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Benjamin Graham’s Net Current Asset Approach OnLine Exclusive By Wayne A. Thorp, CFA

utside of , edition of “ Analysis,” which sheet. In contrast, NCAV deducts O perhaps no other is he coauthored with . In total liabilities (current and - as well-known as his mentor Benja- the book, (net) current asset value is term) from current assets. However, min Graham. Considered by most to defined as: Graham used the terms interchange- be the father of value investing and “current assets alone, minus all ably. often credited as the creator of the liabilities and claims ahead of the Compared to , the analyst profession, Graham’s issue.” NCAV method is a more rigorous value-oriented investing methodolo- The common definition of NCAV is: standard. Book value can include gies have been the topic of countless intangible assets, many of which may articles and academic studies. In fact, NCAV = current assets – [total liabilities + be impaired in some manner. Fur- AAII tracks three different Graham ] thermore, book value includes land, methodologies at the Stock Screens property and equipment, which are area of AAII.com. However, his origi- Current assets consist primarily of ignored altogether by NCAV. How- nal stock selection approach has not cash and cash equivalents, receiv- ever, over time, the on-the-book value garnered the same attention as his ables, and inventories. Basically, these of such assets is more than likely not later concepts. are assets that are already cash or are an accurate representation of their Graham developed and actual worth. tested the net current asset “From 1970 to 1983, value (NCAV) approach NCAV & Market Value between 1930 and 1932. Ac- cording to private investing an investor could have In “,” the firm Tweedy, Browne Com- authors note that net asset pany: “The net current asset earned an average return of value, or book value, seem- value approach is the oldest ingly was of little importance approach to in to looking at “indus- groups of securities with 29.4% by purchasing trial companies,” citing the common selection character- fact that stocks can sell at high istics of which we are aware.” that fulfilled Graham’s multiples or at mere fractions Graham reported that the of book value. Investor rea- average return, over a 30-year soning was that share prices, period, on diversified portfo- requirement and holding by and large, are driven by a lios of net current asset stocks company’s earning power and was about 20%. An outside them for one year.” payments, which in study showed that from 1970 general have no close relation- to 1983, an investor could ship to the asset value (ex- have earned an average return of convertible into cash within a rela- cluding utilities and financial firms). 29.4% by purchasing stocks that tively period of time (usually Therefore, investors and speculators fulfilled Graham’s requirement and less than a year). Net current assets alike had, for the most part, come to holding them for one year. exclude not only the intangible assets ignore asset value. The topic of two “First Cut” col- but also the fixed and miscellaneous Beginning in the 1930s, following umns by John Bajkowski in the AAII assets. In addition, Graham believed the market crash of 1929, Graham Journal (September 2007 and April that preferred stock belongs on the and Dodd noticed a large number 2009), the NCAV approach is more liability side of the balance sheet, of stocks selling below their current fully explained in this CI Online Ex- not as part of capital and surplus. In asset value, meaning that the share clusive, highlighting how you can use “Security Analysis,” preferred stock price of a company is less than the computerized stock screening tools is dubbed “an imperfect creditorship per share value of current assets. to identify stocks meeting Graham’s ” that is best placed on the During this period, the low prices to criteria. balance sheet alongside funded debt. net asset values were primarily driven Net current assets differ from by poor earnings, which in turn NCAV Defined working capital in that working drove stock prices down. Perhaps not capital is current assets less current surprisingly, according to Graham Graham first discussed net cur- liabilities, thereby focusing only on and Dodd, the market greeted these rent asset value (NCAV) in the 1934 the current segments of the balance stocks with uncertainty and indif-

