Companies trading at below net cash. Opportunity or value trap?

Companies that are trading at negative enterprise value (EV)

EV = market value of common stock + market value of preferred equity + market value of debt + minority interest - cash and investments.

Why is the market having a very negative perception of the company's future prospects (rightly or wrongly), governance and/or believe the cash is not real?

Some of these companies are simply too small, and not tradeable.  

Some are shell companies waiting for a corporate exercise.

There are many reasons:

Fake bank statements

It is very hard to fake bank statements and accordingly, net cash on the balance sheet.  But if the monies are located offshore, this might not be the case.  

Recall, several China based companies, such as China Stationery and Xingquan International Sports Holdings previously listed on Bursa.  Investors were badly burnt, following revelations of massive accounting irregularities - including the reported cash going missing and discovery of previously unknown (un-authorised) loans.  When something appears too good to be true, it often is.

Poor corporate governance

The integrity of management and controlling shareholders is a key factor for investors when valuing stocks and this is reflected in the stock price.

Investors lack of confidence maybe when investors expect that the cash - even though real - could be used in a way that is not in the interests of minority shareholders.  It has happened time and time again.

Contingent liabilities

Existing cash on the balance sheet could be whittled away by contingent liabilities, when the market anticipates imminent payments for retrenchment exercises, lawsuits and so on.  

Persistent loss-making and negative cash flows from operations

When a company is persistently loss-making and importantly, suffers negative cash flows from operations - whether due to idiosyncratic issues and/or broader economic downturn - that too will eat into its cash hoard.  If the market has a downbeat outlook for the company's prospects, it will place a big discount on the stock.  

Time to monetisation factor

Oftentimes, companies trade at discounts to their net cash and more broadly, the value of their underlying assets, because of the "time to monetisation" factor.  It takes many years to translate an asset into earnings, cash flows and returns to shareholders.

Absence of powerful activist shareholders

There was no EV company among components of the S&P's 500 index and only a handful of very small companies in the Russell 3000 Index.   This could be attributed to the presence of powerful activist shareholders in a mature market.  The absence of activist investors may well be the problem for Bursa.

Warren Buffett’s Greatest Competition

There’s no disputing that Warren Buffett is the best investor of all time. His net worth speaks for itself. In fact, there is only one person in history worthy of comparison.

That person is young Warren Buffett.

Let’s take a look at the numbers Buffett achieved in the 1950s and 1960s compared to his performance thereafter.

From 1957 to 1969, Buffett achieved an average return of 29.5% and a cumulative return of 2794.9%!

In this timeframe, the Dow had a negative return in 5 out 12 years. Buffett had a positive return in all 12 years, with his most successful year, 1968, reaching a remarkable 58.8%. That beat the Dow by more than 50 percentage points.

This was the pinnacle of Buffett utilizing the strategies of Benjamin Graham and investing in net net stocks. He focused on the best possible NCAV investments, such as Western Insurance Securities Company, and often chose fairly concentrated portfolios. Once he found the stocks, he simply puffed the cigar and celebrated his victories.

Back then, finding these valuable, cheap companies was difficult. Young Warren Buffett had to do his own research and put in relentless man-hours. He spent months combing through Moody's stock manuals to find a handful of available net nets. Today, you can find a good selection of high-quality international net net stocks by signing up for free net net stock picks or, even better, opting for full access to Net Net Hunter.

For comparison, between the years of 1965 and 2014 when Warren Buffett became a behemoth, Berkshire achieved a compounded annual return of 19.4%, over 10% less than the best years of his investment life. And, these numbers were heavily boosted by the returns young Warren Buffett achieved in the late 1960s. During this timespan, he also had a few negative years and a few more in which the S&P 500 outperformed his portfolio.

A return of 19.4% annually is nothing to sneeze at. Most investors do worse. Still, 84-year-old billionaire Warren Buffett wouldn’t last a round in the ring with his agile, quick-footed 30-year-old self. At a Berkshire Hathaway annual meeting, he admitted it:

"Yeah, if I were working with small sums, I certainly would be much more inclined to look among what you might call classic Graham stocks, very low PEs and maybe below working capital and all that. Although -- and incidentally I would do far better percentage wise if I were working with small sums -- there are just way more opportunities. If you're working with a small sum you have thousands and thousands of potential opportunities and when we work with large sums, we just -- we have relatively few possibilities in the investment world which can make a real difference in our net worth. So, you have a huge advantage over me if you're working with very little money." – Warren Buffett

You have thousands and thousands of potential opportunities that Buffett does not! By being able to invest in net net stocks, classic Graham stocks, you have a huge advantage over the Oracle of Omaha.

