Exploring Graham's Net-Net Working Capital Strategy

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Includes: ACHV, ADVM, ALBO, CHMA, EVFM, GIGM, KALV, MATN, MGEN, MSN, MTEM, NRXGQ, NVLN, OPTT, PCO, RBCN, RIOT, RTTR, SPRT, VSTM, WILC
by: David Chopin

Summary

A "net-net" is a stock which is trading for less than its current assets minus all liabilities.

Over this series, I hope to illustrate how well Benjamin Graham's net-net investing strategy works today.

I will focus my strategy on net-net working capital and specifically net-nets trading below their net cash value.

At the end of the article, I will list companies which currently present potential NNWC opportunities.

Few people have influenced the world of investing as much as Benjamin Graham. His techniques helped found the school of "value investing," the idea of investing in securities trading below their determined intrinsic value. His disciples include Irving Kahn, Walter Schloss, and most notably Warren Buffett. He is the father of value investing, and his techniques are still widely used today. One of his more well-known techniques, net-net investing, focuses on valuing companies on their current assets alone. When a company is valued at less than its current assets minus all liabilities, it is likely a net-net. Net-nets are ugly, cheap, but potentially valuable companies which serve as guides to finding inefficiencies in financial markets. In this article, I will define the different types of net-nets, and provide examples of current net-net opportunities.

Net-current-asset-value

Net-current-asset-value is the most popular technique for determining the value of a company during liquidation. It gives investors an idea of what the company could sell for if it decided to discontinue its business and sell all of its assets. This provides a very simple way to determine a margin of safety and identifies stocks with a limited downside risk. Benjamin Graham defines it in chapter 15 of The Intelligent Investor:

Net-Current-Asset Issues: The idea here was to acquire as many issues as possible at a cost for each of less than their book value in terms of net-current-assets alone - i.e., giving no value to the plant account and other assets. Our purchases were typically made at two-thirds or less of such stripped-down asset value.

This excerpt from Graham has provided value investors the formula for NCAV. A company's NCAV is calculated by subtracting total liabilities from all current assets, thus:

Dividing this NCAV by the number of shares outstanding gives us the NCAV per share. The NCAV per share is a rough estimate of the value each share of a company would hold if it were to liquidate all of its assets effectively.

Comparing this NCAV per share to the current market price per share gives investors an idea of the potential upside the security has. Value investors many time only buy shares if they trade below a predetermined multiple of NCAV per share. Graham understood that not all assets are perfectly liquid, so he would only purchase companies if their price per share was less than 2/3 their NCAV per share. He later explains that buying a diversified group of stocks trading below 2/3 their NCAV per share would provide satisfactory results (and would often times beat the market).

Net-net-working-capital

Net-current-asset-value is not the only liquidation value Graham developed during his career. Similar to NCAV, the net-net-working-capital (NNWC) figure is a valuation technique which also attempts to determine the value of a company if it were to face liquidation. During his career, Graham found that liquidating companies can usually convert a certain portion of their current assets into cash depending on what kind of asset it was. He found that during a liquidation cash and cash equivalents would yield nearly 100% of their appraised value. A company could also convert at least 75% of their accounts receivable and at least 50% of their inventories into cash most of the time. Using this knowledge he developed the net-net-working-capital figure. Chapter 43 of Security Analysis: Sixth Edition gives investors the most information about this technique.

This figure too can be used on a per share basis. Graham recommended buying companies that were trading below their NNWC per share.

Both the NCAV and NNWC provide a fairly conservative estimate of a company's worth during a worst-case-scenario. It is one of the easiest methods of determining a margin of safety. Many times a company's NCAV and NNWC will be very similar. But companies whose current assets are comprised more of receivables and inventories rather than cash will see their NNWC be a much smaller figure than their NCAV. This is why I prefer using Graham's NNWC as opposed to the NCAV figure. NNWC allows an individual to adjust the current assets to more realistically reflect what they would yield during a liquidation.

Identifying NNWC Opportunities

Throughout last year, I read Graham's works and became interested in his net-net value techniques. During the first few months of 2016, I decided to try to identify as many securities as possible which meet Graham's NNWC criteria. By mid-March, I had identified 21 companies which appeared to provide an attractive opportunity based on value of their current assets. I calculated each one's NNWC and net cash value (cash and equivalents - total liabilities) and found that they all traded below their NNWC and the value of their cash less all liabilities. These companies were:

