Net Current Asset Value: What, Why and How
This article on Net Current Asset Value was written by Isaac Aydelman. Isaac is a student of economics and a former soldier. He was drawn to net net investing for their historical returns and how the strategy paired well with his personality. He manages his own personal account and is always looking for new opportunities. He uses Net Net Hunter's high performance net net checklist to identify his stocks. Download our net net checklist right now for free. Click Here. Article image (Creative Commons) by Marco Verch, edited by Net Net Hunter.
Why should you be thinking about net current asset value today? Because the markets can be a volatile place, and following the old buy-and-hold, 60/40 stocks-and-bonds approach may not be the best thing for you.
2020’s COVID-19 epidemic is a perfect example. Believers in portfolio diversification have been crushed as they watched all of their assets go down in tandem. Momentum investors learned the hard way that what went up keeps going up—until it doesn't. But net current asset value (NCAV) investing looks poised to have a very strong future.
We may very well be seeing one of the best value investing opportunities of the last decade unfolding before our eyes. But we’re getting ahead of ourselves; First, what do we really mean when we say net current asset value?
What Is Net Current Asset Value?
Net current asset value is a conservative measure of a firm’s real world liquidation value, based solely on the current assets it holds on its books, minus all of its liabilities.
The formula for NCAV in its simplest form is:
Current Assets - All liabilities - Preferred Shares = NCAV
What exactly are current assets? Items such as marketable securities come to mind. Cash and cash equivalents, accounts receivable, and other liquid assets such as stock inventory, marketable securities, and prepaid liabilities also qualify.
Non-current assets? Well, that means basically everything else. Buildings, land, and any other physical assets that can't be instantly redeemed for cash are not factored into the formula. Intangible assets are usually long-term assets, but a complete no-go. For example, trademarks or goodwill are not even remotely considered, as they have subjective values and by definition have very weak liquidity.
The liabilities part of the equation is a lot simpler: We take ALL liabilities and subtract them from the current assets the business holds. Be it long-term liabilities such as pension plans and long-term loans, or current liabilities like accounts and wages payable—it is all going to be subtracted from the current assets in order to get the net current asset value of the business.
Finally, we treat preferred shares as a type of liability and also subtract them from the firm’s current assets in order to receive the most conservative measure of the business’s value.
Wondering why we don’t only subtract long-term liabilities instead of all liabilities, or why we also include preferred shares in the formula? Read on to get your answers.
Why Should I Use Net Current Asset Value?
Why do we want to measure the net current asset value of a company? The creator of this method, Benjamin Graham, called it a business’s liquidation value. The premise was simple: It is logically irrational for a business to trade below what it would be worth if it was liquidated. Either the value would increase, or it would be liquidated. Either way, the company provided great upside potential.
In addition to this, it was the most conservative valuation method possible, as it did not rely on any future prediction of business performance, like using price/equity, for example.
NCAV is so conservative in fact that Graham felt assured that if the company he had invested in filed for Chapter 11 bankruptcy protection, its assets would be sold off and investors could expect a return close to his valuation.
This covered the downside, but Graham took it one step further and sought to invest in companies trading at a ⅔ discount to their NCAV. If bought at enough of a discount, this could ensure an attractive return even if a business went under. He called these companies net nets, as current assets are “netted” against current liabilities, and the remainder is then netted against long-term liabilities (and preferred shares).
Warren Buffett’s Cigar Butts
Another famed investor had a different take on investing using net current asset value. Warren Buffett affectionately termed it cigar butt investing:
“If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the ‘cigar butt’ approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit.”— Warren Buffett, 1989 Berkshire Hathaway Letter
The ability to invest in a struggling business and walk away with a handsome profit presents an amazing opportunity to the intelligent investor.
Despite having backing from two of the most famous investors in the world, investing in net net companies has found little popularity. How could that be? Well, for starters, many investors would take one look at some of these undervalued companies and run the other way.
