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.