Deep Value Investing: Thoughts and Analysis on Benjamin Graham’s Net Current Asset Value (NCAV) Approach Part 1

Objective: Define and interpret Benjamin Graham’s Net Current Asset Value (NCAV) metric and approach

When I first started investing in the stock market in 2012, I would often ask myself this question:

1) What is the ideal price to pick up a “good stock”?

2) How do I beat the market?

It was only until one eventful day while waiting for a friend I randomly walked into a book store and picked up a copy of Benjamin Graham’s investing classic “The Intelligent Investor”. That was when I found the answers I was looking for.

In Chapter 1 of “The Intelligent Investor” Benjamin Graham writes:

“In his endeavour to select the most promising stocks either for the near term or the longer future, the investor faces obstacles of two kinds. The first stemming from human fallibility and the second from the nature of his competition. He may be wrong in his estimate of the future; or even if he is right, the current market price may already fully reflect what he is anticipating. In the area of near-term selectivity, the current year’s results of the company are generally common property on Wall Street; next year’s results, to the extent they are predictable, are already being carefully considered. Hence the investor who selects issues chiefly on the basis of this year’s superior results, or on what he is told he may expect for next year, is likely to find that others have done the same thing for the same reason.” [1]

This statement made very logical sense to me. It is obvious that “good” stocks being good are wanted by everybody (a subjective term).  Therefore, there will a lot of media coverage and analysts following it. Therefore, in my humble opinion, with so many smart and brilliant analysts with all their excel spreadsheets and financial models following a darling sexy stock, future forecasts or expectations of the company would have already being reflected in the stock price due to market efficiency. The more analysts following a particular company, the more efficient its price is. Therefore, in order to generate a higher return than the market, I will need to adopt a contrarian strategy. I will need to avoid the competition and take the path less travelled.  This is where Benjamin Graham’s Net Current Asset Value (NCAV) Approach (Also known as net net investing/ Deep Value Investing) comes in.

In Graham’s other investing classic “Security Analysis” NCAV is defined as

(Current Assets – (Total Liabilities + Preferred stock))/Total Amount of shares

We then screen for companies where their stock price is trading below their NCAV per share.

Benjamin Graham and many of his prodigies including Warren Buffett utilised this approach to achieve market beating returns.

The NCAV equation is essentially a conservative proxy liquidation value of a company. Which is the amount residual after paying off all debtors. In an event of a firm’s liquidation, the current assets like inventory or accounts receivable may suffer impairment, this is when the long term assets (depending on the quality their long term assets and level of impairment too) steps in to fill the gaps.

I may argue that certain long term assets like prime land grade A office buildings and securities and investments can be added into the current assets equation due to their liquidity and quality. Therefore, it is crucial to read the financial statement footnotes to perform an estimation of their quality and liquidating value.

In many discussions and articles I have read both online and offline, NCAV is interpreted as a more conservative form of book value. As it discards all intangibles and severely writes off the long term assets due to the many unforeseen errors of liquidation. Therefore, the whole point of buying a stock below its NCAV is equivalent to buying sometime so cheaply that the loss of capital is very minimal (Classic Value Investing framework). Without a doubt, this practice of buying stocks at a discount to book has been proven to be very effective (there are many case studies available online).

However, I humbly feel that this interpretation is only one side of the lattice. Benjamin Graham was an innovator way ahead of his time and his Net Current Asset Value approach opens up an entire new framework on investing.

Allow me to explain why:

Firstly, Benjamin Graham’s NCAV approach screens companies that are obscure and ignored by the market either due to low analyst coverage or low market capitalisation. Think about how difficult it would be to get the informational advantage for large cap companies that are covered by so many analysts and brokerages. This is why when one screens for obscure ugly companies, one has a higher chance of buying them at a significant discount to assets/earnings. Of course, not every cheap stock out there is a good buy. When one see a stock trading below its NCAV, one needs to ask whether the stock is in cyclical decline or due to business model disruption. There needs to be a filter and checklist to select the wheat from the chaff. (This will be discussed in subsequent articles)

Logically, only beaten down obscure ugly companies with disappointing earnings would be trading at prices below their NCAV. It would make no sense to value profitable companies using the NCAV approach as it would only ignore their intangible branding and income streams and thus undervalue them.  There could be many reasons why the market would value NCAV companies as such. The companies might be faced with problems such as gloomy industry prospects, obsolete business models, ridden with lawsuits, or an overall distrust of management by the market.

Secondly, Benjamin Graham’s NCAV approach screens companies that have a large current ratio. (This makes sense, given that current assets could easily pay out all liabilities) A very high current ratio could be interpreted as been poorly managed. (Many Japanese NCAV companies have a current ratio of 9) These kind of companies generally attract shareholder activists or private equity firms. These people could either buy out the company, restructure them, or force a liquidation. These catalysts will therefore improve shareholder value. A good example would be how famed activist investor Carl Icahn forced Apple to pay out more dividends, given Apple’s huge amount of cash in their balance sheet.

Generally, in order to unlock value for a stock trading below is NCAV, there needs be strategic actions taken by the management (Selling off business arms, turning the operating business around) or by private equity/ activist firms (Mergers, buyouts).

This article attempts to define and interpret Benjamin Graham’s NCAV approach. There will be a part 2 continuation of this article where we will look into the stellar results of net net investing and discuss how one should approach net net investing.

 “There are many respectable fathers scattered across the centuries to choose from. Select a genius and make yourself their adopted son. You can even inherit their name and make claim to be a true descendant and then go forth and share this wealth of knowledge with others.”

Seneca on the Shortness of Life Chapter 15

 

References

 [1] Graham, B. (1973). The Intelligent Investor. 4th ed. USA: Harper Business Essentials, pp.31.

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