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robert tattersall

Over an investment career spanning 40 years, I always had a great interest in stocks trading below the net-net working capital value popularized by investment legend Ben Graham. These are companies where the value of the current assets (primarily cash, accounts receivable and inventory) minus all liabilities is greater than the market capitalization for the entire company. This means that, in theory, you could liquidate the current assets at 100 cents on the dollar, pay off all the liabilities and still have more cash per share than the stock price. No value is given to the fixed assets or intangibles. Clearly, these are companies trading below liquidation value and are ripe for takeover or other shareholder intervention.

So much for the theory. As a practical matter, I have found that a strategy of investing in these stocks has become less successful in recent years, for two reasons. The first is simply because the list itself has shrunk so that there are only a handful of candidates for additional research and many of the incumbents are perennial value traps and not real bargains. In fact, at the end of 2016, there was only one TSX-listed company which met the criterion (Goodfellow Inc., ticker symbol GDL) and only half a dozen in the previous two years. It is tough to build a diversified portfolio when your research universe is this small.

More important, my experience has been that by the time a stock price reaches liquidation value, the company is in dire straits. As a result, the customers probably aren't paying on time, so the accounts receivable are not worth face value. In addition, the inventory is likely out of fashion or technologically obsolete, so it may be closer to scrap value than book value.

The assumption that current assets can be liquidated at book value is obviously a major flaw in the Ben Graham formula for net-net working capital. What we need is a better estimate of the real value of assets on the balance sheet without having to do a detailed appraisal of every company in our universe.

For this purpose, I suggest discounting the assets to a level that would give comfort to a lender – in other words, their collateral value. You can easily make your own assumptions, but here are the collateral percentages which I use in my initial screening:

  • Cash and short-term investments are worth 100 cents on the dollar;
  • Accounts receivable are worth 75 cents on the dollar;
  • Inventory is worth 50 cents on the dollar;
  • Net, depreciated fixed assets are worth 100 cents on the dollar.

This last assumption is the most doubtful. It clearly depends on the nature and age of those fixed assets, so this should be one of the first items to review when a stock passes the screen.

After the collateral value of the assets has been calculated, return to the Ben Graham version and deduct all liabilities to derive the net collateral value per share. Now you are looking for stocks trading below what is perhaps a more realistic assessment of their liquidation value.

To illustrate the process, here are the numbers for an oil service stock in my portfolio, Essential Energy Services Ltd. (ESN-TSX). At a recent price of 53 cents, the stock trades at less than half of its book value per share because the sector is out of favour and there is a pending lawsuit alleging patent infringement that is not included in the liabilities. Net-net working capital per share is only 12 cents, so the stock would not excite Ben Graham, but the collateral-value calculation presents a different picture: As of June 30, 2017, cash on the balance sheet was $1.1-million, accounts receivable were $24.4-million, inventory was $30.8-million and net fixed assets (mainly drilling rigs) were $139.6-million. Total liabilities, excluding any legal costs, were $46.3-million.

Adding up the collateral value, we have cash at 100 cents for $1.1-million, receivables at 75 cents for $18.3-million, inventory at 50 cents for $15.4-million and net fixed assets at 100 cents for $139.6-million for a total value of $174.4-million. Deduct total liabilities of $46.3-million to leave a net collateral value of $128.1-million. With 142 million shares outstanding, net collateral value per share is 90 cents. This is below the book value of $1.14, but well in excess of the market price. In fact, the collateral value of the fixed assets could be marked down to 65 per cent of book value ($90-million) and still have a borrowing power in excess of the stock price.

There is no guarantee that stocks trading below net collateral value per share will be subject to a takeover offer or go private, but the numbers make it feasible to buy the company with no money down. That is why they are intriguing candidates for a patient investor.

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

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