Friday, December 22, 2006

Net Current Asset Value Strategy Evaluated

Net Current Asset Value (NCAV) strategy is a screen popularized by Benjamin Graham to find undervalued book-value bargain stocks. The net current asset value of the company is the total current assets less total liabilities. Current assets include cash, short-term investments, net receivables, inventory, and other current assets. A company's stock is considered a NCAV bargain (aka net/net stock) if the current total market-cap is a fraction of the net current asset value, usually two-thirds. As a value investor, I was drawn to these stocks because the risk seemed very limited if we are buying the stock at a fraction of liquidation value. Over this past year, I've experimented with this strategy by investing in a number net/net stocks that I deemed safe.

According to this site, this strategy has proven to be very successful, returning 29.4% compared to 11.5% of the S&P, spanning a 13-year period between 1970-1983. This is a real long time ago and things may be very different now. A few other sites also discuss the NCAV strategy. The Cheap Stocks blog often analyzes these net/net stocks. The stocks he invests in are representative of the best of the net/net choices. The GrahamInvestor also has a screen that lists the top few NCAV candidates. These are all good places to start.

From looking at these sites and analysis, I hand-picked six net/nets over the year. I invested in LKI, MARSB, HDL, JBSS, DHOM, and EWEB. DHOM was not a net/net stock at the time of the purchase, but is currently a net/net candidate on GrahamInvestor's screens because some long-term assets have been moved to the inventory row of the balance sheet. I held very small positions in each of these stocks and often took short-term tax losses and waited a month to re-purchase without getting hit by a wash sale. My final return on these stocks is estimated to be about 1.2%. MARSB, EWEB, and LKI were big winners, returning well over 20% each. I lost money on both JBSS and HDL, but DHOM was by far my biggest loser, with some shares declining more than 50%. I have to admit that my position sizing was a bit poor. I did not load up enough on the winners and was overweight the loser. In my defense, of course everything looks easy in hindsight. Even though one year's performance may not be representative of any strategy, it became apparent to me that this strategy holds more risk than I had originally expected. The occasional big loser can blow away any gains from the winners and the majority of the NCAV candidates will probably be losers. In other words, the strategy requires good stock selection on top of the screen.

In my opinion, there are two problems with the NCAV strategy. The first is that it was conceived and successfully employed around the time of the Great Depression, a time when there were a lot of these stocks to choose from. Nowadays only a handful of stocks satisfy these screens and you'll almost never find a company that doesn't have blemishes. Such companies include businesses that have been displaced by disruptive technologies like Handleman (HDL), a company that services CD distribution. Other companies like DHOM and JBSS may not be able to pay back their debt. And finally there are companies like EWEB that don't have much of a business model.

Another problem with this strategy is that you're putting blind faith in the company and its management to manage the current assets well. We're using a liquidation valuation to value a company that is still a going-concern. This company can very well be on a one-way trip to bankruptcy. One also has to be careful that the current assets include enough cash to handle interest payments on any debt. When a company is not able to meet its obligations and are forced to liquidate, the book value may necessarily be impaired.

If one were to successfully employ NCAV, I think he/she needs to be diversified across many issues and he/she must also be able to screen out the duds. Irwin Michael of ABC Funds does a pretty good job playing in this realm. He has a commentary site that provides detailed analysis and updates. I would recommend investing in his mutual fund over hand-picking NCAVs. Over the next year, I will be slowly unraveling my own NCAV purchases. I still own DHOM, JBSS, and HDL.

Friday, December 08, 2006

Book Report: Common Stocks and Uncommon Profits by Phil Fisher

As I tackle my large list of investment books to read, I will write little summaries in my blog to remind myself of the important messages in the book. I hope these little crib sheets are useful for others who may not have time to read the book.

This is my report on Philip Fisher's Common Stocks and Uncommon Profits. I highly recommend reading this book along with Benjamin Graham's Intelligent Investor. Fisher stresses finding exceptional growth stocks that are selling at reasonable prices. Philip Fisher is probably second only to Benjamin Graham in shaping how value investors like Warren Buffet approach stocks. His investing career began with the great crash in 1929 and included many bear and bull markets. In his approach to investing, he stressed doing deep research by employing the "scuttlebutt" approach to find growth stocks. Scuttlebutt is the use of many different sources to find information about the company, the management, and the products. He used such inventive methods to find answers to his 15 points of quality in every stock he analyzed.

Here lists the 15 things Phil Fisher looks for in common stocks:
1) Do the products have enough market potential to increase sales for the next few years?
2) Does management have the drive to continue increasing total sales through innovation?
3) How effective is the conpany's R&D relative to its size?
4) Is the sales and marketing organization above-average?
5) Does the company have good profit margins?
6) How is the company improving profit margins?
7) Does the company treat workers well?
8) Does the company treat executives well?
9) Does the company have a deep management bench?
10) Does the company control cost and accounting well?
11) Does the company stand out amongst competitors in any way (particular to industry)?
12) Is the company long-range forward-looking?
13) Is the company going to dilute shareholders?
14) Does the company speak freely of the good as well as the bad?
15) Does the management have impeccable integrity?

He also gives a few short lists what investors should not do:
1) Buy promotional companies.
2) Ignore good stocks that are thinly traded or over-the-counter.
3) Buy stocks based on tone of annual reports.
4) Assume a high price already discounts all future growth.
5) "quibble over quarters and eighths."
6) di-worsify.
7) Be afraid to buy in times of political uncertainty.
8) Let what doesn't matter influence one's decisions.
9) Anchor oneself to price target even if the stock is undervalued at current prices.
10) Follow the crowd.

In the third part of the book, entitled Developing an Investment Philosophy, Fisher gives us concrete applications of the principles described in the book. I found this part of the book to be the most useful as a few of the stories and lessons resonated with me. IMHO, it's always easier to learn from examples than from lists. In this section, there was a story of a client who wouldn't buy a stock above his arbitrarily set price and subsequently missed a 50% return because it always traded fractionally above his buy-below price. I similarly missed Mastercard this year because I was not willing to pay more than $46. This was my largest mistake of this year, an error of omission.

Fisher also encourages investors to not time markets by making big moves into and out of equities. He believes growth stocks chosen carefully will ride out down-markets and staying committed to such stocks would prevent missing out on its imminent recovery. He quite accurately predicts that most market-timers will not repurchase stocks once it has started rising due to psychological anchoring to the lowest price. Even though the current market condition appears to be priced for perfection (or at least a soft-landing), I will follow Fisher's advice and stay the course. My positions should allow me to outperform even with a downturn.