  • Avalanche Biotechnologies (AAVL)
  • ARCA biopharma, Inc. (NASDAQ:ABIO)
  • Biodel, Inc. (BIOD)
  • Carbylan Therapeutics, Inc. (CBYL)
  • Cyclacel Pharmaceuticals, Inc. (NASDAQ:CYCC)
  • Eleven Biotherapeutics, Inc. (EBIO)
  • Endocyte, Inc. (NASDAQ:ECYT)
  • MEI Pharma, Inc. (NASDAQ:MEIP)
  • Neothetics (NEOT)
  • NephroGenex (NRX)
  • Neurometrix, Inc. (NASDAQ:NURO)
  • OncoGenex Pharmaceuticals, Inc. (OGXI)
  • Ocean Power Technologies, Inc. (NASDAQ:OPTT)
  • OXiGENE, Inc. (OXGN)
  • QLT Inc. (USA) (QLTI)
  • Rubicon Technology, Inc. (NASDAQ:RBCN)
  • Signal Genetics, Inc (SGNL)
  • Skyline Medical, Inc. (SKLN)
  • Support.com, Inc. (NASDAQ:SPRT)
  • Tetraphase Pharmaceuticals (NASDAQ:TTPH)
  • Verastem (NASDAQ:VSTM)

I have reduced the values of cash, receivables, inventory, liabilities, and ultimately NNWC to a per share basis. Hopefully this will help demonstrate what types of current assets a company's NNWC is comprised of. For example, a company with a NNWC/share of $1.00 and a cash/share value of $0.90 would indicate that 90% of the company's NNWC is derived from its cash. All data below was as of March 15, 2016. Receivables and inventory are taken at 75% and 50% of their reported value respectively. Per share data is rounded to the nearest cent.

NNWC Analysis:

Ticker AAVL ABIO BIOD CBYL CYCC EBIO ECYT MEIP NEOT NRX NURO OGXI OPTT OXGN QLTI RBCN SGNL SKLN SPRT TTPH VSTM
Shares 26,860,056 9,051,217 64,148,271 26,322,494 34,702,910 19,587,277 42,152,733 34,155,997 13,730,410 12,944,518 4,049,807 29,812,998 1,936,801 26,545,000 52,829,398 26,160,308 10,635,454 5,203,428 54,875,121 36,599,227 36,992,418
Cash ($) 259,080,000 41,482,000 40,845,000 59,878,000 24,189,000 46,362,000 173,600,454 53,790,000 51,270,399 20,902,000 12,462,827 55,186,000 9,463,298 30,251,000 141,824,000 34,271,000 12,124,000 7,733,097 65,734,000 205,912,000 110,258,000
Cash/share ($) 9.65 4.58 0.64 2.27 0.70 2.37 4.12 1.57 3.73 1.61 3.08 1.85 4.89 1.14 2.68 1.31 1.14 1.49 1.20 5.63 2.98
Receivables ($) 336,750 0 0 0 0 0 6,508 0 0 0 557,034 1,584,000 10,901 312,000 215,250 2,457,000 410,250 10,647 7,514,250 3,113,250 438,750
Receivables/share ($) 0.01 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.14 0.05 0.01 0.01 0.00 0.09 0.04 0.00 0.14 0.09 0.01
Inventory ($) 0 0 0 0 0 0 0 0 0 0 544,542 0 0 0 0 14,886,000 182,000 118,445 0 0 0
Inventory/share ($) 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.13 0.00 0.00 0.00 0.00 0.57 0.02 0.02 0.00 0.00 0.00
Total liabilities ($) (11,727,000) (1,304,000) (1,867,000) (7,458,000) (7,699,000) (18,938,000) (7,039,440) (3,378,000) (19,937,970) (10,708,000) (3,471,782) (20,769,000) (3,844,964) (1,698,000) (3,825,000) (4,565,000) (2,164,000) (2,602,104) (10,146,000) (10,862,000) (10,625,000)
Liabilities/share ($) (0.44) (0.14) (0.03) (0.28) (0.22) (0.97) (0.17) (0.10) (1.45) (0.83) (0.86) (0.70) (1.99) (0.06) (0.07) (0.17) (0.20) (0.50) (0.18) (0.30) (0.29)
NNWC ($) 247,689,750 40,178,000 38,978,000 52,420,000 16,490,000 27,424,000 166,567,522 50,412,000 31,332,429 10,194,000 10,092,668 36,001,000 5,629,235 28,865,000 138,214,250 47,049,000 10,552,250 5,260,085 63,102,250 198,163,250 100,071,750
NNWC/share ($) 9.22 4.44 0.61 1.99 0.48 1.40 3.95 1.48 2.28 0.79 2.49 1.21 2.91 1.09 2.62 1.80 0.99 1.01 1.15 5.41 2.71
Net cash value ($) 247,353,000 40,178,000 38,978,000 52,420,000 16,490,000 27,424,000 166,561,014 50,412,000 31,332,429 10,194,000 8,991,090 34,417,000 5,618,334 28,553,000 137,999,000 29,706,000 9,960,000 5,130,993 55,588,000 195,050,000 99,633,000
Net cash/share ($) 9.21 4.44 0.61 1.99 0.48 1.40 3.95 1.48 2.28 0.79 2.22 1.15 2.90 1.08 2.61 1.14 0.94 0.99 1.01 5.33 2.69
Price/share ($) 4.87 3.71 0.35 0.71 0.47 0.49 3.35 1.18 0.71 0.46 1.73 0.83 2.13 0.70 2.24 0.90 0.55 0.257 0.85 3.98 1.36
Price/NNWC 52.81% 83.58% 57.60% 35.65% 98.91% 35.00% 84.78% 79.95% 31.11% 58.41% 69.42% 68.73% 73.29% 64.37% 85.62% 50.04% 55.43% 25.42% 73.92% 73.51% 50.27%
Price/net cash 52.88% 83.58% 57.60% 35.65% 98.91% 35.00% 84.78% 79.95% 31.11% 58.41% 77.92% 71.90% 73.43% 65.08% 85.75% 79.26% 58.73% 26.06% 83.91% 74.68% 50.50%

