Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.
Buy a company: Nothing down, easy payments.
When value investors scour the globe for bargains, they often start with the classic Ben Graham “net-net working capital” screen. It is extremely conservative because it starts with current assets – typically cash, accounts receivable and inventories – and deducts all liabilities to arrive at net-net working capital. No value is given to fixed assets such as land, plant and equipment, or to intangibles such as goodwill, licenses and franchise value. The objective is to find stocks which trade below this so-called liquidation value.
While the formula is clearly conservative, it does suffer from a few imperfections. The major stumbling block is the fact that very few stocks pass the screen, so an investor is hard-pressed to create a portfolio. At the beginning of 2012, for example, there was a grand total of 12 TSX-listed stocks which met the Ben Graham test. They had a median market capitalization of $100-million and a float of perhaps half that – barely sufficient to create a portfolio for a small investor.
More important, the net-net valuation assumes that all of the current assets can be liquidated at 100 cents on the dollar. This is a reasonable assumption for cash and short-term investments, generous for accounts receivable and heroic for inventory. In addition, the decision to ignore all long term assets may be prudent with regard to intangibles, but many established companies hold undervalued fixed assets on their balance sheet.
This is not a new problem, of course, and twenty five years ago I received screens from the New York-based brokerage firm Oppenheimer that addressed these issues. The official name was the collateral value screen, but Norm Weinger of Oppenheimer referred to it as his “Buy a company, no money down” list. You will understand why shortly.
The starting point is to ask what a banker would loan you against the collateral value of the assets on a company balance sheet. A banker will always lend you money if you don’t need it, so the assumptions were 100 cents on the dollar for cash and short term investments, 75 cents on the dollar for accounts receivable and 50 cents for inventory. These are quite substantial haircuts to the book value of the current assets, so this part of the equation is much more conservative than the Ben Graham approach.
There is no right answer to determine the valuation of long-term assets, so we simply assume 100 cents on the dollar for the depreciated net book value of the fixed assets and give no value to intangibles. If the company has been in business for some time and owns real estate, then the net fixed assets are almost certainly undervalued. If it is a retail chain, then the fixed assets are probably leasehold improvements and coat hangers, which aren’t likely to have much resale value. This is obviously a piece of the puzzle that will need further analysis for those stocks that pass the screen.
The final step is to multiply the asset side of the balance sheet by these percentages to establish the gross collateral value, then deduct all debt to derive the net collateral value of the company. The screen looks for companies with a market capitalization less than the net collateral value. If the numbers are correct, your friendly banker will loan you the collateral value of the assets, you pay off the debt and you still have more cash per share than the stock price. At this point, you can offer to take over the company with its own cash. No wonder Mr. Weinger said everyone could be an investment banker with this screen!
I described the collateral value screen at a CFA investment seminar in Vancouver earlier this month and Davies Town of Mackenzie Cundill offered to run the formula on my behalf. Mr. Town clearly has access to a giant global database, because his list contained 5,272 net collateral value candidates for additional research – dramatically more than the 683 qualifiers under the Ben Graham test.
Of the total, 5,000 were less than $1-billion market cap, so it too is dominated by the small cap universe. In fact, the median market cap was only $33-million. On the other hand, there were 270 global companies with a market cap in excess of $1-billion, so it is a more practical screen for an institutional investor.
Turning to the Canadian content, there were 504 listed Canadian stocks, of which 365 were listed on the Venture Exchange. The median market cap for the whole list was tiny at $7-million, but there were 11 candidates in excess of $1-billion, including Encana , Talisman , Nexen , Hudbay Minerals and WestJet .
The list contains a heavy representation of resource stocks, both large and small, and a large part of the collateral value is derived from the fixed assets valued at 100 cents on the dollar. Clearly, investors are saying that a dollar of cash raised by corporate finance is worth less than a dollar when converted into exploration and development costs. In other words, a large number of Venture Exchange companies destroy value rather than create it.
Some companies that appear on the screen, such as Westjet, Air Canada and Le Chateau, may do so because the debt represented by significant lease payments is not captured by the computer database. The net collateral value screen avoids some of the weaknesses of the Ben Graham classic, but it obviously has its own imperfections. This highlights the need for additional analysis before investing.
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