Returns of Benjamin Graham’s Net Current Asset Value Strategy, Part 1.

There have been various studies that analyzed the performance of Benjamin Graham’s strategy of purchasing stocks trading below net current asset value (NCAV). These stocks are also called net-nets. Graham developed and tested this criterion in the early 1930s and first described his net current asset value rul for stock selection in the 1934 edition of ”Security Analysis.

The common definition of Net Current Asset Value is:

NCAV = current assets – (total liabilities + preferred stock)

The first studies and the majority of examinations have been made in US. Later other studies have been made also in major international markets. Although There were many differences across each study a general conclusion was that stocks meeting Benjamin Graham’s net current asset value criterion outperform a broad market average. And the outperformance has been superior most of the time.

Variety of Studies Carried Out Along the Years

In the ”Intelligent Investor” Benjamin Graham provides evidence to illustrate the power of his net-net approach. Graham made his test by buying one share of each of the 85 companies that met his net-net criteria on 31 December 1957, and then holding them for two years. Graham wasn’t contented with just buying firms trading on prices less than net current asset value. He required greater margin of safety buying only stocks with prices of less than two-thirds of net current asset value. The gain from the entire portfolio in that period was 75%, against 50% for the S&P’s 425 industrials. What was more remarkable was that none of the issues showed significant losses, seven held about even and 78 showed appreciable gains.

Professor of finance, Henry Oppenheimer from the State University of New York at Binghampton, examined the returns to Graham’s net current asset value strategy over a 13-year period from 31 December 1970 to 31 December 1983. Oppenheimer’s study assumed that all stocks meeting the investment criterion were purchased on 31 December of each year, held for one year, and replaced on 31 December of the following year by stocks meeting the same criterion on that date. Oppenheimer used the same two-thirds margin of safety of net current asset value as Graham. The total number of researched net-net shares was 645. The smallest annual sample was 18 stocks and the largest was 89. Oppenheimer found that the average return over the 13-year period he examined was 29.4% per year comparing 11.5% for the NYSE-AMEXin index. $10,000 invested in the net current asset value portfolio would have increased to $285,197 compared to $10,000 invested in the market would have increased to just $41,169.

Founder and portfolio manager of Carbon Beach Asset Management, Tobias E. Carlisle, who is famous for his books ”Deep Value”,”Quantitative Value”(co-authored Wesley Gray) and ”Concentrated Investing” (co-authored Allen C. Benello and Michael van Biema), tested the performance of Graham’s net current asset value strategy with Jeffrey Oxmanin and Sunil Mohantyn from St. Thomas University. They continued examination from the end of Oppenheimer’s data in 31 December 1983 to 1 December 2008. Net current asset value strategy returned on average 35.3% yearly for the full period of 25 years. It outperformed the market by an average of 22.4% yearly, and a comparable Small Firm Index portfolio by an average of 16.9% yearly. The fewest net-net selection was only 13 stocks in 1984 and the most net-nets, 152 stocks, were found in 2002.

Also Joseph D. Vu published his examination of the performance of Graham’s net current asset value strategy in Financial Review 23, no. 2 (1988), entitled: ”An Empirical Analysis of Benjamin Graham’s Net Current Asset Value Rules.” A study was conducted to provide evidence that the net current asset value rule evolved by Ben Graham in 1930 still is profitable in the 1970s and 1980s. Vu researched return of net-net stocks in US market from April 1977 to December 1984. Stocks meeting Graham’s criterion returned on average 38.5% yearly comparing 32.1% for the market index.

Famous value investors Joel Greenblatt and Richard Pzena together with money manager Bruce L. Newberg published their findings in the The Journal of Portfolio Management Summer issue 1981, Vol. 7, No.4. An article was entitled: “How the Small Investor Can Beat the Market: By Buying Stocks That Are Selling Below Their Liquidation Value.” Greenblatt and his co-authors argued within the article that only way the small investor can beat the market, is by looking for undervalued stocks. To start, they used Graham’s traditional net-nets formula to screen for bargains. After using this, Greenblatt went further in an attempt to remove bad stocks from the list. To accomplish this goal, Greenblatt and his co-authors added the P/E ratio to their NCAV screening criteria. Using both Graham’s net current asset value and PE ratio, Greenblatt tested four different portfolios and compared those portfolios against the OTC and Value Line’s own value index from April 1972 to April 1978. This period was characterized by an extreme amount of volatility.

  1. Portfolio

* Price below NCAV

* P/E floating with corporate bond yields

* No dividends required

  1. Portfolio

* Price below 85% of NCAV

* P/E floating with corporate bond yields

* No dividends required

  1. Portfolio

* Price below NCAV

* P/E of less than 5

* No dividends require

  1. Portfolio

* Price below 85% of NCAV

* P/E of less than 5

* No dividends required

Stocks with a market cap of less than $3 million were discarded from the study. Stocks were sold after a 100% gain or two years had passed, whichever resulted first.

The returns of the four portfolios were following:

  1. Portfolio returned 20.0% per year
  2. Portfolio returned 27.1% per year
  3. Portfolio returned 32.2% per year
  4. Portfolio returned 42.2% per year

Inspired by the study Greenblatt founded hedge fund Gotham Capital which returned average 40% per year from 1985 to 2006. Gotham’s stellar performance came from deep value and special situations investing and the maintenance of an extremely concentrated portfolio.