All of the above data is available online from the SEC's EDGAR database.

Testing the Strategy

Using the 21 NNWC stocks I identified, I constructed two portfolios of a theoretical $210,000 each. I equally weighted each company in the portfolios, assigning (about) $10,000 to each. Share data was based off of their March 15, 2016, price.

The first portfolio will be rebalanced on an annual basis. This means on March 15, 2017, I will sell all my positions and redistribute the cash evenly among any number of new NNWC opportunities I have identified. The second portfolio is similar, but it will be rebalanced on the first of each month. I hope to identify whether the monthly rebalanced portfolio (taking into consideration the transaction fees associated with rebalancing) outperforms the annually rebalanced portfolio. I understand there is backtesting software available which would take care of the rebalancing for me, but I want to experience the discipline required to run an effective net-net portfolio.

Portfolio Performance

I must admit that when I initially created this portfolio, I was very skeptical that it would perform well. After all, companies which qualify as a "net-net" are usually very beaten up. Most of them operate at a loss and have seen their price depreciate significantly over the past 12 months. This is why I didn't initially feel compelled to write an article tracking the performance of the portfolio. However, after over just a month of tracking these companies, I now feel the need to document their performance. Below is the performance of the annually rebalanced portfolio since its March 15 inception.

Ticker Initial price per share ($) Price per share as of April 25 close ($) Overall return (%)
EBIO 0.49 1.04 112.24%
NEOT 0.71 1.28 80.28%
TTPH 3.98 5.91 48.49%
VSTM 1.36 1.86 36.76%
OGXI 0.83 1.08 30.12%
MEIP 1.18 1.49 26.27%
NRX 0.46 0.58 26.09%
AAVL 4.87 6.11 25.46%
ECYT 3.35 4.14 23.58%
BIOD 0.35 0.418 19.43%
SPRT 0.85 0.97 14.12%
SGNL 0.55 0.62 12.73%
ABIO 3.71 4.17 12.40%
CBYL 0.71 0.77 8.45%
OXGN 0.70 0.756 8.00%
NURO 1.73 1.80 3.47%
OPTT 2.11 1.98 -6.16%
CYCC 0.47 0.44 -6.38%
SKLN 0.257 0.22 -14.40%
RBCN 0.90 0.70 -22.22%
QLTI 2.24 1.49 -33.48%
Overall 19.30%

I understand that one month is not long enough of a time to determine if an investment strategy is effective or not, but the 17%+ gain over the past few weeks has caught my attention and convinced me to begin documenting the performance of this portfolio. The first thing most people will notice about the performance of the companies in my portfolio is that the price of Eleven Biotherapeutics has appreciated over 100%. This gain is the result of an influx of day traders targeting the stock and consequential short squeezes. I do not necessarily expect share prices to remain at this level, but it has helped me realize that day traders could be a big catalyst for these NNWC stocks. Their speculation has shot the price of EBIO's shares above the original liquidation value of $1.40 per share (although its price has since dropped), and those who initiated positions before the run up have been handsomely rewarded. Eleven Biotherapeutics and Neothetics, Inc. are both major outliers from the other 19 stocks listed in my portfolio, but even when we factor out the performances of these two stocks, the portfolio has still increased some 11.19%. Compare the 19.30% return of the portfolio and the 11.19% return when excluding the outliers and we see that this portfolio has easily outperformed the S&P 500, which has gone up about 3.50% over the same period.