February Online Exclusive 2010 1 OnLine Exclusive ference. The number of companies of the working-capital alone— “Security Analysis,” they suggested trading below current asset value disregarding all other assets—and two possible reasons why buying again spiked during the post-war if the earnings record and prospects stocks below current asset value may period from 1947 to 1950. How- are reasonably satisfactory, there fail: ever, this time, high earnings forced is strong reason to believe that the 1) Changing intrinsic value; or working capital levels above lagging investor is getting substantially more 2) Market behavior. stock prices. However, the market than his money’s worth.” The “market-behavior problem,” as once again ignored these “bargain Graham’s need for a “ of they termed it, relates to the fact that issues.” safety” shines through in this ex- there is nothing that says that a stock Graham and Dodd pointed out, ample. First of all, he isn’t interested price must adjust to the value an however, that when stocks trade in the total assets of a company. analyst places on it. The authors also below the company’s current asset Instead, he is only interested in the argue that intrinsic value is always level they are, in effect, trading below most liquid assets on the balance changing based on the development the company’s liquidating value. As- sheet. In “,” of the business—earnings, , suming a company’s working etc. Therefore, if a company capital is conservatively trading below current asset stated, it is reasonable to “Using net current assets value loses money or sub- assume that most companies stantially reduces its working can be sold off for at least the capital, its intrinsic value will value of these assets. Further- as a proxy for liquidating likely be less than it was when more, they felt it was also it was initially evaluated. reasonable to expect that the value, Graham and Dodd As a result of this decline in company’s remaining assets— intrinsic value, the stock may plant, property, equipment no longer be undervalued and other miscellaneous as- were able to create an actual and, in fact, may now be sets—would fetch enough to overvalued. offset “shrinkage” in current relationship between the Graham and Dodd felt that, assets resulting from con- given the market’s reaction verting them into cash. to stocks selling below net Using net current assets as market price of a stock and current asset value, investors a proxy for liquidating value, were avoiding these issues Graham and Dodd were able the realizable value of a for fear that the companies’ to create an actual relation- prospects were so poor that ship between the market price working capital would decline of a stock and the realizable company’s assets.” in the future. However, in value of a company’s assets. analyzing companies that When they found companies trading Graham points out that a business were selling below current asset value well below their liquidating values, should be worth to any private owner in 1932, 1933, 1938, and 1939, they bought them in bulk. at least the amount of the working Graham and Dodd discovered that capital, since the business ordinarily the market’s indifference was mis- Buying “Bargain Issues” would be expected to fetch that much placed. They concluded that: at liquidation. Furthermore, Graham “…stocks selling below working In the 1949 edition of his book wasn’t satisfied with merely buying capital and showing a fair record of “The Intelligent Investor,” Graham firms trading at less than net cur- earnings and dividends are likely to offered this definition of a “bargain rent asset value. He required an even be ‘bargain’ issues and are likely to issue”: greater margin of safety and only turn out to be unusually satisfactory “To be as concrete as possible, let looked at stocks whose prices were purchases.” us suggest that an issue is not a true less than two-thirds of net current To offset the potential of investing ‘bargain’ unless the indicated value asset value. in individual stocks that turn out to is at least 50 percent more than the be unprofitable, Graham suggested price.” Risks of “Undervalued holding at least 30 stocks at a time. He goes even further when it comes Stocks” to stock price relative to a company’s Screening on NCAV net current asset value: Graham and Dodd were keenly “…if a can be aware that some in low- Table 1 summarizes the Graham bought at no more than two-thirds price-to-NCAV stocks would fail. In approach to NCAV stock selec-

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Table 1. The Graham NCAV Stock Selection Process in Brief

Philosophy and Style Secondary Factors The Graham net current asset value approach is one of the • “Reasonably satisfactory” earnings record and prospects: oldest documented stock selection methodologies, dating Companies that are losing money or have an erratic earn- back to the 1930s. Net current asset value, or NCAV, looks ings history are likely to see their intrinsic value decline, at current assets minus total liabilities and preferred stock. making them less undervalued or potentially overvalued. Graham also termed NCAV a company’s “liquidation value.” • “Sound financial condition”: As a test for financial strength, His rationale was that this was the minimum value a company Graham suggests looking for companies with total stock- would be able to garner if its assets were sold off. Graham holder’s equity (common and preferred equity) greater purchased large numbers (from 30 to as many as 100) “bar- than the total of current liabilities and long-term debt. gain” issues to limit the risk of any one individual issue. Stock Monitoring and When to Sell Universe of Stocks • Graham held large numbers of companies trading below No restrictions. By their nature, however, the stocks typically their net current asset value to mitigate individual com- passing this screen are small-capitalization stocks, or even pany risk, suggesting as many as 30. His Graham-Newman micro-caps. fund held as many as 100 of these issues at a time. Primary Criteria • When he bought a stock trading at 67% of its net current Bargain price with a margin of safety: Price no more than two- asset value, he would hold it until he had a 50% gain on it thirds the company’s net current asset value. or until he had held it for two years.

