult current market situation. Interest rates in developed markets are low and cause unsatisfactory fixed income instrument yields. The lack of investment alternatives pushes many of us to reallocate our savings in the stock market. Consequences are high P/E ratios (the S&P 500 ratio is currently around 20.25) and fears of a clear market overvaluation.
Readers of Benjamin Graham's books, Security Analysis (1934) and The Intelligent Investor (1973), will be familiar with his perspective on value investing. Two of his major selection criteria are a sufficiently low P/E ratio and a steady earnings history. In earlier versions of his works, he recommended searching for stocks with P/E ratios lower than 10 and restricting the analysis to such stocks. He searches for bargain stocks that can be bought for a good price with a sufficiently high margin of safety (e.g. sufficiently high current and historical P/E ratios, which promise similar stability in the future).
In The Intelligent Investor, he suggests an additional kind of stock for consideration: stocks that trade below their net working capital alone. The net working capital is calculated as a company's current assets minus current liabilities. If the net working capital of a company is below its market value, it appears that the investor is able to purchase the net working capital, which can be regarded as the most liquid form of assets a company possesses, for less than its market price. Since the net working capital consists of short-term (less than one year) assets and liabilities, its value on the balance sheet should be very close to its actual market value.
I used the database Compustat to create a list of companies that traded below their net working capital at the end of 2014 (more recent data is not available on Compustat, yet). These companies comprise an interesting list for the active value investor as it might contain potential bargains. However, the reader has to be aware that many of these stocks are penny and small cap stocks that are traded in illiquid markets and experienced a period of poor stock and/or operational performance. The list can be a starting point for a rigorous analysis of the individual issues for the actively trading investor (i.e. an investor who seeks better than average returns). The list cannot be a replacement for careful analysis based on the sound investment principles of value analysis.
Here are some summary statistics of the 93 companies in the list (all numbers in million USD):
The smallest company GeoMet Inc. (NASDAQ:GMET) had a market value of $206,600 and the largest, Cabela's Inc. (NYSE:CAB), had a market value of $3,747,312,000 at the end of 2014. In comparison, one of the smallest companies in the S&P 500 has an approximate market value of $2,530,000,000. Clearly, the list focuses on risky small cap stocks but also includes some with a relatively high market capitalization, which could potentially be bargain issues with high margins of safety. Again, this conjecture has to be confirmed through careful fundamental analysis of the individual issues.
The data set can be downloaded from my personal website here.
I plotted the average performance over the past 10 years of the companies included in the list below. The portfolio is formed by investing an equal amount in each security at the beginning of 2005 and holding it until 2015, at which time we calculate the net working capital and set it in relation to the market value.
Surprisingly, the performance is pretty solid. If an investor had invested in the companies in the beginning of 2005, he would have experienced an annualized return of approximately 10%. Remember that we would expect a rather poor performance during this time period since the companies' net working capital sold below their market value at the end of the investment period. The sharp drop in the 2008 period can probably be attributed to the global financial crisis.
Next, I subtract the risk-free daily return from the portfolio return and regress the resulting time series on the three Fama and French factors. The results are shown in the figure below:
The regression confirms the conjecture I made in the introduction. The SMB factor loads while the HML factor is statistically insignificant, indicating a concentration on small cap value stocks. Mark that the alpha during the period is significantly negative - the portfolio underperformed the general market on a risk adjusted basis over the past 10 years. An untabulated regression of the adjusted returns on the market factor yields a portfolio beta of 0.008. Thus, the portfolio behaved much less volatile than the general market.
Past performance of the strategy
How has the strategy performed over the recent past? Graham delivered plenty of evidence for market outperformance in the periods covered by his books. However, we are more interested in how his principles did in the recent past. The summary stats for a portfolio based on the net working capital principle formed at the end of 2004 can be found in the figure below (mktval = market value; NWC_mktval = net working capital divided by market value; act = current assets; lct = current liabilities; mktval, act, and lct are recorded in millions of USD):
The portfolio had similar characteristics as the one we would now invest in. The focus lies heavily on small cap value stocks; however, we have a couple of large companies scattered within (e.g. Goodyear Tire & Rubber Co. (NYSE:GT), AK Steel Holding Corp. (NYSE:AKS)). The two companies highlight my earlier point: The list should not be taken as a fixed portfolio. Each company has to be analyzed thoroughly before investing and the larger ones should be more attractive than the smaller ones as their bankruptcy risk is much lower. GT had a great performance over the investment period and is now worth a multiple of the initial investment, while AKS underperformed. Furthermore, many of the smaller stocks were trading as penny stocks and still do. These kinds of investments are, in my opinion, not feasible for individual investors and should be left for institutions that can bear the risk. I suggest that the readers restrict themselves to the stocks trading on the major exchanges.
Here's the performance plot and figures:
The strategy outperformed the market massively. If an investor had taken the position 10 years ago and had held it over the period, they would have quadrupled their money. Again, the Fama and French three factor analysis yields that the portfolio is based on small cap value stocks and that the returns are less volatile than the market. However, it underperforms on a risk adjusted basis (statistically significant, negative alpha).
Going long in companies that trade below their net working capital still seems to be a strategy that outperforms the general market. However, it fails to do so on a risk adjusted basis, thus, if you can borrow at the riskless rate (what you probably can't unless you are a large institutional investor), you could do better with the same level of risk by borrowing at the riskless rate to leverage the general market portfolio (e.g. through an S&P 500 index fund). Anyways, the point of this article is not that one should implement a mechanical trading strategy to exploit the pattern. The point is that the list that I posted contains companies that might be attractive investment opportunities for the active investor. These investment opportunities have to be identified through thorough fundamental analysis - the list is merely a good starting position for such rigorous analysis.
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 microcap stocks. Please be aware of the risks associated with these stocks.