Benjamin Graham's Net Current Asset Value Approach

Outside of Warren Buffett, perhaps no other investor is as well-known as his mentor Benjamin Graham. Considered by most to be the father of value investing and often credited as the creator of the stock analyst profession, Graham’s value-oriented investing methodologies have been the topic of countless articles and academic studies. In fact, AAII tracks three different Graham methodologies at the Stock Screens area of AAII.com. However, his original stock selection approach has not garnered the same attention as his later concepts.

Graham developed and tested the net current asset value (NCAV) approach between 1930 and 1932. According to private investing firm Tweedy, Browne Company: “The net current asset value approach is the oldest approach to investment in groups of securities with common selection characteristics of which we are aware.” Graham reported that the average return, over a 30-year period, on diversified portfolios of net current asset stocks was about 20%. An outside study showed that from 1970 to 1983, an investor could have earned an average return of 29.4% by purchasing stocks that fulfilled Graham’s requirement and holding them for one year.

The topic of two “First Cut” columns by John Bajkowski in the AAII Journal (September 2007 and April 2009), the NCAV approach is more fully explained in this CI Online Exclusive, highlighting how you can use computerized stock screening tools to identify stocks meeting Graham’s criteria.

NCAV Defined

Graham first discussed net current asset value (NCAV) in the 1934 edition of “Security Analysis,” which he coauthored with David Dodd. In the book, (net) current asset value is defined as:

“current assets alone, minus all liabilities and claims ahead of the issue.”

The common definition of NCAV is:

NCAV = current assets – [total liabilities + preferred stock]

Current assets consist primarily of cash and cash equivalents, receivables, and inventories. Basically, these are assets that are already cash or are convertible into cash within a relatively short period of time (usually less than a year). Net current assets exclude not only the intangible assets but also the fixed and miscellaneous assets. In addition, Graham believed that preferred stock belongs on the liability side of the balance sheet, not as part of capital and surplus. In “Security Analysis,” preferred stock is dubbed “an imperfect creditorship position” that is best placed on the balance sheet alongside funded debt.

Net current assets differ from working capital in that working capital is current assets less current liabilities, thereby focusing only on the current segments of the balance sheet. In contrast, NCAV deducts total liabilities (current and long-term) from current assets. However, Graham used the terms interchangeably.

Compared to book value, the NCAV method is a more rigorous standard. Book value can include intangible assets, many of which may be impaired in some manner. Furthermore, book value includes land, property and equipment, which are ignored altogether by NCAV. However, over time, the on-the-book value of such assets is more than likely not an accurate representation of their actual worth.

NCAV & Market Value

In “Security Analysis,” the authors note that net asset value, or book value, seemingly was of little importance to investors looking at “industrial companies,” citing the fact that stocks can sell at high multiples or at mere fractions of book value. Investor reasoning was that share prices, by and large, are driven by a company’s earning power and dividend payments, which in general have no close relationship to the asset value (excluding utilities and financial firms). Therefore, investors and speculators alike had, for the most part, come to ignore asset value.

Beginning in the 1930s, following the market crash of 1929, Graham and Dodd noticed a large number of stocks selling below their current asset value, meaning that the share price of a company is less than the per share value of current assets. During this period, the low prices to net asset values were primarily driven by poor earnings, which in turn drove stock prices down. Perhaps not surprisingly, according to Graham and Dodd, the market greeted these stocks with uncertainty and indifference. The number of companies trading below current asset value again spiked during the post-war period from 1947 to 1950. However, this time, high earnings forced working capital levels above lagging stock prices. However, the market once again ignored these “bargain issues.”

Graham and Dodd pointed out, however, that when stocks trade below the company’s current asset level they are, in effect, trading below the company’s liquidating value. Assuming a company’s working capital is conservatively stated, it is reasonable to assume that most companies can be sold off for at least the value of these assets. Furthermore, they felt it was also reasonable to expect that the company’s remaining assets—plant, property, equipment and other miscellaneous assets—would fetch enough to offset “shrinkage” in current assets resulting from converting them into cash.