This lack of interest makes it all the better for those willing to make use of Graham’s old strategy; competition erodes profit potential, and if everyone was investing in these companies, the discounts would no longer exist. Thankfully, human psychology is an unstoppable force that shows no signs of letting up. Profits go to intelligent investors with strong emotional temperaments.
Net Current Asset Value Provides a Strong Margin of Safety
While Buffett mentions some of these companies are not high quality and could be struggling for a number of reasons we’ll tackle in a moment, the philosophy of investing in net net companies provides a sizable margin of safety.
The incredibly conservative valuation method itself provides some serious downside protection. Discarding all long-term assets regardless of how lucrative they may be can downplay hidden value; focusing on current assets alone forces you to value a company on its foundation, and current assets are often the lifeline of a business during a downturn.
On the other hand, liabilities are what cause a business to go bankrupt and come in different types and flavors. By treating all liabilities the same, we eliminate the need to predict if a company will be able to cover its debts, in all sorts of scenarios regarding all of its types of liabilities. It makes the valuation simpler, and more to the point, maximizes downside protection.
In addition to this, for a business to trade at a discount to its net current asset value, it would have to experience a serious drop in its stock price. Sometimes, net net stocks lose as much as 90% of their share price. If you followed Graham’s rule and invested only at a significant discount, you would have only invested after the large drop.
Companies able to cling to life after a beating like that will most likely stick around in the long term, and if they don’t, we can find relief knowing that they have enough liquid current assets on their balance sheet to provide a decent return to investors if liquidated!
Not that many go bankrupt. Firms that trade below net current asset value must have very strong balance sheets—it’s written into the formula (Current Accounts – ALL Liabilities). By definition, a company’s cash and cash-equivalents must be able to cover all of its liabilities at present day. This helps protect against insolvency, since a company only reaches insolvency once its liabilities overtake its assets and cash flow, and it no longer has the means to cover the business’s financial obligations. In fact, despite the enormous problems many of these firms face, James Montier reported that only 5% of net nets suffer a decline greater than 90%, versus 2% for stocks in general. That’s a small difference!
Still, like with any strategy, you may fall upon companies that go bust without providing an adequate return or perennially trade below net current asset value, only to move sideways for years. Graham himself understood the risk here and had an answer—diversification:
“Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss – not that loss is impossible. But as the number of such commitments is increased, the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business.”— Ben Graham, The Intelligent Investor
Graham may have been one of the earliest proponents of the importance of stock diversification in a portfolio. In his book The Intelligent Investor, he clearly recommended regular investors hold a “minimum of ten different issues and a maximum of about 30,” diversifying much of the risk away that comes with investing in a single troubled company.
When Do Companies Trade Below Net Current Asset Value
Net nets stocks tend to have dropped a lot in share price, typically due to an overreaction by the market.
As Buffett stated above, these companies are going through some fundamental issues with their business. Some of these issues can be sector or geographically specific, while others can be unique to the company. However, even if these issues are solvable, the market often immediately counts them as a critical blow to the business.
Most net net stocks fall into the category of cheap micro and nanocap stocks, which are companies with a market capitalisation of less than $300 and $50 million USD, respectively. Companies this small tend to be much more volatile than the large Fortune 500 companies that populate the S&P 500. This is due to a combination of the market perceiving them as more risky investments, a lack of liquidity to buy and sell their shares, and a lack of institutional money trading them.
During marketwide selloffs, such as a financial crisis or recession—not unlike what we are seeing now—these small businesses usually suffer the most severe drops. Additionally, the market is quick to punish these companies outside of marketwide selloffs with overblown reactions to small bits of bad news, such as an earnings miss or a legal dispute.
It is not all doom and gloom, though; the overreaction often pushes their stock price to be worth less than their net current asset value, handing us a fantastic investment opportunity that we are about to show is handed to us on a silver platter of high investment returns.
Net Current Asset Value: A History of Success
We have spoken about the what, why, and how of investing using net current asset value, but what about the most crucial point: What returns can an investor expect?