tion. Now that we have defined the screening process. Therefore, we problems with the company itself or his requirement for buying stocks created a custom field that deducts problems with its industry. Graham based on net current asset value, we total liabilities and preferred stock admitted that not all stocks chosen turn our attention to finding stocks from current assets (all from the in this manner will have excessive that meet that requirement. The latest fiscal year) and divides this by returns, which is why he stressed the easiest and quickest way to identify the average number of shares out- need for adequate diversification. In companies sharing similar financial standing over the last fiscal year. (See an article published in 1975 for a characteristics is by using either a Table 2 for the formula.) seminar, Graham states that the port- Web- or software-based screening Using this custom field and re- folio at his investment firm Graham- tool. We used AAII’s Stock Investor quiring that the latest weekly closing Newman often included more than Pro fundamental stock screening and price is not more than 66.7% of net 100 bargain issues at a time. research database to develop our current asset value per share, we ar- In order to winnow our group even Graham NCAV screen. As of January rive at 456 companies as of January further, and to potentially weed out 22, 2010, the Stock Investor database 22, 2010. some of the duds, some qualifying consisted of 9,874 companies traded Even though we have eliminated filters are required. on U.S. exchanges. over 95% of the companies in the Graham’s NCAV approach begins current database, we still have Profitable Operations by identifying stocks trading at a over 400 candidates from which to In “The Intelligent Investor,” discount to the company’s net current choose. Furthermore, many of these Graham suggests buying stocks that asset value per share; specifically, at companies are cheap for a reason— are priced below net current as- least one-third below . perhaps either because of underlying sets only if the company’s “earnings We are not aware of any screening Table 2. Graham NCAV Custom Fields for Use With AAII’s Stock Investor Pro services that allow you to screen for Custom Field Name Formula this specific cri- Net Curr Assets per Shr Y1 ([Current assets Y1]-[Total liabilities Y1]-[Preferred stock Y1])/[Shares Average Y1] terion. However, Total Equity Y1 [Equity (common) Y1]+[Preferred stock Y1] with Stock Investor Curr Liab + LT Debt Y1 [Current liabilities Y1]+[Long-term debt Y1] Pro, you can create custom fields that Stock Investor Pro subscribers can download a text file of these fields atwww.aaii.com/ci/201002/customfields.txt for cutting you can then use in and pasting into the Custom Field Editor.

February Online Exclusive 2010 3 OnLine Exclusive

Table 3. Translating Style Into Screening: The Graham NCAV Approach

Low NCAV after deducting operating expenses from revenues (although Graham looked for stocks trading for less than two-thirds of it is typically calculated by making adjustments to net income). the company’s net current asset value, which he defined as Many screening services should allow you, at a minimum, to current assets less total liabilities and preferred stock. Most screen for positive operating cash flow over the last year. screening services will not allow you to screen on this value. As a proxy, you can screen for companies with low price mul- Financial Strength tiples such as price-to-book-value ratio or price-to-sales ratio. All else equal, companies that have strong balance sheets are You can also use variables such as the current ratio or quick less likely to fail than those that do not. Therefore, as a test of ratio to identify companies with high levels of liquid assets financial strength we look for companies where the value of relative to liabilities. equity (common and preferred) exceeds the value of current liabilities and long-term debt. While it is unlikely you will find Satisfactory Earnings a screener offering these exact variables, you should be able Graham did not specifically outline any qualifying filters he to screen for such items as debt-to-equity to eliminate those applied to the low-price-to-net-current-asset-value universe. companies with high levels of debt relative to some asset or He did suggest, however, only buying such stocks if the earn- equity measure. ings record and prospects were satisfactory. To this end, we eliminated companies that have had negative earnings over Additional Filters the trailing 12 months or for any of the last four fiscal quar- We also excluded non-U.S.-based companies and stocks trad- ters. Most screening services should allow you, at a minimum, ing as American depositary receipts (ADRs) on U.S. exchanges. to screen for positive earnings over the last year. This is to avoid issues related to differing accounting standards and potential withholding taxes on dividends. Finally, stocks in Positive Cash Flow the financial sector are excluded because their financial state- Since it is possible for companies with positive earnings to ments are not directly comparable to other industries. While still have problems paying their bills, we also require that most screeners will not allow you to exclude ADRs or stock companies have positive operating cash flow over the last 12 based in a specific country, you should have better luck being months and for each of the last four fiscal quarters. Operat- able to exclude specific industries or sectors. ing cash flow, generally speaking, is what a company has left record and prospects are reason- cash flows are just that—cash gener- equity to liabilities and debt: ably satisfactory.” As we mentioned ated from the operations of a com- earlier, one way a company’s intrinsic pany. Generally speaking, cash from Stock equity (including preferred stock) ≥ value falls—thereby making an operations is defined as revenues less current liabilities + debt apparently undervalued stock less all operating expenses. undervalued—is by losing money. To Adding these criteria to our For this filter, we had to create two this end, we require companies to Graham NCAV screen lowers the custom fields within Stock Investor: have positive from number of passing companies to five. The first totaled the value of a com- continuing operations for the trailing pany’s common and preferred equity 12 months as well as for each of the Strong Balance Sheet for the last fiscal year and the second last four fiscal quarters. This lowers Having isolated companies with is the sum of a company’s current the total number of passing compa- minimum levels of profitability and liabilities and long-term debt (see nies from 456 to 17. operating cash flow, we shift our Table 2 for the formulas). Requiring A company with positive earnings attention back to the balance sheet. that a company’s total equity be can still have problems paying its NCAV is a balance-sheet-based greater than or equal to its current bills if it does not generate sufficient metric and companies with posi- liabilities and long-term debt did not cash from its normal operations. This tive NCAV have current assets that eliminate any additional companies, could force it to liquidate assets to exceed the total value of their total so five companies still remain. meet its obligations. Therefore, we liabilities and preferred stock. Lastly, we excluded non-U.S.-based also require that companies have For another test of financial companies and stocks trading as positive operating cash flow over the strength, we look to the 1975 American depositary receipts (ADRs) last 12 months and for each of the seminar materials in which Graham on U.S. exchanges. This is to avoid last four fiscal quarters. Operating suggests comparing a company’s total issues related to differing accounting

