Deep value investing

Benjamin Graham, who is regarded as the father of value investing, believed that a stock could generate above average returns when it traded below its long-term fundamental value.

The larger the discount the stock enjoys over its intrinsic value, the higher the probability it will beat overall market returns.

Graham has developed several approaches in computing the intrinsic value of a stock and one of these is the net current asset value method, commonly known as the “net-net strategy.”

This approach, which Graham successfully tested in the early 1930s few years after the Great Depression, requires investing in stocks that are priced at least 67 percent of a firm’s underlying current assets net of all liabilities.

For example, if the sum of a company’s cash, accounts receivable and inventory is computed at P100 a share and the sum of its current liabilities and long-term debt is P70 a share, the difference between the two, which is P30 per share, shall be called net current asset value.

If the market price of the stock is trading at least one-third of the net current asset value, which in this case is P10 a share, it simply means the company is priced at its liquidation value while giving away its fixed assets and others for free.

Graham believed there was no reason for a stock to trade continuously at this huge discount so there was a very good chance the stock would recover strongly in due time.

But in a market where share prices have fallen significantly this year, like in the Philippines, how applicable is this strategy?

Let’s examine this strategy by screening the potential value stocks from 2015 at yearend prices. During that time, the PSE Index was also on a downward trend, having lost a total of 15 percent of its value eight months ago.

Following the criterion of the net-net strategy, only four of the more than 300 stocks yielded at least 67 percent discount to net current asset value.

They were Apollo Global, which had 96 percent discount; San Miguel Purefoods, 88 percent; Panasonic, 88 percent and Concrete Aggregate B, 79 percent.

Assuming you bought all these stocks and held them for two years, your portfolio would have generated a median return of 258 percent at end of 2017, outperforming the PSE Index, which rose by 23 percent.

While the net-net strategy generated excess returns over time as shown by historical performance, bear in mind that the reason why these stocks traded at a huge discount was their poor growth outlook, problematic profitability, or illiquid shares in the market.

In a way, we can say net-net stocks can be highly speculative and risky. The only fundamental reason that makes them attractive is the value potential that they offer in case of liquidation.

Not all net-net stocks share the same characteristics. Some may have profitable businesses while others may be holding assets with no reliable sources of income.

Let’s say we put more weight on cash assets by assuming that a liquidating company will be able to collect only 75 percent of its accounts receivable and sell 50 percent of its inventories.

Applying these haircuts to the net-net criterion using the same historical data in 2015, the result would yield only one stock, Panasonic, which offered 84 percent discount to market price.

This stock went on to generate cumulative returns of 130 percent by end of 2017 but has since corrected from profit taking during the market downtrend.

If we use the net-net strategy at current prices with same haircuts, we will again have Panasonic at 79 percent discount. So will history repeat itself?

Value investing can be lucrative but may be risky, too. The only way to manage this risk, as Graham said, is to avoid overpaying a stock no matter how attractive it is by having a comfortable margin of safety.