Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mac kenzie Investments.
As a long time value investor, one of my favourite research tools is the famous Ben Graham “net-net working capital” screen.
This analysis begins with current assets – typically dominated by cash, accounts receivable and inventories – and then deducts all liabilities, not just current liabilities, to arrive at a net working capital per share value. No value is given to fixed assets such as plant, machinery and real estate, nor to intangibles such as goodwill, patents, licenses or other intellectual property.
The result is truly a liquidation value per share. Stocks which trade at or below this value are clearly neglected and, presumably deeply undervalued.
I regularly receive such a screen of global stock markets, courtesy of David Sandel of Simcoe Partners in New York. It is of great interest, not just for the names which appear on the list, but also for the opportunity to see how the list expands and contracts during a market cycle.
Unlike many valuation models which look for relative value and so can always find attractive stocks, the net-net screen is based on absolute balance sheet values. So, when few names appear on the list, the message is clear: the overall market is fully-valued.
Most stocks which pass this screen are very low priced and so a 5¢ or 10¢ move could easily remove them from consideration. As a result, the Simcoe Partners screen uses a maximum cut-off point at 1.25 times net-net rather than 1.00 times so that we don’t miss out on a candidate with otherwise attractive features. Since the same criterion has been used for some time, it doesn’t affect the conclusions though it obviously overstates the number of real Ben Graham bargains.
Let’s begin with a few big picture observations before zeroing in on the Canadian qualifiers. At the beginning of 2011, there were 305 names on the global listing. Canada scored 8, the U.S. 34, the U.K. 14 and China 34. A year later, most markets around the world except for the U.S. were down by mid-teen percentage points so it is not surprising that the list has expanded, although the magnitude might take your breath away.
At the end of 2011, the list had soared to 683 qualifiers. Canada now scored 21, the U.S. 61, the U.K. 17 and China tripled to 95. It is possible that the entire database is now larger, but the message is still clear: there are a lot more cheap stocks around the world than a year ago. If you have a bearish outlook, the market has beaten you to it.
The industry sectors most heavily represented in the net-net screen are worthy of an article themselves, but first we should determine if this is a legitimate portfolio selection screen. And, if we have the intestinal fortitude to actually follow through alongside Ben Graham.
One year isn’t long enough to test a portfolio strategy and eight stocks don’t constitute a portfolio, but it will give us a feel for the kind of names you will need to live with if you aspire to being a deep value investor in Canada.
At the beginning of 2011, the eight names on the screen were: Prophecy Resources , C.E. Franklin , Hartco , Canadian Phoenix Resources , Aberdeen International , H. Paulin , Hardwoods Distribution Income Fund and Coopers Park Corporation .
It is a fair guess that your broker will not have the ticker symbols for these stocks on the tip of his tongue. During the course of the year, Prophecy Resources became Prophecy Coal and spun off the metal properties to the shareholders, but all the others struggled through the year and came out the other end intact.
Six out of the eight stocks declined in value, but the average price decline was 7.2 per cent – about half that of the S&P/TSX Index. Not bad for a group of stocks that have no visibility or sex appeal.
Actually, that is why they performed relatively well: they had no visibility or sex appeal, so the stock price contained no expectations. In fact, four of them are still on the list as we enter 2012: C.E. Franklin, Aberdeen International, H. Paulin and Hardwoods Distribution Income Fund.
Did I own all these net-net candidates in my portfolio? No. Even after 40 years of value investing, I still mistakenly believe that I can pick and choose the winners from a collection of cigar butts.
To be fair, with an average stock price of $3.40 and a market capitalization of $60-million, and a float possibly half that, these will never be institutional favourites. But, with the average Canadian equity mutual fund down about 12 per cent for the year, maybe that isn’t a bad thing.
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