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Table 4. Graham NCAV Criteria for Use With AAII’s Stock Investor Pro

Data Category Field Operator Factor Compare to (Field, Value, Industry) Custom Fields* Net Curr Assets per Shr Y1 >= 0.667 Price (In Price and Share Statistics data category) Custom Fields* Total Equity Y1 >= Curr Liab + LT Debt Y1 (In Custom Fields* data category) Income Statement - Annual EPS-Continuing 12m > 0 Income Statement - Quarterly EPS-Continuing Q1 > 0 Income Statement - Quarterly EPS-Continuing Q2 > 0 Income Statement - Quarterly EPS-Continuing Q3 > 0 Income Statement - Quarterly EPS-Continuing Q4 > 0 Cash Flow - Annual Cash from operations 12m > 0 Cash Flow - Quarterly Cash from operations Q1 > 0 Cash Flow - Quarterly Cash from operations Q2 > 0 Cash Flow - Quarterly Cash from operations Q3 > 0 Cash Flow - Quarterly Cash from operations Q4 > 0 Company Information Country Equals United States Company Information ADR/ADS Stock Is False Company Information Sector Not Equal Financial

*See Table 2 for information on creating Custom Fields. standards and potential withholding Analysis,” Graham and Dodd write important to stress that the in taxes on dividends. Finally, stocks that they used this number as a buy Table 5 is not intended to be a buy in the financial sector are excluded and sell signal: When the number or recommended list. Stocks meeting because their financial statements are was large (many firms selling on the the Graham NCAV screen require ad- not directly comparable to other in- NYSE below their net current asset ditional due diligence before adding dustries. Adding the final three filters values), the market had reached a them to your investment portfolio. eliminated two additional companies, buy range; when the number was leaving us with three companies very small, the market was danger- Current Financials passing our Graham NCAV screen. ously high. During the Depression By their nature, most companies Table 3 summarizes the filters for years, when the market was vastly trading below NCAV are very small the screen and Table 4 shows the oversold, Graham found such issues in terms of and criteria as used in Stock Investor Pro. to be plentiful. However, the bull trading volume. Of the 456 com- market that began in 1949 led to panies whose price is two-thirds or Passing Companies such a dearth of these same stocks less of NCAV, almost 90% trade on that Graham and his partners dis- the Over the Counter Bulletin Board Table 5 lists the three companies solved the Graham-Newman invest- (OTCBB) or on the pink sheets. passing the Graham NCAV screen as ment firm in 1956. Since such an overwhelming number of January 22, 2010. The number of of the current low-price-to-NCAV companies selling at a sub-current- Due Diligence stocks trade over the counter, we asset basis will rise and fall de- chose not to exclude them. pending on the market. In “Security At this point, I feel it is extremely When companies trade over the

Table 5. Companies Passing the Graham NCAV Screen

Price-to- Price- EPS Curr Price Net to- Growth Liab & as % of Current Book P/E Rate LT Debt to Market 52-Wk Price Assets Value Ratio (3 Yr) Tot Equity Cap High Company Name (Exchange: Ticker) ($/Sh) (X) (X) (X) (%) (%) ($ Mil) (%) Description BGI, Inc. (O: BGII) 0.01 0.07 0.05 0.1 0.0 17.4 0.1 20 sweepstakes gaming GSI Group Inc. (USA) (O: GSIGQ) 0.06 0.12 0.09 2.1 (-23.6) 13.1 32.9 53 lasers & motion devices China Dasheng Biotechnology Co. (O: CDBT) 0.79 0.46 0.09 0.3 na 9.6 1.8 5 wellness prods

Exchange Key: O = over the counter. Source: AAII’s Stock Investor Pro/Thomson Reuters. Data as of 1/22/2010.