President of Wendl Financial, Victor J. Wendl, has published a book ”The Net Current Asset Value Approach To Stock Investing” where he analyzed how net current asset value method performed during the 60 years from 1951 to 2009. Stock was included in the portfolio if the current trading price were below 75% of net current asset value calculation. Stocks were held between one and five years. In summary longer holding period gave weaker results. The study also showed that in general, the more undervalued a stock is relative to its net current asset value, the higher the future return. Combining additional criteria, like low P/E and dividend-paying were also studied. Net current asset value portfolio (return 19.89%) beat both S&P 500 index (return 10.67%) and Wilshire Small-Cap index (return 11.20%) by a wide margin.

Chongsoo An (from Department of Economics, Gangneung-Wonju National University, Korea), John J. Cheh and Il-woon Kim (from George W. Daverio School of Accountancy, The University of Akron, U.S.A.)    published their own study in Journal of Economic & Financial Studies; Vol. 03, No. 01: February (2015), entitled: ”Testing Benjamin Graham’s Net Current Asset Value Model.” The study period was from 2 January 1999 to 31 August 2012. The results were compared to the performance of S&P 500 as the market index.

In their study stocks were divided in three different portfolios:

Portfolio 1: Net Current Asset Value/Market Value > market price×1                                                Portfolio 2: Net Current Asset Value/Market Value > market price×2                                               Portfolio 3: Net Current Asset Value/Market Value > market price×5

The final sample size for each portfolio was 84 firms, 32 firms, and 10 firms for Portfolio 1, Portfolio 2, and Portfolio 3, respectively. Portfolios were rebalanced yearly.

The annualized returns of three portfolios are following:

  1. Portfolio 17.17%
  2. Portfolio 17.78%
  3. Portfolio 18.34%

The performance of S&P 500 during the same period was 2.91%. As the stock holding period is decreasing from one year to six months, and finally to 4 weeks, returns are generally decreasing and cannot beat the market anymore.

These amazing results are not just limited to the United States.

Famous value investor and behavioral finance expert James Montier examined the performance of buying net-net stocks on a global basis. He purchased a portfolio of net-net stocks in all developed markets globally over the period 1985 to 2007. The returns of this investing strategy were impressive. An Equally weighted basket of net-nets generated outstanding average return of 35%per year versus market return of 17% per year. Net current asset value strategy worked well at the global level and within regions these stocks outperformed the market by 18% in the USA, 15%in the Japan and 6% in the Europe.

In the first study outside of USA Bildersee J.S., Cheh J.J. ja  Zutshi A. examined net-nets strategy in the Japan market from April 1975 to March 1988 .Study published in Japan and the Worlds Economy 1993, entitled: ”The Performance of Japanese Stocks in Relation Their Net Current Asset Values.” In order to maintain a sample large enough for cross-sectional analysis, Graham’s criterion was relaxed so that firms are required to merely have a Net Current Asset Value/Market Value ratio greater than zero. Net current asset value portfolio return in study was 20.55% and the market index return over the same period was 16.63% annually. Not a great difference, but it was obviously a difficult period in Japan. The Nikkei index peaked in the end of 1989, and never recovered. After that it would have been the best time for Graham’s net-net stocks.

Ying Xiao and Glen C. Arnold from Salford Business School examined the Net Current Asset Value/Market Value strategy in London. The research period was from January 1980 to December 2005. Portfolios of stocks are formed annually in July. To be included in the sample for year t, firms must have data for NCAV in December of t – 1, and at least one return observation in the post-formation period. The six-month lag between the measurement of NCAV and return data allows for the delay in publication of individual companies’ accounts, thus ensuring that the financial statements are public information before the returns are recorded. Only those stocks with 2/3 of net current asset value are included in the portfolios. Buy-and-hold portfolios held for one, two, three, four, or five years are constructed. One year holding period returned 31.19% when the market index return over the same period was 20.51%. Two years holding period returned 75.11%, three years 126.27%, four years 191.62% and five years 254.02%. One million pounds invested in equal weighted net current asset value portfolios starting on 1 July 1981 would have increased to 432 million pounds by June 2005. By comparison one million pounds invested in the entire U.K. main market would have increased to 34 million pounds by end of June 2005. Huge difference in the long term.

Conclusion

A review of the studies clearly shows that regardless of the differences in study methodology and the markets where these studies have been done, that stocks meeting Benjamin Graham’s net current asset value criterion outperform a broad market average – and generally notably. Not only did the strategy returned continued superior performance, it also had fewer losing years.

In the next part we look at different value of investors in their practical work using Graham’s method.

More information:

http://www.valuewalk.com/2015/02/benjamin-graham-ncav-returns/

James Montier: ”Value Investing; Tools and Techniques for Intelligent Investment

http://www.valuewalk.com/wp-content/uploads/2015/03/Ben-Graham-Net-Current-Asset-Values-A-Performance-Update.pdf

Tobias E. Carlisle: “Deep Value

http://csinvesting.org/wp-content/uploads/2015/01/Benjamin-Graham-s-Net-Nets-Seventy-Five-Years-Old-and-Outperforming1.pdf

http://www.valuewalk.com/2015/04/original-magic-formula/

http://www.journalofeconomics.org/index.php/site/article/view/151/260

http://weeko.fr/wp-content/uploads/2011/11/Xiao-Arnold-2008-Testing-Benjamin-Graham-Net-Current-Asset-Value.pdf

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