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Investors win when a negative value stock pays off

Norm Rothery

Deborah Baic/The Globe and Mail

Norman Rothery is the value investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

To measure the market value of a stock many investors turn to its market capitalization. But that only represents the cost of the firm's shareholders' equity.

To get a better sense of the value of a company as a whole, analysts like to consider its enterprise value. They start with market capitalization but also add the market value of the firm's preferred equity and debt while subtracting any cash it might have. After all, if you buy a company, you get both its assets and its liabilities.

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While most investors aren't looking to buy an entire company, enterprise value can still be used as a replacement for market capitalization in ratio analysis to good effect.

For instance, value investors like to look for stocks with low price-to-sales ratios (P/S). But stocks with low enterprise-value-to-sales ratios (EV/S) fare even better according to James O'Shaughnessy's What Works on Wall Street.

He calculates that the tenth of stocks with the lowest P/S ratios gained 11.5 per cent a year on average from January 1, 1964 to December 31, 2009 while low EV/S stocks gained 12.7 per cent annually. Both handily beat the market's returns of 10.2 per share a year.

However, enterprise value has one peculiarity that market capitalization does not. It's possible for a company to have a negative enterprise value. That might sound odd at first but remember the calculation subtracts a firm's cash from the market value of its equity and debt.

If it has enough cash, and comparably little equity and debt, then a negative value may result.

Theoretically, such companies represent outstanding bargains. Alon Bochman, CFA, is the managing partner of Stepwise Capital based in New York, and he likens such situations to buying a house for $1-million that includes a safe in the basement that holds $1.2-million.

Such intriguing deals led him to study negative equity companies and recently he released some of his preliminary findings.

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Mr. Bochman focused on U.S. stocks with negative enterprise values over the period spanning March 30, 1972 to September 28, 2012. Each month he looked for firms in negative territory and followed them over the next 12 months to see how they fared.

The negative enterprise value stocks went on to gain an average of 50 per cent over the subsequent year. The best returns were to be had from tiny stocks with market capitalizations of less than $50-million, which gained 60 per cent on average. Slightly larger stocks with market capitalizations between $50-million and $500-million climbed by 28 per cent and larger firms gained 21 per cent.

Now, before you run off to buy such stocks, a number of caveats are in order.

Importantly, negative enterprise value stocks tend to be fairly rare in normal times and their numbers often swell after market crashes. As a result, the study picks up more stocks at market lows and relatively few near the highs. It's a bias that goes a fair way in explaining the eye-popping returns. After all, if you primarily bought most of your stocks near market lows, you'd probably do quite well.

In addition, the data on very small stocks tends to be a little flakey. Even the best databases are plagued with a variety of problems, which makes working in the area difficult.

To make matters worse, investors have to pick their way through outright frauds and avoid companies controlled by cravenly avaricious managers when dealing with some small stocks.

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Nonetheless, negative enterprise value stocks represent an interesting area for deep value investors, and Mr. Bochman's work holds promise. I'll be sure to keep an eye on his progress.

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