February Online Exclusive 2010 5 OnLine Exclusive counter, they are not required to $17 million. would be hesitant to buy a stock with file reports with the SEC. Financial Low market-cap stocks often also a bid-ask spread of more than 2%. analysis is only as good as the finan- have low trading volume, some- Looking at CDBT that same after- cial data on which it is based, so it is times making it difficult for even an noon, its bid price was $0.48 and the imperative to have current financial individual investor to accumulate a ask price was $0.50, for a percentage data compiled following accepted meaningful number of shares without spread of 4.2%. accounting principles. When we look moving the stock price. In this case, at our passing companies, red flags we borrow a rule used with the AAII Conclusion begin to appear. Shadow Stock Portfolio: The average First off, we find that BGI Inc. daily number of shares traded should made a suc- (BGII) has not filed a 10-Q or 10-K be four times the amount needed for cessful career out of buying low- since 2006. Next, we learn that GSI the position. Otherwise, it may be priced stocks that offered him a Group (GSIGQ) is in bankruptcy too difficult to get in and out of the “margin of safety.” However, the sim- and filed for Chapter 11 protection in position quickly. plicity of his methodology is equally November 2009. This highlights the For example, if I had $5,000 to impressive. Even he was aware of need to invest in a well-diversified invest in China Dasheng Biotech- this, as he commented in the 1973 collection of low-price-to-NCAV nology (CDBT), I would be able to edition of “The Intelligent Investor,”: stocks to mitigate the risk of any buy 6,330 shares at its January 22, “It always seemed, and still seems, one individual issue. Furthermore, 2010, closing price of $0.79. There- ridiculously simple to say that if one GSIGQ’s latest 10-Q and 10-K fore, I would like to see CDBT trade can acquire a diversified group of reports date back to 2008. Lastly, at least 25,000 shares a day (specifi- common stocks at a price less than China Dasheng Biotechnology’s latest cally 25,320, or 6,330 × 4). At the the applicable net current assets 10-Q dates to March of 2009 and its Scottrade Web site, we find that the alone—after deducting all prior most recent 10-K is for the period 10-day average trading volume for claims, and counting as zero the fixed ending June 30, 2008. Since this CDBT is 74,300. and other assets—the results should data is what led to these companies When looking at illiquid, low- be quite satisfactory.” passing the screen in the first place, I trading-volume stocks, we often find Despite the simplicity of his ap- would be hesitant to act on them un- higher bid-ask spreads—the amount proach, it seems that, for the most less I could find more recent financial by which the ask price exceeds the part, the market ignored the stocks data. bid. This is essentially the differ- Graham most coveted. To be able to ence between the highest price that a go against the mood of the market Liquidity buyer is willing to pay for a stock and takes conviction and faith in your When a company’s stock trades the lowest price for which a seller approach, both of which Graham over the counter, it usually means is willing to sell it. Outside of the had in great quantity. Furthermore, that the company is too small to commission your broker charges, the Graham achieved his impressive meet exchange listing requirements. bid-ask spread is the cost of buying track record by investing in bulk, Looking at the three companies that or selling the stock; the higher the which allowed him to all but elimi- passed our Graham NCAV screen spread, the higher the cost of buying nate the risk of individual issues. in Table 5, we see that the market or selling. For BGII, with its zero The number of stocks meeting this caps for these companies range from 10-day average trading volume, its requirement will ebb and flow with $100,000 (yes, that is one hundred spread was 100% the afternoon the movement of the market. Cur- thousand dollars) for BGI Inc. to al- of January 28 ($0.0055 bid versus rently, the number of companies is most $33 million for GSI Group Inc. a $0.011 ask). That means that if low, reflecting the impressive run in Even AAII’s Shadow Stock Portfolio, I were to buy this stock, the price the market over the second-half of which invests in micro-cap stocks, would need to rise 100% in order for 2009. With such a small number of sets a minimum market cap floor of me just to break even. Realistically, I candidates, it is important to limit your risk in individual stocks. Fur- thermore, as our analysis illustrated, Wayne A. Thorp, CFA, is editor of Computerized Investing and not all companies that end up passing AAII’s financial analyst. Follow him on Twitter @CI_Editor. the Graham NCAV are worthy invest- ment candidates.

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