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If you are a value investor, a logical place to start your search is by looking for companies that pass the iconic Ben Graham net-net working capital screen.
If you are a value investor, a logical place to start your search is by looking for companies that pass the iconic Ben Graham net-net working capital screen.

strategy

A rather stunning discovery in our end-of-year search for ‘net-net’ stocks Add to ...

Mid December is a great time to look for bargains in the stock market because discouraged tax-loss sellers quite often throw out some real gems. If you are a value investor, a logical place to start your search is by looking for companies that pass the iconic Ben Graham net-net working capital screen. These are stocks which trade below the value of current assets minus all liabilities, with no value given to fixed assets or intangibles. In theory, you sell the current assets (typically cash, accounts receivable and inventory) at face value, pay off all the liabilities at par and still have more cash per share than the current stock price. Plus, you haven’t even begun to dispose of the fixed assets.

So, for the past few years at this time I have asked David Sandel of Simcoe Capital in New York for a screen of global equities which meet this rigorous criterion. As a practical matter, we accept stocks up to a premium of 20 per cent over net-net value as many low-priced stocks move in and out of contention on small price changes.

With North American equity markets flirting with record highs, it is no surprise that the list has been shrinking, but I was stunned to discover that as of Dec. 12, 2016, there was a grand total of one Canadian stock on the database: Goodfellow Inc. This wholesale distributor of lumber and related business materials was also on the list last year and the year before, so it may be a value trap rather than an unrecognized bargain.

In looking back over the complete list from last year, there were a total of eight candidates: Goodfellow Inc., Buhler Industries, Americas Petrogas, Redline Communications, Rocky Mountain Dealerships, Pan Orient Energy, McCoy Global Inc. and Logan International. Returns from these stocks for the year to date have ranged from a gain of 41.7 per cent for Rocky Mountain Dealerships to a loss of 27.2 per cent for Redline Communications (which was the subject of a Globe Investor profile late last month). Only three of the eight stocks reported a flat or positive return year to date, so an equal-weight basket was down 6 per cent compared to a gain of 16.8 per cent for the TSX composite.

Although the return from net-net stocks in 2016 was disappointing, the nine stocks which qualified at the beginning of 2015 outperformed the TSX composite by a wide margin that year, leaving the strategy almost even with the market index over two years. That is hardly an endorsement of what should be a low-risk approach to equity investing. The real problem, of course, is that you cannot build a diversified portfolio around a list of eight or nine illiquid small cap stocks and you certainly shouldn’t be heading into 2017 with a one-stock portfolio.

One alternative is to expand our horizon beyond the Canadian market to see if others offer more opportunities. The global database has been quite stable at around 900 names over the past three years, but country exposure expands and contracts as the local market fluctuates. Right now, by far the largest number of net-net candidates can be found in Japan with 333 names. Hong Kong, South Korea and Taiwan each contribute another 90, with Malaysia and Singapore reporting almost 50 each. Three quarters of the bargains are located on Asian markets. Individual investors will find it difficult to purchase these stocks directly, but an ETF or index fund with a tilt toward small cap stocks in any of those markets should capture some of the value.

Closer to home, the United States offers 27 net-net candidates, down from 39 last year, but still enough to merit investigation. They are too many to list here, although the following names will be recognizable to Canadians: Bebe Stores Inc., a women’s fashion retailer; West Marine Inc., a marine accessories retailer; and Rocky Brands Inc., a supplier of rugged boots and shoes to consumers and the military. As usual, computer databases are prone to error, so check the numbers carefully before investing.

The other alternative is to recognize that the shrinking number of net-net stocks is simply nature’s way of telling us that the Canadian market is quite fully valued. Instead of relaxing our criteria in the search for bargains, we should follow the lead of Ben Graham in these situations: He simply stepped away from the market.

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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