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As a long-time value investor, I favour Ben Graham's iconic "net-net working capital" screen as a starting point for identifying undervalued stocks worthy of additional research. In Canada, though, we have just seen two consecutive years of below market performance from this screen, which suggests that the list may no longer be a source of great contrarian investment ideas. But, since investors often abandon a strategy after a couple of years of underperformance, (just before a rebound), we should be reluctant to concede defeat simply on the basis of poor returns in 2013 and 2014.

First, a reminder of the definition of a "net-net" stock: Begin with current assets – typically dominated by cash, accounts receivable and inventories – and then deduct all liabilities, not just current liabilities, to arrive at a net-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, licences or other intellectual property. This is truly a liquidation value per share. Stocks which trade at or below this value are clearly neglected and, presumably undervalued.

I receive such a screen of global stock markets, courtesy of David Sandel of Simcoe Partners in New York on a regular basis. The number of global stocks on the list waxes and wanes depending on market levels in each country, but the Canadian candidates are always few in number: typically a dozen or less, though it did spike up to 21 at the beginning of 2012. Not only is the list nasty, brutish and short, the average market capitalization is less than $100-million, the float of available shares is maybe half that and some stocks (value traps) show up every year. As a practical matter, the list would be even shorter if we rigorously applied the Ben Graham definition of net-nets, but because these low-priced stocks can move in and out of contention with a 10 cent price move, we relax the screen to include stocks up to 120 per cent of net-net value.

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In spite of these imperfections, a "portfolio" made up of equal weights in all the stocks which passed the screen each year outperformed the TSX composite index by almost four percentage points annually for the three years ended December, 2013, despite a shortfall in 2013. The 2014 portfolio, however, suffered a dramatic setback with the nine stocks listed at the beginning of 2014 falling on average 9 per cent by Dec. 23 compared with a gain of 7 per cent for the TSX composite. If I were still employed and in client retention mode, I would point out that of the nine names, half were listed on the Venture Exchange, one-third were involved in gold mining and all of them were microcap, so a decline of 9 per cent compares quite favourably with the TSX small cap index return of minus 8 per cent and the Venture Exchange Index return of minus 27 per cent over the same time period.

So, is it time to concede that the net-net stock screen worked fine for Ben Graham but is less effective in an environment where virtually every investor has access to a computer and a stock database?

Certainly not. In fact, a research study from Salford University in Britain, which tested the net-net strategy on U.K. stocks during the 1985-2005 period, found it was successful over the entire period, but it came with strings attached: It had a small-cap bias, in some years the portfolio had fewer than 10 qualifying stocks, and the strategy may not work four years out of 10 even though it was successful for the long term. This appears to replicate the Canadian experience and explains why it is not a strategy for the fainthearted.

Looking back over the past few years in Canada, some tweaking to the list may be justified without causing Ben Graham to turn in his grave. Companies which have already announced that they are in liquidation mode often appear on the list because they have converted their assets to cash. There are no operating assets to provide upside potential, so it makes sense to exclude them from consideration. Also, companies where the bulk of the assets are in jurisdictions where you are unsure about the rule of law deserve extra scrutiny in case management stops returning your phone calls.

As usual, it is important to do your own research and don't waste too much time on the self-liquidators or the overseas asset plays.

With those qualifiers in place, here is a list of all nine Canadian stocks which pass the net-net screen as of Dec. 23, 2014: Webtech Wireless Inc., Orbit Garant Drilling Inc., Clarke Inc., Goodfellow Inc., Ace Aviation Holdings Inc., Buhler Industries Inc., Automodular Corp., Calvalley Petroleum Inc. and Coopers Park Corp.

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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