Using net current assets as a proxy for liquidating value, Graham and Dodd were able to create an actual relationship between the market price of a stock and the realizable value of a company’s assets. When they found companies trading well below their liquidating values, they bought them in bulk.

Buying “Bargain Issues”

In the 1949 edition of his book “The Intelligent Investor,” Graham offered this definition of a “bargain issue”:

“To be as concrete as possible, let us suggest that an issue is not a true ‘bargain’ unless the indicated value is at least 50 percent more than the price.”

He goes even further when it comes to stock price relative to a company’s net current asset value:

“…if a common stock can be bought at no more than two-thirds of the working-capital alone—disregarding all other assets—and if the earnings record and prospects are reasonably satisfactory, there is strong reason to believe that the investor is getting substantially more than his money’s worth.”

Graham’s need for a “margin of safety” shines through in this example. First of all, he isn’t interested in the total assets of a company. Instead, he is only interested in the most liquid assets on the balance sheet. In “The Intelligent Investor,” Graham points out that a business should be worth to any private owner at least the amount of the working capital, since the business ordinarily would be expected to fetch that much at liquidation. Furthermore, Graham wasn’t satisfied with merely buying firms trading at less than net current asset value. He required an even greater margin of safety and only looked at stocks whose prices were less than two-thirds of net current asset value.

Risks of “Undervalued Stocks”

Graham and Dodd were keenly aware that some investments in low-price-to-NCAV stocks would fail. In “Security Analysis,” they suggested two possible reasons why buying stocks below net current asset value may fail:

1) Changing intrinsic value; or
2) Market behavior.

The “market-behavior problem,” as they termed it, relates to the fact that there is nothing that says that a stock price must adjust to the value an analyst places on it. The authors also argue that intrinsic value is always changing based on the development of the business—earnings, dividends, etc. Therefore, if a company trading below net current asset value loses money or substantially reduces its working capital, its intrinsic value will likely be less than it was when it was initially evaluated. As a result of this decline in intrinsic value, the stock may no longer be undervalued and, in fact, may now be overvalued.

Graham and Dodd felt that, given the market’s reaction to stocks selling below net current asset value, investors were avoiding these issues for fear that the companies’ prospects were so poor that working capital would decline in the future. However, in analyzing companies that were selling below net current asset value in 1932, 1933, 1938, and 1939, Graham and Dodd discovered that the market’s indifference was misplaced. They concluded that:

“…stocks selling below working capital and showing a fair record of earnings and dividends are likely to be ‘bargain’ issues and are likely to turn out to be unusually satisfactory purchases.” [Graham used the terms working capital and net current assets interchangeably.] To offset the potential of investing in individual stocks that turn out to be unprofitable, Graham suggested holding at least 30 stocks at a time.

Screening on NCAV

Table 1 summarizes the Graham approach to NCAV stock selection. Now that we have defined his requirement for buying stocks based on net current asset value, we turn our attention to finding stocks that meet that requirement. The easiest and quickest way to identify companies sharing similar financial characteristics is by using either a Web- or software-based screening tool. We used AAII’s Stock Investor Pro fundamental stock screening and research database to develop our Graham NCAV screen. As of February 5, 2010, the Stock Investor database consisted of 9,905 companies traded on U.S. exchanges.

Graham’s NCAV approach begins by identifying stocks trading at a discount to the company’s net current asset value per share; specifically, at least one-third below net asset value.

We are not aware of any screening services that allow you to screen for this specific criterion. However, with Stock Investor Pro, you can create custom fields that you can then use in the screening process. Therefore, we created a custom field that deducts total liabilities and preferred stock from current assets (all from the latest fiscal year) and divides this by the average number of shares outstanding over the last fiscal year. (See Table 2 for the formula.)

Using this custom field and requiring that the latest weekly closing price is not more than 66.7% of net current asset value per share, we arrive at 357 companies as of February 5, 2010.