Following Benjamin Graham and a Young Warren Buffett

So, this brings us back to the beginning. A young Warren Buffett risked everything and hopped on a train to Washington D.C. to work for Benjamin Graham, the father of value investing.

In 1954, he accepted a job at Graham’s partnership for a starting salary of $12,000 a year. Under Graham’s tutelage, he fine-tuned his ability to spot promising net net stocks, as opposed to merely cheap stocks.

Both are obviously value stocks, but cheap stocks can be any stock where the current price is lower than the underlying intrinsic value. Net net stocks are valued purely on their net current assets. That’s cash, accounts receivable, and inventory minus total liabilities, preferred shares, and various off-balance sheet liabilities. Working capital. This is better known as the NCAV, or Net Current Asset Value.

If the stock price was 2/3 of the NCAV, Graham would buy. When the stock price returned to the full NCAV, Graham would sell. Assuming he found a good net net stock, his downside is protected by the discount to net liquid assets, providing a huge margin of safety. It’s such a solid strategy that you, as a small investor, don’t really have to know a thing about the industry. By comparison, Buffett went into textiles in a major way and lost his shirt.

There have been multiple studies that show Graham’s strategy consistently shows returns of a basket of net net stocks in the 20-35% range. From 1970 to 1983, an investor could have earned an average return of 29.4% by purchasing stocks that fulfilled Graham’s requirements and holding them for at least a year.

Buffett himself, using Graham’s strategy, stated that he would see returns within a 2-year timeframe 70 to 80% of the time. He would take a puff and sell instead of collecting boxes of cigars and waiting for them to appreciate in value.

Despite the simplicity of his approach, it seems most investors ignore the stocks that Graham would have most coveted. Investors nowadays want to invest as if they’re billionaires, choosing a wide range of large cap stocks and holding on to them until retirement, death, or the next big market crash.

Going against the market takes conviction and faith in your approach, something both Graham and Buffett had in spades. Smart value investors don’t brag about owning Apple or Google. They talk about small wholesale electronics factories and unknown retail companies. They are excited about international microcap stocks in Japan or Australia.

If you’ve read this far, you’re not Warren Buffett, the immobile billionaire. You’re young Warren Buffett, the wide-eyed investor hopping on a train heading toward immeasurable wealth.

Read more here:

http://www.netnethunter.com/how-young-warren-buffett-started-his-fortune/

Purchase of Bargain Issues

We define a bargain issue as one which, on the basis of facts established by analysis, appears to be worth considerably more than it is selling for.

The genus includes bonds and preferred stocks selling well under par, as well as common stocks.

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

What kind of facts would warrant the conclusion that so great a discrepancy exists?

How do bargains come into existence, and how does the investor profit from them?

There are two tests by which a bargain common stock is detected.

The first is by our method of appraisal.  This relies largely on estimating future earnings and then multiplying these by a factor appropriate to the particular issue.

The second test is the value of the business to a private owner.  This value also is often determined chiefly by expected future earnings - in which case the result may be identical with the first.  But in the second test more attention is likely to be paid to the realizable value of the assets, with particular emphasis on the net current assets or working capital.


Courage in depressed markets

At low point in the general market a large proportion of common stocks are bargain issues, as measured by these standards.

It is true that current earnings and the immediate prospects may both be poor, but a level-headed appraisal of average future conditions would indicate values far above ruling prices. 

Thus the wisdom of having courage in depressed markets is vindicated not only by the voice of experience but also by application of plausible techniques of value analysis.

The same vagaries of the marketplace which recurrently establish a bargain condition in the general list account for the existence of many individual bargains at almost all market levels.

The market is always making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.  Even a mere lack of interest or enthusiasm may impel a price decline to absurdly low levels.

Thus we have two major sources of undervaluation:  (a) currently disappointing results, and (b) protracted neglect or unpopularity.


The private-owner test

The private-owner test would ordinarily start with the net worth as shown in the balance sheet.  The question then arises as to whether the indicated earning power is sufficient to validate the net worth as a measure of what a private buyer would be justified in paying for the business as a whole.

