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Value investing has an appealing logic to many investors. The idea is simple. Value investing generally involves searching for stocks trading at discounts to their fair value. These stocks can be bought and held until they trade at or above their fair value.
These ideas were first put forth by Benjamin Graham, a business school professor who counted Warren Buffett among his students. Graham is widely considered to be the father of value investing and he wrote widely on the topic. His work includes descriptions of strategies that he found to be successful.
Graham developed and tested the net current asset value (NCAV) approach between 1930 and 1932. He later reported that the average return, over a 30-year period, on diversified portfolios of NCAV stocks was about 20%. An independent study showed that from 1970 to 1983, the strategy gained an average of 29.4% a year.
What Is NCAV?
Graham defined NCAV in the 1934 edition of Security Analysis, the book he cowrote with David Dodd. He said NCAV is equal to “current assets alone, minus all liabilities and claims ahead of the issue.” In accounting terms this is current assets minus the sum of total liabilities and preferred stock.
Current assets are cash and cash equivalents, receivables, and inventories. They are already cash or are convertible into cash within a relatively short period of time (usually less than a year). Net current assets exclude intangible assets along with the fixed and miscellaneous assets of a firm.
Some readers may see a similarity between NCAV and working capital which is defined as current assets minus current liabilities. The difference is that NCAV deducts total liabilities (current and long-term) from current assets.
Compared to book value, the NCAV method is a more rigorous standard. Book value can include intangible assets, which can be overstated in value. Book value includes land, property and equipment which can take considerable time to convert to cash.
In their book, Graham and Dodd pointed out that when stocks trade below the company’s NCAV they are, most likely, trading below the company’s liquidating value. This means that it is reasonable to assume that most companies can be sold off for at least the value of these assets.
They also noted there was a margin of safety in the company’s remaining assets, fixed assets like plant, property and equipment. These assets could, in time, be sold to offset any loss incurred when converting the current assets into cash.
Graham and Dodd created an investment strategy based on NCAV. When they found companies trading well below their liquidating values, they bought them.
Screening on NCAV
In the 1949 edition of his book, “The Intelligent Investor,” Graham explained exactly how to screen for buy candidates. He wrote, “…if a common stock can be bought at no more than two-thirds of the working-capital alone—disregarding all other assets—and if the earnings record and prospects are reasonably satisfactory, there is strong reason to believe that the investor is getting substantially more than his money’s worth.”
To find a reasonably satisfactory earnings record, we required companies to have positive earnings per share from continuing operations for the past12 months.
Earnings can hide operational difficulties since there can be accounting assumptions that generate earnings for some companies. To minimize this risk, we required that companies also have positive operating cash flow over the last 12 months. Cash from operations is defined as revenues less all operating expenses.
Graham also believed low debt levels would help these companies survive. Therefore, we screened for companies that have total-liabilities-to-total-assets ratio below 50%. This confirmed companies have more assets than liabilities.
We then screened for low prices, less than $2 a share. However, these stocks can be illiquid with low trading volume. Despite the risks, this can be a useful approach, again, in the long run. As Graham wrote in the 1973 edition of “The Intelligent Investor”:
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