I am happy to say that not only does net current asset value provide a huge margin of safety, but it also gives investors a rate of return higher than than the benchmark S&P 500! Nor is this strategy a secret—there have been multiple wide-ranging studies analysing multiple time frames and geographic locations:
- In 1986, one of the most broad studies was conducted by H.R. Oppenheimer for the Financial Analysts Journal. In it, the study compared the performance of all companies trading at ⅔ their net current asset value compared to the performance of the S&P between 1970-1982. What the study found was that these net nets tripled the returns of the S&P, and factoring taxes and commissions still posted double returns.
- For his book, James Montier posted a more up-to-date study looking at the returns of a global basket of net nets from 1985-2007. Even in modern times, net nets posted an average annual return of 35% versus the 17% of an equal-weighted basket of S&P stocks. Montier additionally noted that a majority of net net opportunities in modern times were found in Japan.
- The University of Salford published a study looking at the performance of companies on the London Stock Exchange trading at ⅔ of their net current asset value from 1980-2005. The study found that by the end of the study period, 1,000,000 GBP invested in only net nets would have increased to 423,000,000 GBP, in comparison to 34,000,000 GBP if invested in the broad UK market.
- Continuing the Oppenheimer study, Thobias Carlisle investigated the returns of companies trading at ⅔ their net current asset value from 1984-2008. He found that these net net stocks had an average monthly performance of 2.55%, amounting to 30.6% per annum.
Across space and time, investing in businesses that are trading at ⅔ their net current asset value has rewarded investors handsomely.
We’ve broken down what net current asset value is, why it works as a valuation method, and how much an investor can expect to profit from it, so how come everybody isn’t doing it?
Net Current Asset Value: What’s the Catch?
There is a lot to like about using net current asset value, but no strategy is perfect. As we have shown, valuing companies using their NCAV is effective, but there are some drawbacks that investors need to be aware of.
Waiting for companies to return to their NCAV is a long-term strategy. You can’t expect to make short-term gains like a trader, and you can’t be swayed by the daily, weekly, and even monthly movements of the market as a whole. Most studies have noted that the effectiveness of the strategy works only for holding periods of one year or more.
Likewise, this strategy, like all value investing methods, will experience periods of underperformance. Specifically during roaring bull markets, growth-orientated strategies are likely to outperform. However, as with the business cycle, the outperformance is cyclical, and over a very long-term horizon, value has been shown to outperform growth as a whole.
As mentioned before, these companies are facing fundamental business issues. With that, there is the chance that management is not successful in solving the problem at hand. This leads to a company staying on your portfolio for years, perennially staying undervalued and taking up your cash. This is why some level of diversification is important, as well as having a holding period rule—to make sure you are not caught holding a “perennial net net.”
The last drawback doesn’t apply to most investors but is important nonetheless: This strategy is not profitable with large sums of money. Buffett himself lamented this in his 2014 Berkshire letter:
“My cigar-butt strategy worked very well while I was managing small sums.… But a major weakness in this approach gradually became apparent: Cigar-butt investing was scalable only to a point. With large sums, it would never work well…”- Warren Buffett, 2014 Berkshire Hathaway Letter
As most of these companies are nano/microcaps, investing a large sum quickly erodes profits as you would be pushing the stock price up by buying all the shares. The illiquidity also would make buying up a large quantity of shares a significant undertaking.
Conclusions to Draw from Net Current Asset Value
While the data shows that investing in businesses based on a discount to net current asset value is a very successful strategy, there is a caveat that it's not for everyone.
This strategy involves rummaging through tiny, troubled companies, many of which are going through a crisis of some sort. It means holding these flailing businesses for a year or more, oftentimes with little change in their stock prices.
On the other hand, net current asset value provides an amazing margin of safety, a simple, straight-to-the-point measure of a company’s true worth, a philosophy that makes intrinsic sense, and decades of data backing up the strategy’s results. It’s enormously profitable over the long term for small intelligent investors with strong temperaments.
Imagine you knew with 100% certainty that a spot in the ground contained gold. You also knew with certainty that it would take some time and hard work sifting with a pan to get to it. Wouldn’t you jump at the opportunity to get rich? Time to sit there, sift through the mud, and find those net net nuggets.
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