All the fixed assets like machinery and buildings come for free when companies trade at below net current assets
By TEH HOOI LING
Businesstimes.com
WITH the stock market sinking day after day into what seems like an abyss, few dare touch shares with a 10-foot pole. But have we entered the realm of irrational fear?
One way to know is to examine how cheap prices have become. Well, here's how cheap: Based on a rough screening, about 100 Singapore-listed companies are trading below their net current assets. That's their current assets after deducting all liabilities - be they short- or long-term - as well as minority interests.
In other words, at today's prices investors are getting a discount on current assets like cash, receivables and inventories net of all the company's obligations. Fixed assets like buildings and machinery come free.
Of the 100-over companies, I went through about 50 and found the discounts of some to be as deep as 70 per cent or more (see accompanying table).
The first component of value investing employed by Benjamin Graham was what his famous disciple Warren Buffett described as 'cigar butt investing'. Basically, Graham liked stocks that were akin to cigar butts found on the street - still smouldering, and from which it was possible to snatch one or two last puffs.
Graham's favourite valuation signal was a stock selling at a price below its net current assets - that is, a stock selling for less than its net working capital after deducting all of its prior obligations.
In his words: 'The type of bargain issue that can be most readily identified is a common stock that sells for less than the company's net working assets alone, after deducting all prior obligations. This would mean that the buyer would pay nothing at all for the fixed assets - buildings, machinery, etc - or any goodwill items that might exist.
'Very few companies turn out to have an ultimate value less than the working capital alone, although scattered instances may be found. The surprising thing, rather, is that there have been so many enterprises obtainable which have been valued in the market on this bargain basis.
'It is clear that these issues were selling at a price well below the value of the enterprise as a private business. No proprietor or majority holder would think of selling what he owned at so ridiculously low a figure. In various ways, practically all these bargain issues turned out to be profitable and the average annual return proved much more remunerative than most other investments.'
And to give himself more safety of margin, Graham advocated buying companies trading at less than two-thirds of their net current asset value. Let's call these stocks 'net-nets'.
In his book Intelligent Investor, he provided a table showing the results of the net-nets approach. The return from buying one share of each of 85 net-net companies on Dec 31, 1957, and then holding for two years, was 75 per cent. This compared with a 50 per cent gain from the S&P's 425 industrials. None of the issues showed a significant loss. Seven were almost unchanged and 78 showed appreciable gains.
Others have tested his approach. In 1986, Henry Oppenheimer examined the returns of buying net-nets between 1970 and 1983. The holding period was one year. Over its life, the portfolio contained a minimum of 18 stocks and a maximum of 89 stocks. Its mean return was 29 per cent per annum, against a market return of 11.5 per cent per annum.
Just this week, James Montier, a Societe Generale strategist who has won a global following through his articles on happiness and the sins of fund management, issued a report on his net-nets strategy on global stocks.
He used a sample of developed markets. Between 1985 and now, he found that an equally weighted basket of net-nets generated an average return above 35 per cent per annum versus a market return of 17 per cent per annum.
Regionally, the strategy outpaced the market by 18 per cent in the US, 15 per cent in Japan and 6 per cent in Europe. Montier noted that one wouldn't expect to find lots of stocks trading at less than two-thirds of net current assets. Of the developed markets he looked at, he ended up with a median number of 65 stocks and a mean of 134 stocks in the portfolio every year. In 2003, there were more than 600 net-nets in the markets he studied. That, he pointed out, was a signal of value in the market. Right now, despite the sharp falls in the market year-to-date, Montier found only 176 companies trading as net-nets. Well, obviously, he didn't look at Singapore.
It is to be expected that net nets are typically small caps. This is true of the list I generated. The median market cap of Singapore net-nets I happened to go through is $33 million. The average is $56 million.
In the big developed markets, the current crop of net-nets that Montier found had a median market cap of US$21 million and an average of US$124 million.
And guess where he is finding most of the net-nets now? About half the developed world's net-nets are in Japan, according to him. Sometimes there is a reason why these stocks are trading at such deep discounts. Montier found 5 per cent of his net-nets selection suffered more than a 90 per cent loss in value in a single year. However, on a portfolio basis, as mentioned, it fared much better than the general market. Also, he found that the net-nets strategy generated losses in only three years in the entire sample he back-tested; in contrast, the overall market witnessed six years of negative returns.
As Graham himself noted: 'Our experience with this type of investment selection - on a diversified basis - was uniformly good. It can be affirmed without hesitation that it constitutes a safe and profitable method for determining and taking advantage of undervalued situations.'
I'm not too sure if the back-testing done by Montier and the others took into consideration transaction costs. If not, the returns from the net-nets strategy may have been overstated. Imagine buying one lot each of the 100 net-nets in Singapore. In some cases, the transaction cost would amount to more than the cost of the stock itself, given that some are trading at just one or two cents.
Also, one should be discerning about what constitutes current assets if one were to consider investing in these stocks. For example, a few of the companies that appear on my list have 'developmental properties' itemised as one of their current assets. Of course, we know property prices are coming down. So there is a high likelihood that the value of these assets will be written down. Similarly, there could be write-offs on the accounts receivable or things like dues from subsidiaries. Also, a number of the deeply discounted stocks are China- based companies, where corporate governance has been an issue in the past.
Still, if the discounts are deep enough, it would probably have made up for the risks of write-downs and so forth. Indeed, some companies themselves see so much value in their stocks that they have been scooping up their own shares in the open market.
One example is HTL. The company's current market cap is only 64 per cent of its net current assets. The group managed to eke out a net profit of $3.6 million in the second quarter, and it thinks H2 will be better. No wonder its directors have been busy buying its shares from the open market.
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