If the answer is definitely yes, we suggest that an ordinary investor should find the common stock attractive at a price one-third or more below such a figure.

If instead of using all the net worth as a starting point the investor considered only the working capital and applied his test to that, he would have a more convincing demonstration of the existence of a bargain opportunity.

For it is something of an axiom that a business is worth to any private owner at least the amount of its working capital, since it could ordinarily be sold or liquidated for more than this figure.

Hence, if a common stock can be bought at no more than two-thirds of the working -capital value alone- disregarding all the 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.



Benjamin Graham
The Intelligent Investor

Net Net Working Capital (Value Investing)

What is Net Net Working Capital?

Net Net Working Capital = Cash + Short Term Marketable Investments + Accounts Receivable * 75% + Inventory * 50% – Total Liabilities

“Net Net Working Capital” (NNWC) is one of the first stock valuation screening methods to be defined in the value investing world.  Benjamin Graham also referred to this as Net-Current-Asset Value (NCAV).

The Net Net Working Capital formula may help identify undervalued stocks.  Benjamin Graham actually used the term “Net Working Capital” but current value investors and Graham followers use the terms “net nets” or “Net Net Working Capital” interchangeably.

One value investing strategy of Graham was to purchase stocks that were trading at less than two-thirds of the Net-Current-Asset Value per Share (i.e. less than two-thirds of the Net Net Working Capital Value per Share).  This type of value investing strategy could be thought of as a “liquidation value investing strategy”.  In other words, Graham is proposing that the stock is so cheap that even under a situation where the business was wound down, that the investor would have a such a suitable margin of safety that a return could still be earned.  Of course, Graham is not counting on a liquidation since there are costs associated with that action.  Rather, Graham is satisfied that he is paying nothing for the fixed assets of the business nor is he paying anything for any potential earnings.

According to Graham, “The type of bargain issue that can be most readily identified is a common stock that sells for less than the company’s net working capital alone, after deducting all prior obligations.* This would mean that the buyer would pay nothing at all for the fixed assets—buildings, machinery, etc., or any good-will items that might exist.  Very few companies turn out to have an ultimate value less than the working capital alone, although scattered instances may be found.”  (Source:  The Intelligent Investor by Benjamin Graham).

Of course, stocks that are trading below their NNWC may be trading at such low multiples for various reasons (e.g. pending bankruptcy, misstated financial statements, or a host of reasons why investors may be shunning a particular stock).  Regardless, we present the Net Net Working Capital formula and provide further discussion.

Net Net Working Capital = Cash + Short Term Marketable Investments + Accounts Receivable * 75% + Inventory * 50% – Total Liabilities

Once the NNWC is determined, this amount divided by the number of shares outstanding will provide the NNWC per share.  NNWC per share that is less than the current share price may be an indication of an undervalued stock or a deep value stock.  Graham advocated buying a basket of stocks whose prices traded significantly below NNWC per share (or Net Current Asset Value per Share – NCAV per Share).

The NNWC formula considers that not all balance sheet amounts may reflect current reality.  A 25% discount is applied to accounts receivable as these amounts may not actually be collectible.  In addition, a 50% discount to inventory is applied given that it may be stale or obsolete.  Of course, this is a first screen and potential investors should consider whether further discounts would be prudent.

The estimation or calculation of intrinsic value is as much art as science.  Any investor can run a mathematical screen to identify stocks trading at various metrics that could indicate potential value.  However, it must take keen business sense and deep curiosity to ask why a stock may be trading at the level it is, whether there actually is business value and how much, and what potential catalysts could emerge to unlock value.  The Net Net Working Capital formula is one more value investing tool.

Net Net Working Capital Formula – Further Analysis and Discussion:

Net Net Working Capital is a subset of Graham’s Net Working Capital is a subset of Net Working Capital (also known as Working Capital).

1) Net Working Capital = Current Assets – Current Liabilities

2) Graham’s Net Working Capital = Current Assets – Total Liabilities

3) Net Net Working Capital = Cash + Short Term Marketable Investments + Accounts Receivable * 75% + Inventory * 50% – Total Liabilities

Note that the results of each formula are presented in a decreasing order.  That is to say Net Net Working Capital will provide the lowest and hence, most conservative, value.  In other words, all else being equal, of the three formulas above, a stock trading below Net Net Working Capital provides the investor with the largest margin of safety.