Even though we have eliminated over 95% of the companies in the current database, we still have over 300 candidates from which to choose. Furthermore, many of these companies are cheap for a reason—perhaps either because of underlying problems with the company itself or problems with its industry. Graham admitted that not all stocks chosen in this manner will have excessive returns, which is why he stressed the need for adequate diversification. In an article published in 1975 for a seminar, Graham states that the portfolio at his investment firm Graham-Newman often included more than 100 bargain issues at a time.

In order to winnow our group even further, and to potentially weed out some of the duds, some qualifying filters are required.

Profitable Operations

In “The Intelligent Investor,” Graham suggests buying stocks that are priced below net current assets only if the company’s “earnings record and prospects are reasonably satisfactory.” As we mentioned earlier, one way a company’s intrinsic value falls—thereby making an apparently undervalued stock less undervalued—is by losing money. To this end, we require companies to have positive earnings per share from continuing operations for the trailing 12 months. This lowers the total number of passing companies from 357 to 69.

A company with positive earnings can still have problems paying its bills if it does not generate sufficient cash from its normal operations. This could force it to liquidate assets to meet its obligations. Therefore, we also require that companies have positive operating cash flow over the last 12 months. Operating cash flows are just that—cash generated from the operations of a company. Generally speaking, cash from operations is defined as revenues less all operating expenses.

Adding these criteria to our Graham NCAV screen lowers the number of passing companies to 42.

Strong Balance Sheet

Having isolated companies with minimum levels of profitability and operating cash flow, we shift our attention back to the balance sheet. NCAV is a balance-sheet-based metric and companies with positive NCAV have current assets that exceed the total value of their total liabilities and preferred stock.

For another test of financial strength, we look to the 1975 seminar materials in which Graham suggests comparing a company’s total equity to liabilities and debt:

Stock equity (including preferred stock) current liabilities + debt

As a proxy for this, we used the total-liabilities-to-total-assets ratio. Requiring that a company’s total liabilities be no more than 50% of its total assets eliminated five additional companies, so 37 companies still remain.

Lastly, we excluded non-U.S.-based companies and stocks trading as American depositary receipts (ADRs) on U.S. exchanges. This is to avoid issues related to differing accounting standards and potential withholding taxes on dividends. Finally, stocks in the financial sector are excluded because their financial statements are not directly comparable to other industries. Adding the final three filters eliminated 16 additional companies, leaving us with 21 companies passing our Graham NCAV screen.

Table 3 summarizes the filters for the screen and Table 4 shows the criteria as used in Stock Investor Pro.

Passing Companies

Table 5 lists the 21 companies passing the Graham NCAV screen as of February 5, 2010. The number of companies selling at a sub-current-asset basis will rise and fall depending on the market. In “Security Analysis,” Graham and Dodd wrote that they used this number as a buy and sell signal: When the number was large (many firms selling on the NYSE below their net current asset values), the market had reached a buy range; when the number was very small, the market was dangerously high. During the Depression years, when the market was vastly oversold, Graham found such issues to be plentiful. However, the bull market that began in 1949 led to such a dearth of these same stocks that Graham and his partners dissolved the Graham-Newman investment firm in 1956.

Due Diligence

At this point, I feel it is extremely important to stress that the listing in Table 5 is not intended to be a buy or recommended list. Stocks meeting the Graham NCAV screen require additional due diligence before adding them to your investment portfolio.

Bankrupt Firms

Graham was keenly aware that some firms trading below their net current asset value would fail. That is why he advocated buying these firms in large numbers—as many as 30 at a time. This level of diversification lowers the portfolio exposure to such failures. Looking at our listing of 21 companies, we find that two are already in bankruptcy (as designated by the “Q” at the end of their ticker): S&K Famous Brands, Inc. (SKFBQ) and GSI Group Inc. (GSIGQ).

Current Financials

When companies trade over-the-counter, they are not required to file reports with the SEC. Financial analysis is only as good as the financial data on which it is based, so it is imperative to have current financial data compiled following accepted accounting principles. When we looked at our passing companies, more red flags began to appear.

Of the 21 companies passing the screen as of February 5, 2010, only three have filed a quarterly report (10-Q) with the SEC since June 30, 2009—China Marketing Media Holdings (CMKM), MangoSoft, Inc. (MGOF), and Boss Holdings, Inc. (BSHI). I would be hesitant to act on the other firms unless I could find more recent financial data.

