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Investment Ideas Bye-bye to net-net: How regulators have killed a legendary stock-picking strategy for value investors

Old-school value investors frequently look for stocks that pass the net-net working capital screen favoured by the original value investor, Ben Graham. Simply stated, this screen looks for companies where the stock market value is less than the balance sheet value of the current assets minus, not just the current liabilities, but all the liabilities – hence the name, net-net working capital.

In theory, you could liquidate the current assets, typically cash, accounts receivable and inventory, pay off all the liabilities and still have more cash per share than today’s stock price. Plus, you haven’t even begun to sell the long-term assets such as plant, equipment and real estate. In the real world, there are hurdles to overcome, such as selling accounts receivable and inventory for 100 cents on the dollar, but this is a starting point for additional analysis.

As a practical matter, few Canadian stocks have passed this screen in recent years. Those that do tend to be microcaps with limited trading volume or perennial value traps. Now, an accounting change that became effective this year makes it unlikely that the screen will turn up any candidates in the future. Value investors will have to search elsewhere.

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International Financial Reporting Standard 16 (IFRS 16) has made it mandatory this year for companies to show on the balance sheet the value of the “right of use" leased assets as an asset, and the corresponding discounted present value of the relevant lease payments as a liability. In other words, a contractual lease payment is just as much a liability as a bank loan and so it should be reflected on the balance sheet along with the associated asset – the right to use that real estate or equipment. Until now, many leased assets did not typically appear anywhere on the balance sheet, although the lease payments were disclosed in the footnotes.

The problem for the value investor is that long-term leases create long-term assets, so the assets are not part of working capital, but, to adhere to IFRS 16, the increased liabilities are deducted to calculate net-net working capital. With current assets unchanged and total liabilities increased, there will be even fewer companies that pass the net-net working capital screen. I think that it is now an interesting historical artifact with no practical application for today’s investors.

The introduction of IFRS 16 doesn’t just affect value investors. For companies that appeared to be “asset light” by making extensive use of leased facilities, the addition of the leased assets and liabilities will bulk up the balance sheet. Return on shareholders’ equity will not change, but asset turnover ratios (sales divided by assets) will go down, while some measures of financial leverage will go up.

Adherents to the Efficient Markets Hypothesis will shrug off this new accounting disclosure because lease payments were already disclosed in the footnotes. Everyone knows, for example, that retailers and real estate companies have huge lease obligations. None of this should come as a surprise to investors and so stock prices will not be affected.

That may be true for companies where management has determined that the future value of the leased premises is approximately equal to the present value of the future lease payments: an identical amount is added to both sides of the balance sheet with no impact on shareholder equity. But what about companies with leased assets in out-of-favour locations that are locked into onerous leases? Many traditional mall-based retailers, for example. Sooner or later this disconnect will have to be recognized.

Out of curiosity, I made a brief review of this year’s financial statements for half a dozen Canadian retailers, ranging from Le Château Inc. to Indigo Books & Music Inc. to Canadian Tire Corp. Ltd.

Without exception, all of these companies saw a negative adjustment to shareholders’ equity as a result of adopting IFRS 16. This means book value per share was eroded and the financial leverage multiplier (total assets divided by common equity) went up – sometimes by an alarming amount. If IFRS is intended to provide a more accurate picture of corporate balance sheets, then Canadian retailers are suddenly less attractive to investors who focus on growth in book value as a proxy for management value-added.

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My conclusion: Investors should become familiar with IFRS 16 and look closely at the change in company balance sheets since year-end 2018, especially for old-line retailers and other businesses with customer-facing premises. The introduction of leases onto the balance sheet could change investors’ view of the profitability of the business and the degree of embedded financial leverage. This, in turn, may affect the valuation of the stock.

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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