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#1 Value Investing Rule. Buy Stocks At Less Than Company's Net Working Capital

The founders of value investing, Graham and Dodd, recommended that investors purchase stocks trading for less than two-thirds of the company's

net working capital (working capital = current assets-current liabilities) or net current assets

, which is the working capital less all other liabilities. Many stocks fit these criteria during the Great Depression in 1929-1932, but unfortunately far fewer today.

Net current assets are defined as cash and other assets which can be turned into cash within one year, such as cash, accounts receivable and inventory, less all liabilities and claims senior to a company's common stock (current liabilities, long-term debt, preferred stock, unfunded pension liabilities).

Net current assets are an approximate measure of the estimated liquidation value of a company, but with no value ascribed to the company's property, plant, equipment etc. For most of today's companies, the valuation of intrinsic value will be significantly in excess of net current asset value.

For example if current company's assets are estimated at $100 per share, and all current liabilities + long term debt + preferred stock + bonds equal to 30 per share, the net current assets or net working capital would be $70 per share.

$70 - 66% = $46.2

So, if we buy this stock at or less than $46, we'll have a pretty good margin of safety. The Graham-Newman Corporation managed by Ben Graham did a nice 20% yearly return during 30 years.

Though abundant in Benjamin Graham and later in Warren Buffet era during the post war economic boom, at present day stocks, trading at 66% of net current assets or less, are few and when uncovered, they often belong to very illiquid micro-capitalization companies (under $50 millions) that can accommodate only modest levels of investment. But from time to time they turn up.

Stocks with Low Price in Relation to Book Value

Stocks with a low price-to-book ratio had noticeably better returns over the 18-year period than stocks priced high to their book value. It was also noticed that stocks, which had performed poorly for some years, subsequently increased up to 40% more than the major market indexes afterwards.

Another interesting thing was that, companies with the lowest price-to-book ratio experienced a significant decline in earnings, while companies of highest price-to-book ratio value experienced a significant increase in earnings.

Small Market Capitalization Companies with Low Price-to-Book ratio vs. Large Caps.

It turned out that smaller market capitalization companies at the lowest prices in relation to book value provided the best returns over large caps. The analysts conclusion was that, price-to-book value "is consistently the most powerful for explaining the cross-section of average stock returns."

Low Price-to-Book Value Companies Consistency of Returns vs. High Price-to-Book Value Companies

The lowest price-to-book value shares, as time shows, outperformed the highest price-to-book value stocks in 16 of the 22 years, or 73% of the time. As for three-year holding periods, the low price-to-book companies beat high price-to-book companies in 18 out of the 20 three-year periods. The five-year holding periods performed even better.

Are Low Price-to-Book Value Stocks' Higher Returns associated with Higher Risk?

The research showed that stocks with lower price to book ratio don't have anything to do with the increased risk for investors.

Out of 1000 stocks of large capitalization companies examined from 1979 through 1995, low price/earnings and low price-to-book value strategies resulted in sizeable excess returns net of transaction costs and after adjusting for risk.