The concept of having a durable margin of safety for investments is critical in all market environments but even more important in the economic climate of early 2009. I do not know of many economists who accurately predicted the macroeconomic climate of the past year and there are virtually no stock market forecasters who predicted 50 percent declines in the major averages. I certainly did not anticipate the market carnage and I have no faith in my ability to know where the Dow or S&P 500 will be at this time next year.
Rather than attempting to forecast the economy or the direction of the overall market, it makes sense to identify individual securities that trade at levels that provide a solid margin of safety. The silver lining of the market declines over the past year is that there are many more bargains available, but how can one separate stocks that have been legitimately hammered from those that might represent bargains?
Graham’s NCAV Concept
Benjamin Graham pioneered a technique that holds a great deal of promise in today’s market. Graham’s concept of identifying bargain issues, or Net-Current-Asset Value Stocks (NCAV), is as relevant today as when he wrote about it in The Intelligent Investor
The NCAV concept involves identifying companies that are trading at below the level of the current assets on the balance sheet less all liabilities. Current assets consist primarily of cash and cash equivalents, trade receivables, and inventories. These are assets that are either cash or convertible into cash within a relatively short timeframe (usually less than a year). From current assets, one subtracts all liabilities on the balance sheet, not just current liabilities. This value is then compared against the market valuation of the company.
This approach involves a far more rigorous standard than merely looking for companies trading at less than book value. Book value can include all kinds of intangible assets, many of which may be impaired in some manner. This is far more true today than when Graham was using this technique. Goodwill and intangibles litter the balance sheets of most companies and determining impairments is subjective at best. Graham’s NCAV approach values intangibles at zero. In addition, land, property, plants, and equipment are not even considered in the NCAV approach.
Limitations
Graham always recommended that this approach should be used to select a diversified group of stocks selling at under net current asset value. Why is this recommended? There are many limitations and variables that could exist to make a single investment of this kind unprofitable. It is prudent to have a diversified list to mitigate the risk of any particular NCAV situation not working out as expected. Some of the major limitations include the following:
Unprofitable Operations
It is obvious that even a company that currently is trading for far less than NCAV could end up destroying shareholder value further if the company has a track record of unprofitable operations and negative cash flow. It makes sense to filter out companies that have a pattern of unprofitable results and lack a coherent strategy for the business.
Concentrated Ownership
Many NCAV stocks have concentrated ownership profiles in which one individual or a small group controls the company. In such scenarios, it may be difficult or impossible to unlock the value in the company if the agenda of the controlling parties differs from your interests. For example, if the owners of a NCAV stock are also on the payroll, it is always possible for excessive compensation practices to divert the value from shareholders to the owners via payroll. Therefore, examining whether the company has trustworthy management is important. Often investors examine 10K reports but fail to examine proxy statements detailing executive compensation practices. This can be a warning sign when examining any company, but is particularly important for NCAV scenarios.
Small Market Capitalization and Trading Volume
It is very rare to find a company trading at below NCAV that has a market capitalization much greater than $100M. Most NCAV stocks have been overlooked by institutions or are too small to have a material impact on the results of large money managers. While this creates a potential opportunity for enterprising individual investors, sometimes the market capitalization is so small that trading volume makes it difficult or impossible to accumulate a meaningful number of shares without moving the market price. This has happened to me in the past on relatively small positions. If you are dealing with a stock that has average daily trading volume of 5,000 shares and trades at $5/share, if you attempt to make an investment of $10,000, you are accounting for a very significant portion of that day’s volume. Suddenly, even a small investor is facing issues such as having to spread out purchases over many days to accumulate a meaningful position – a dilemma normally only impacting larger investors and institutions.
Regardless of the limitations, today’s market environment has created opportunities in this area that did not exist a year ago. I plan to write more about NCAV stocks, although the limitations noted above will eliminate my ability to write about stocks until after I obtain a position. I will disclose any positions in discussions of individual securities.
As individual investors, we can benefit from today’s easy access to information. Graham had to manually filter through stacks of S&P reports but we have the advantage of screening tools to narrow down the list. It is actually quite surprising that such opportunities exist at all, and another sign of general market inefficiency during periods of economic stress.