What goes down, must come up! Investigating Companies with Negative Book Value WHAT GOES DOWN, MUST COME UP! INVESTIGATING COMPANIES WITH NEGATIVE BOOK VALUE White Paper 17 July 2019 Research, Solactive AG 1 What goes down, must come up! Investigating Companies with Negative Book Value TABLE OF CONTENTS Executive Summary ............................................................................................................................................................................................................... 3 Highlights .................................................................................................................................................................................................................................. 3 Introduction .............................................................................................................................................................................................................................. 3 Negative Book Value Universe ............................................................................................................................................................................................ 3 Rebalancing And Returns .................................................................................................................................................................................................... 3 Universe Characteristics ...................................................................................................................................................................................................... 4 Size Makes A Difference ........................................................................................................................................................................................................ 5 Liquidity Matters As Well ..................................................................................................................................................................................................... 5 Combining Size And Liquidity ............................................................................................................................................................................................. 6 Historical Turnover ................................................................................................................................................................................................................. 6 Basket Tradability ................................................................................................................................................................................................................... 6 Conclusion ................................................................................................................................................................................................................................. 6 References ................................................................................................................................................................................................................................ 7 Appendix ..................................................................................................................................................................................................................................... 7 Disclaimer.................................................................................................................................................................................................................................. 9 Contact ..................................................................................................................................................................................................................................... 10 2 What goes down, must come up! Investigating Companies with Negative Book Value EXECUTIVE SUMMARY resemble that of a call option holder on the assets of the company with a strike price equal to the In this white paper, we attempted to study the nominal value of its debt. In other words, historical behavior of US companies with negative theoretically, the shareholder’s value should be book value (i.e., with total liabilities greater than strictly non-negative. Therefore, the fact that these total assets). We discovered that the market companies are sometimes omitted by both capitalization of companies with negative book academic and practitioners alike should come as no value was more than USD 1.28 trillion as of April 30, surprise to well-versed market participants. 2019. A periodically rebalanced universe of companies with negative book value, outperformed Nevertheless, if we consider value premium to be the broader US equities over the period from derived from a company’s distress risk, then the November 30, 1998, to April 30, 2019. Therefore, returns of the companies with negative book value they are not insignificant any longer to be should be disproportionally higher than their disregarded by academics and practitioners alike. positive book value counterparts as, in theory, they are more susceptible to this risk factor [1]. HIGHLIGHTS In this paper, we attempted to study the historical Within the universe of companies that had performance of US companies with negative book reported negative book value at least once value relative to the broader US equities, as well as between November 30, 1998, and April 30, 2019, to identify the factors that drive the performance of we observed that companies with negative book value. approximately 55% of the companies NEGATIVE BOOK VALUE UNIVERSE subsequently reported positive book value We formed the negative book value universe in two within one year after declaring negative book steps. First, we took all the companies with value negative book-value per share (BVPS) companies with smaller market capitalization headquartered and incorporated in the US and outperformed those with larger market listed on NYSE and/or NASDAQ. Second, we capitalization excluded the companies ranking within the bottom companies with higher ability to manage short- 2.5% by cumulative market capitalization coverage term obligations, as measured by the current from step one, to avoid the inclusion of very small ratio (defined as current assets / current companies with incomplete accounting liabilities), outperformed those with lower information. ability REBALANCING AND RETURNS a periodically rebalanced strategy comprising Throughout the paper, we rebalanced the negative of smaller stocks with higher current ratio book value universe as well as corresponding generated an annualized excess total return of portfolios on the last trading day of May and 4.9% over the broader US equities November with selection date as of the end of April INTRODUCTION and October each year. We lagged the book value per share (BVPS), and other fundamental data by Book value reflects the accounting value of a three months from the selection date to avoid data company to its ordinary shareholders. Given backfill bias. We used monthly stock returns from publicly-traded companies’ limited liability November 30, 1998, to April 30, 2019, for all of our structure, a shareholder’s payoff function would back-tests. 3 What goes down, must come up! Investigating Companies with Negative Book Value UNIVERSE CHARACTERISTICS we rebalanced the universe periodically, survivorship was not a major issue in our back-tests. The past decade witnessed an exponential growth in the market capitalization of companies declaring negative book value. The cumulative market Exhibit 2: Percentage Of Companies From The Negative capitalization of companies in the negative book Book Value Universe Which Subsequently Declared Positive value universe was approximately USD 1.28 trillion Book Value Or Got Delisted as of April 30, 2019 (see Exhibit 1). The top 5 largest % companies that delisted companies in our universe as of November 30, 2018 % companies whose BVPS turned positive were Home Depot, McDonald’s, Phillip Morris, 100% AbbVie, and Colgate Palmolive. 90% 80% 70% Exhibit 1: Market Capitalization Of Companies In The 60% Negative Book Value Universe 50% MCap (USDbn) # companies (right axis) 1 2 3 4 5 6 7 8 9 10 1400 140 # years after declaring negative BVPS 1200 120 Source: Solactive and FactSet. Data from November 30, 1998 to April 30, 2019. Chart is provided for illustrative purposes. 1000 100 800 80 600 60 The Consumer Services, Technology, Consumer 400 40 Non-Durables, Industrials, and Healthcare sectors 200 20 jointly represented more than 90% of the negative book value universe averaged over the entire back- 0 0 tested period (see Exhibit 3). One of the reasons is Nov-12 Nov-18 Nov-16 Nov-14 Nov-10 Nov-02 Nov-98 Nov-08 Nov-06 Nov-04 Nov-00 that companies in these sectors spend heavily on Source: Solactive and FactSet. Data from November 30, 1998 to April 30, R&D and/or advertising. Under GAAP, they are not 2019. Chart is provided for illustrative purposes. able to capitalize these value-adding expenses, which leads to a suppression in their book-value [2]. Based on our empirical investigation, the majority of the time, negative book value did not lead to the Exhibit 3: Average Sector Exposure Of The Negative Book inevitable death of a company. Our historical Value Universe analysis showed that between November