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Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments. (Sami Siva/The Globe and Mail)
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments. (Sami Siva/The Globe and Mail)

Analysis

Net-net capital portfolio not for faint of heart Add to ...

Strategy Lab contributor Norman Rothery recently tackled an issue that’s important for those investors who rely on screens to identify attractive stocks. Should you buy all of the stocks that pass your screen, or simply view them as prospects, which require additional analysis before you sort out winners from losers?

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His conclusion was that most of us should resist the temptation to fine-tune a screen’s output. Our attempt to pick winners will likely result in a lower return than buying the entire list.

Mr. Rothery’s finding is of particular interest to enthusiasts of the net-net working capital screen made famous by Ben Graham, the father of value investing. It identifies deep bargain stocks trading at a discount to the value of their current assets less all liabilities – essentially, stocks that are trading below what they would be worth if the company were liquidated.

One disadvantage with the screen is that the list of candidates in Canada tends to be short and most of the firms relegated to the list have obvious problems. Most years, a portfolio made up of net-net stocks will be lumpy, poorly diversified and ugly.

With that in mind, I went back to the beginning of 2012 to see which stocks would have been in a Ben Graham net-net portfolio; I then looked at how they performed over the past year.

Starting with a list of global net-net stocks as of Dec. 31, 2011, I extracted the Canadian names trading at no more than a 20 per cent premium to net-net working capital.

At the beginning of 2012, there were 21 Canadian stocks that passed the screen, with an average market capitalization of $85-million and an investable float of perhaps half that. Three of them were China-based (Migao, Hanfeng Evergreen and Boyuan Construction) and the recent controversy over Sino-Forest would likely have created some discomfort in placing a buy order. An additional five were controlled by individuals or families who were still active in the business, so a takeover of underperforming assets was not going to take place without their consent. (Aastra Technologies, Le Chateau, Hartco, H. Paulin , Goodfellow).

In spite of these potential drags on performance, an equal weight investment in the overall list handily outperformed the S&P/TSX Composite’s 4 per cent gain with a return of 18 per cent for the entire year. Admittedly, the strong relative performance was helped by three takeovers – of C.E. Franklin (up 57 per cent), Geomark (up 78 per cent) and H. Paulin (up 199 per cent). But these stocks were already identified as undervalued, so takeovers at a substantial premium should not have come as a surprise for a patient investor.

A small, patient investor, mind you. With only 21 thinly traded stocks to buy, this was not a strategy for a large institutional investor. It also required a strong stomach: Five of the 21 stocks declined by 50 per cent or more during the year.

This volatile experience is not confined to Canada. A study by researchers at Salford University in the U.K., which tested the net-net strategy on U.K. stocks between 1981 and 2005, found that it was successful over the entire period, but came with strings attached: It was biased toward smaller firms, in some years the portfolio had fewer than 10 qualifying stocks, and the strategy did not work four years out of 10.

Enthusiasts of the Ben Graham screen who can live with these hazards will be interested in the much shorter list of a dozen Canadian stocks that qualify going into 2013, courtesy of David Sandel of Simcoe Partners in New York. The stocks are listed in order of increasing attractiveness relative to net-net working capital. Some of them trade on the Toronto main board and some on the Venture Exchange and the average market capitalization is less than $40-million.

As usual, it is important to check computer-generated output to be sure that it is factually correct. But this time, try to resist the temptation to pick the winners and weed out the losers!

Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.

Below, find a list of Canadian net-net stocks for 2013.

 

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