Value investing is about buying a stock at a sufficient discount to intrinsic value.  Graham’s “Net Working Capital” or the “Net Net Working Capital” formulas can be used as preliminary screens to identify potentially undervalued stocks or deep value stocks.

http://deepvalueinvestor.com/net-net-working-capital/

Short cuts for finding value

Companies and shares are worth the present value of the future cash they can generate for their owners.  This is a rather simple statement, and yet in practice, valuing companies is not so straightforward.

As the famous economist John Maynard Keynes put it, it's better to be vaguely right than precisely wrong, and the better bet is to stick to a few simple valuation tools.  Here are some ways to value companies or shares:

1.  Discount cash flow method.

2.  Asset-based valuation tools.

• Price/Book Value
• Graham's Net Current Asset approach

3.  Earnings-based valuation tools.

• PE ratio

4.  Cash flow-based valuation tools

• DY
• FCF Yield

These different valuation tools each have their own strengths and weaknesses.

• The price-to-book ratio tends to work best with low-quality businesses on steep discounts.  
• The PER tends to work best with high-quality growth companies.  
• The dividend yield and free cash flow yield tend to be suited to mature businesses generating steady returns.

But in every case, you'll probably get closest to the truth by looking at all the different measures.

Also, only invest in good quality businesses.

Book Value: Theory Vs. Reality

Book Value: Theory Vs. Reality
by Andrew Beattie (Contact Author Biography)

Earnings, debt and assets are the building blocks of any public company's financial statements. For the purpose of disclosure, companies break these three elements into more refined figures for investors to examine. Investors can calculate valuation ratios from these to make it easier to compare companies. Among these, the book value and the price-to-book ratio (P/B ratio) are staples for value investors. But does book value deserve all the fanfare? Read on to find out.

What Is Book Value?

Book value is a measure of all of a company's assets: stocks, bonds, inventory, manufacturing equipment, real estate, etc. In theory, book value should include everything down to the pencils and staples used by employees, but for simplicity's sake companies generally only include large assets that are easily quantified. (For more information, check out Value By The Book.)

Companies with lots of machinery, like railroads, or lots of financial instruments, like banks, tend to have large book values. In contrast, video game companies, fashion designers or trading firms may have little or no book value because they are only as good as the people who work there.

Book value is not very useful in the latter case, but for companies with solid assets it's often the No.1 figure for investors.

A simple calculation dividing the company's current stock price by its stated book value per share gives you the P/B ratio. If a P/B ratio is less than one, the shares are selling for less than the value of the company's assets assets. This means that, in the worst-case scenario of bankruptcy, the company's assets will be sold off and the investor will still make a profit. Failing bankruptcy, other investors would ideally see that the book value was worth more than the stock and also buy in, pushing the price up to match the book value. That said, this approach has many flaws that can trap a careless investor.

Value Play or Value Trap?

If it's obvious that a company is trading for less than its book value, you have to ask yourself why other investors haven't noticed and pushed the price back to book value or even higher. The P/B ratio is an easy calculation, and it's published in stock summaries on any major stock research website. The answer could be that the market is unfairly battering the company, but it's equally probable that the stated book value does not represent the real value of the assets. Companies account for their assets in different ways in different industries, and sometimes even within the same industry. This muddles book value, creating as many value traps as value opportunities. (Find out how to avoid getting sucked in by a deceiving bargain stock in Value Traps: Bargain Hunters Beware!)

Deceptive Depreciation

You need to know how aggressively a company has been depreciating its assets. This involves going back through several years of financial statements. If quality assets have been depreciated faster than the drop in their true market value, you've found a hidden value that may help hold up the stock price in the future. If assets are being depreciated slower than the drop in market value, then the book value will be above the true value, creating a value trap for investors who only glance at the P/B ratio. (Appreciate the different methods used to describe how book value is "used up"; read Valuing Depreciation With Straight-Line Or Double-Declining Methods.)