NNWC Opportunities as of April 25

I have identified 21 companies which (as of April 25, 2016) trade below both their NNWC and their net cash value (cash and equivalents - total assets) and two companies which trade below their NNWC but not their NCV.

Trading below both NNWC and NCV:

Company Current price per share ($) Net-net working capital per share ($) Potential upside*
Avalanche Biotechnologies 6.11 9.22 50.9%
Venaxis, Inc. (APPY) 2.91 2.93 0.6%
Biodel, Inc. 0.418 0.61 45.9%
Carbylan Therapeutics, Inc. 0.77 1.76 128.5%
Chiasma, Inc. (NASDAQ:CHMA) 3.68 5.70 54.8
GigaMedia Limited (NASDAQ:GIGM) 2.47 5.14 108.0%
Emerson Radio Corp. (NYSEMKT:MSN) 0.81 1.81 123.4%
Neothetics

1.28

1.56 21.8%
NephroGenex 0.58 0.76 31.0%
OncoGenex Pharmaceuticals, Inc. 1.08 1.21 12.0%
Ocean Power Technologies, Inc. 1.98 2.91 46.9%
OXiGENE, Inc. 0.756 0.95 25.6%
Pendrell Corp. (NASDAQ:PCO) 0.507 0.74 45.9%
QLT, Inc. 1.49 2.62 75.8%
Rubicon Technology, Inc. 0.70 1.80 157.1%
Ritter Pharmaceuticals (NASDAQ:RTTR) 1.65 1.68 1.8%
Signal Genetics, Inc. 0.62 0.82 32.2%
Support.com, Inc. 0.97 1.15 18.5%
Threshold Pharmaceuticals, Inc. (THLD) 0.462 0.50 8.2%
Verastem 1.86 2.71 45.6%
G. Willi-Food International, Ltd. (NASDAQ:WILC) 3.48 12.00 244.8%

Trading below NNWC but not NCV:

Company Current price per share ($) Net-net working capital per share ($) Potential Upside*
CombiMatrix Corp. (NASDAQ:CBMX) 3.10 4.52 45.8%
AG&E Holdings (NYSEMKT:WGA) 0.37 0.39 5.4%

*Potential upside assumes full net-net working capital value is realized, and nothing more.

Highlights

Some of the firms listed in "NNWC Opportunities as of April 25" stand out more than others. I have identified one which appears, personally, to offer potential catalysts to reaching its full NNWC value. A few others appear to have some headwinds, making full realization of NNWC value more difficult.

  • Carbylan Therapeutics appears to be one of the better NNWC opportunities on the list. It has seen an increase of 22.96% over the last three trading sessions, and on Monday, April 25, 6.04 million shares traded hands. This is over eight times the average monthly volume of 723,077 shares per day. The influx of day traders is not the only appealing characteristic of this stock. Carbylan is a clinical-stage pharmaceutical company which is trading well below its NNWC, a piece of the market which has been on fire in the past week (see Eleven Biotherapeutics). Carbylan's shares would see a 128.5% increase in value if they were to reach their NNWC/share.
  • Emerson Radio Corp. and Rubicon Technology, Inc. both initially appear to be trading well below their fair value. These companies are trading at a fraction of their NNWC, but there appears to be a lack of catalysts for both. Both Emerson and Rubicon have been trading below their NNWC for a long period of time, which is usually a bad sign to net-net investors. Their prices have both failed to make new highs since early 2010, and they are part of industries which do not particularly interest day traders (Emerson manufactures home appliances and Rubicon manufactures sapphire crystal products). Both companies meet the criteria for being a part of a diversified net-net portfolio, but they individually do not appear to have any catalysts for significant price appreciation.
  • G. Willi-Food International, Ltd. is the company on the list which most obviously trades below its NNWC. The company is an Israeli-based producer of kosher food, and it has been the subject of some controversy lately. On February 18, 2016, the Israel Securities Authority initiated an investigation at the offices of the company. It conducted the investigation on suspicions of certain breaches of Israeli security law and criminal offenses. Shares were halted on the 18th, and did not resume trading until April 7. The company clearly passes the quantitative criteria for investment in a diversified net-net portfolio, but the situation it is in should encourage deeper analysis by potential investors.

Please note that a net-net investment strategy requires a fair bit of diversification. An investor would be assuming unnecessary down-side risk by investing in a small number of these securities.

I would also like to thank Jae Jun over at Old School Value for providing many resources regarding net-net investment.

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. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The above article is not a buy/sell recommendation for any stocks mentioned, but rather a quantitative analysis regarding the value of their assets.

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.