In 1651, Thomas Hobbes described the life of mankind as “nasty, brutish and short.” He could also have been describing the list of Canadian stocks that typically pass the Ben Graham net-net working capital screen.
As a deep value investor, this is my favourite screen for identifying attractive purchase candidates, but the recent output challenges even the hardiest contrarian investor.
The definition of a net-net stock is quite straightforward. You begin by taking a company’s current assets (primarily cash, accounts receivable and inventory) and deducting its current liabilities. This leaves us with net working capital. From this number, you deduct all other liabilities to derive net-net working capital. No value is given to long-term assets such as buildings, equipment, real estate or intangibles. We are looking for companies with a market value below net-net working capital – essentially companies that are trading below liquidation value per share.
Investors who rely on screening techniques such as these to identify attractive candidates for investment usually regard the results as a first step in the investment process.
But this time last year Norman Rothery reported in The Globe and Mail on a research study that shed new light on the issue. The study asked whether an investor should buy all of the stocks which pass the screen, or simply view them as prospects that require additional analysis before adding them to a portfolio. Mr. Rothery’s review of the literature concluded that most of us should resist the temptation to cherry-pick from the list and simply buy all of them.
My observation was that it is tough to follow that advice in Canada because the net-net list is short, well-known and ugly – although maybe that is why value investing works!
So, I looked at the 21 Canadian stocks which passed the net-net screen at the beginning of 2012. They had an average market cap of $85-million and five of them had controlling shareholders, so they were not likely candidates for takeover. In spite of that, there were three takeovers on the list and the group average return for 2012 was 18 per cent, compared to 4 per cent for the S&P/TSX composite index. A great endorsement of the net-net screen for 2012!
As we entered 2013, the net-net list had eroded to a dozen, the average market capitalization had shrunk to $40-million and trading volume was an issue.
The 2013 list consisted of ADF Group Inc., GobiMin Inc., Bri-Chem Corp., Canada Fluorspar Inc., China Health Labs & Diagnostics Ltd., Strategic Metals Ltd., BENEV Capital Inc., Goodfellow Inc., Hartco Inc., Hanfeng Evergreen Inc., Coopers Park Corp. and Migao Corp.
By Dec. 18, 2013, an equal-weighted portfolio made up of this group of corporate outcasts had delivered a year to date return of 2 per cent. This was below the 7.2-per-cent return from the S&P/TSX composite index, but as an unrepentant value investor, I would argue that the two-year return is still ahead of the benchmark index and transaction costs were minimal as the portfolio was rebalanced only once at the end of 2012.
What are the Canadian net-net stocks heading into 2014? The list has shrunk even more.
The nine names in the accompanying fact box, courtesy of David Sandel of Simcoe Partners, traded at or below 120 per cent of net-net working capital as of mid-December. (We allow a margin of error of 20 per cent to capture low-priced stocks where a 10-cent-move could add or remove them from the list.) The median market capitalization is $64-million and two-thirds trade on the Venture Exchange. You may know the ticker symbols for a couple, but the rest are probably unknown. As usual, you should double check the statistics to be sure that the computer database isn’t stale-dated.
I know that the academic evidence says that we should buy the entire list, but human nature tells me that most of us will still cherry-pick in a futile search for the winners of 2014.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.
Monument Mining Ltd.
Energold Drilling Corp.
Indigo Books & Music Inc.
Greenstar Agricultural Corp.
Mirasol Resources Ltd.
ACE Aviation Holdings Inc.
Coopers Park Corp.