Liquidity

By their nature, most companies trading below NCAV are very small in terms of market capitalization and trading volume. Of the 456 companies whose price is two-thirds or less of NCAV, over 90% trade on the Over the Counter Bulletin Board (OTCBB) or on the pink sheets. Since such an overwhelming number of the current low price-to-NCAV stocks trade over the counter, we chose not to exclude them from our Graham NCAV screen. When a company’s stock trades over-the-counter, it usually means that the company is too small to meet exchange listing requirements. Looking at the companies that passed our Graham NCAV screen in Table 5, we see that the market caps for these companies range from $0 for S&K Famous Brands (SKFBQ) to $58.5 million for Spectrum Group International (SPGZ). Even AAII’s Model Shadow Stock Portfolio, which invests in micro-cap stocks, sets a minimum market cap floor of $17 million.

Low market-cap stocks often also have low trading volume, sometimes making it difficult for even an individual investor to accumulate a meaningful number of shares without moving the stock price. In this case, we borrow a rule used with the AAII Shadow Stock Portfolio: The average daily number of shares traded should be four times the amount needed for the position. Otherwise, it may be too difficult to get in and out of the position quickly.

For example, if I had $5,000 to invest in Boss Holdings, Inc. (BSHI), I would be able to buy roughly 820 shares at its February 5, 2010, closing price of $6.10. Therefore, I would like to see BSHI trade at least 3,300 shares a day (specifically 3,280, or 820 × 4). However, at the Scottrade Web site, we find that the 10-day average trading volume for BSHI is only 564. Even with such a seemingly small amount of money to invest, it would be virtually impossible to buy 820 shares of BSHI without having an impact on the stock price.

When looking at illiquid, low-trading-volume stocks, we often find higher bid-ask spreads—the amount by which the ask price exceeds the bid. This is essentially the difference between the highest price that a buyer is willing to pay for a stock and the lowest price for which a seller is willing to sell it. Outside of the commission your broker charges, the bid-ask spread is the cost of buying or selling the stock; the higher the spread, the higher the cost of buying or selling. For BSHI, its spread was 6.5% the morning of February 12 ($6.00 bid versus a $6.39 ask). If I were to buy this stock, the price would need to rise 6.5% in order for me just to break even. Realistically, I would be hesitant to buy a stock with a bid-ask spread of more than 2%. Looking at MangoSoft (MGOF) that same morning, its bid price was $0.17 and the ask price was $0.60, for a percentage spread of 253%.

Conclusion

Benjamin Graham made a successful career out of buying low-priced stocks that offered him a “margin of safety.” However, the simplicity of his methodology is equally impressive. Even he was aware of this, as he commented in the 1973 edition of “The Intelligent Investor”: “It always seemed, and still seems, ridiculously simple to say that if one can acquire a diversified group of common stocks at a price less than the applicable net current assets alone—after deducting all prior claims, and counting as zero the fixed and other assets—the results should be quite satisfactory.”

Despite the simplicity of his approach, it seems that, for the most part, the market ignored the stocks Graham most coveted.

Graham did invest in an era where the bulk of the companies were industrial firms with a preponderance of “real” assets—inventories of raw materials and finished products as well as plant and equipment—so that the net current asset value of the firm was more accurately reflected in the balance sheet. In today’s service-dominated economy, companies such as Microsoft or Accenture typically carry little in “hard assets”—inventories and the like—making it more difficult for the individual investor to get an accurate picture of what a company would be worth if it were liquidated.

That being said, to be able to go against the mood of the market takes conviction and faith in your approach, both of which Graham had in great quantity. Furthermore, Graham achieved his impressive track record by investing in bulk, which allowed him to all but eliminate the risk of individual issues. He was also adept at modifying his selection methodology to adapt to the changing marketplace.

When buying low-NCAV stocks, it is important to limit your risk in individual stocks. Furthermore, as our analysis illustrated, not all companies that end up passing the Graham NCAV are worthy investment candidates.