Manufacturing companies offer a good example of how depreciation can affect book value. These companies have to pay huge amounts of money for their equipment, but the resale value for equipment usually goes down faster than a company is required to depreciate it under accounting rules. As the equipment becomes outdated, it moves closer to being worthless. With book value, it doesn't matter what companies paid for the equipment - it matters what they can sell it for. If the book value is based largely on equipment rather than something that doesn't rapidly depreciate (oil, land, etc), it's vital that you look beyond the ratio and into the components. Even when the assets are financial in nature and not prone to depreciation manipulation, the mark-to-market (MTM) rules can lead to overstated book values in bull markets and understated values in bear markets. (Read more about this accounting rule in Mark-To-Market Mayhem.)

Loans, Liens and Lies

An investor looking to make a book value play has to be aware of any claims on the assets, especially if the company is a bankruptcy candidate. Usually, links between assets and debts are clear, but this information can sometimes be played down or hidden in the footnotes. Like a person securing a car loan using his house as collateral, a company might use valuable assets to secure loans when it is struggling financially. In this case, the value of the assets should be reduced by the size of any secured loans tied to them. This is especially important in bankruptcy candidates because the book value may be the only thing going for the company, so you can't expect strong earnings to bail out the stock price when the book value turns out to be inflated. (Footnotes to the financial statements contain very important information, but reading them takes skill. Check out An Investor's Checklist To Financial Footnotes for more insight.)

Huge, Old and Ugly

Critics of book value are quick to point out that finding genuine book value plays has become difficult in the heavily analyzed U.S. stock market. Oddly enough, this has been a constant refrain heard since the 1950s, yet value investors still continue to find book value plays. The companies that have hidden values share some characteristics:

• They are old. Old companies have usually had enough time for assets like real estate to appreciate substantially.
  
• They are big. Big companies with international operations, and thus with international assets, can create book value through growth in overseas land prices or other foreign assets.
  
• They are ugly. A third class of book value buys are the ugly companies that do something dirty or boring. The value of wood, gravel and oil go up with inflation, but many investors overlook these asset plays because the companies don't have the dazzle and flash of growth stocks.

Cashing In

Even if you've found a company that has true hidden value without any claims on it, you have to wait for the market to come to the same conclusion before you can sell for a profit. Corporate raiders or activist shareholders with large holdings can speed up the process, but an investor can't always depend on inside help. For this reason, buying purely on book value can actually result in a loss - even when you're right. If a company is selling 15% below book value, but it takes several years for the price to catch up, then you might have been better off with a 5% bond. The lower-risk bond would have similar results over the same period of time. Ideally, the price difference will be noticed much more quickly, but there is too much uncertainty in guessing the time it will take the market to realize a book value mistake, and that has to be factored in as a risk. (Learn more in Could Your Company Be A Target For Activist Investors? Or read about activist shareholder Carl Icahn in Can You Invest Like Carl Icahn?)

The Good News

Book value shopping is no easier than other types of investing, it just involves a different type of research. The best strategy is to make book value one part of what you look for. You shouldn't judge a book by its cover and you shouldn't judge a company by the cover it puts on its book value. In theory, a low price-to-book-value ratio means you have a cushion against poor performance. In practice it is much less certain. Outdated equipment may still add to book value, whereas appreciation in property may not be included. If you are going to invest based on book value, you have to find out the real state of those assets.

That said, looking deeper into book value will give you a better understanding of the company. In some cases, a company will use excess earnings to update equipment rather than pay out dividends or expand operations. While this dip in earnings may drop the value of the company in the short term, it creates long-term book value because the company's equipment is worth more and the costs have already been discounted. On the other hand, if a company with outdated equipment has consistently put off repairs, those repairs will eat into profits at some future date. This tells you something about book value as well as the character of the company and its management. You won't get this information from the P/B ratio, but it is one of the main benefits from digging into book value numbers, and is well worth the time. (For more information, check out Investment Valuation Ratios: Price/Book Value Ratio.)

by Andrew Beattie, (Contact Author Biography)

Andrew Beattie is a freelance writer and self-educated investor. He worked for Investopedia as an editor and staff writer before moving to Japan in 2003. Andrew still lives in Japan with his wife, Rie. Since leaving Investopedia, he has continued to study and write about the financial world's tics and charms. Although his interests have been necessarily broad while learning and writing at the same time, perennial favorites include economic history, index funds, Warren Buffett and personal finance. He may also be the only financial writer who can claim to have read "The Encyclopedia of Business and Finance" cover to cover.



http://www.investopedia.com/articles/fundamental-analysis/09/book-value-basics.asp


Also read: Nets and net net