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Posts Tagged ‘Net nets’

Zero Hedge has an article Buy Cash At A Discount: These Companies Have Negative Enterprise Value in which Tyler Durden argues that stock market manipulation has led to valuation dislocations, and gives as evidence the phenomenon of stocks trading with a negative enterprise value (EV):

With humans long gone from the trading arena and algorithms left solely in charge of the casino formerly known as “the stock market”, in which price discovery is purely a function of highly levered synthetic instruments such as ES and SPY or, worse, the EURUSD and not fundamentals, numerous valuation dislocations are bound to occur. Such as company equity value trading well below net cash (excluding total debt), or in other words, negative enterprise value, meaning one can buy the cash at a discount of par and assign zero value to all other corporate assets.

Just as the fact of your paranoia does not exclude the possibility that someone is following you*, you don’t need to believe in manipulation to believe that negative EV is a “valuation dislocation.” Negative EV stocks are often also Graham net nets or almost net nets, and so perform like net nets. For example, Turnkey Analyst took a look at the performance of negative EV stocks (click to enlarge):

Long story short: they ripped, but they were few (sometimes non-existent), and small (mostly micro), which means you would have been heavily concentrated in a few mostly very small stocks, and regularly carried a lot of cash. If you eliminated the tiniest (i.e. the smallest 10 or 20 percent), much of the return disappeared, and volatility spiked markedly. Says Wes:

A few key points:

  1. After you eliminate the micro-crap stocks, you end up being invested in a few names at a time (sometimes you go all-in on a single firm!)
  2. Sometimes the strategy isn’t invested.
  3. The amazing Bueffettesque returns for the “all firms” portfolio above are exclusively tied to micro-craps.

Here’s the frequency of negative EV opportunities according to Turnkey (click to enlarge):

No surprise, there were more following a crash (1987, 2001, 2009) and fewer at the peak (1986, 1999, 2007). If your universe eliminated the smallest 20 percent (the green line), you spent a lot of time in cash. If your universe was unrestricted (the red line), then you’d have had some prospects to mine most of the time. Clearly, it’s not an institutional-grade strategy, but it has worked for smaller sums.

Zero Hedge screened Russell 2000 companies finding 10 companies with negative enterprise value, and then further subdivided the screen into companies with negative, and positive free cash flow (defined here as EBITDA – Cap Ex). Here’s the list (click to enlarge):

Including short-term investments yields a bigger list (click to enlarge):

Like Graham net nets, negative EV stocks are ugly balance sheet plays. They lose money; they burn cash; the business, if they actually have one, usually needs to be taken to the woodshed (so does management, for that matter). Frankly, that’s why they’re cheap. Says Durden:

Typically negative EV companies are associated with pre-bankruptcy cases, usually involving large cash burn, in other words, where the cash may or may not be tomorrow, and which may or may not be able to satisfy all claims should the company file today, especially if it has some off balance sheet liabilities.

You can cherry-pick this screen or buy the basket. I favor the basket approach. Just for fun, I’ve formed four virtual portfolios at Tickerspy to track the performance:

  1. Zero Hedge Negative Enterprise Value Portfolio
  2. Zero Hedge Negative Enterprise Value Portfolio (Positive FCF Only)
  3. Zero Hedge Negative Enterprise Value (Inc. Short-Term Investments) Portfolio
  4. Zero Hedge Negative Enterprise Value (Inc. Short-Term Investments) Portfolio (Positive FCF Only)

I’ll check back in occasionally to see how they’re doing. My predictions for 2013:

  1. All portfolios beat the market
  2. Portfolio 1 outperforms Portfolio 2 (i.e. all negative EV stocks outperform those with positive FCF only)
  3. Portfolio 3 outperforms Portfolio 4 for the same reason that 1 outperforms 2.
  4. Portfolios 1 and 2 outperform Portfolios 3 and 4 (pure negative EV stocks outperform negative EV including short-term investments)

Take care here. The idiosyncratic risk here is huge because the portfolios are so small. Any bump to one stock leaves a huge hole in the portfolio.

* Turn around. I’m right behind you.

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Jon Heller at Cheap Stocks has a great post on The Downside of Net/Net Investing- Lazare Kaplan (LKI). Says Jon:

In July of 2009,we initiated a new position in the $1.15 range. The shares subsequently ran up to $2.50, but in September, trading was halted,and not a share has traded since.

The company has repeatedly delayed filing it’s financial reports with the SEC, due to:

a material uncertainty concerning (a) the collectability and recovery of certain assets, and (b) the Company’s potential obligations under certain lines of credit and a guaranty (all of which, the “Material Uncertainties”).

The NYSE AMEX granted the company several extensions to regain compliance; the latest on April 26th, which gave the company until May 31st to regain compliance with listing standards.

Pretty standard fare in net net world. Here’s where the going gets weird. LKI is a diamond vendor. It seems that it has been in a trading halt because some of its diamonds have gone missing. Quite a few of them. When the going gets weird, as Hunter S. Thompson used to say before he was shot out of a cannon, the weird turn pro: LKI is suing its insurers for $640M. From the May 20 press release:

LAZARE KAPLAN INTERNATIONAL SUES ITS INSURERS FOR $640 MILLION

New York, NY – May 20, 2010 – Lazare Kaplan International Inc. (AMEX:LKI) (“Lazare Kaplan”) announced today that in a federal lawsuit filed on Monday, May 17, 2010, it sued various Lloyds of London syndicates and European insurers for $640 million in damages arising out of the disappearance of diamonds that were insured by the defendants, including consequential damages. The lawsuit alleges that the insurers breached two “all risk” New York property insurance policies, and an Agreement for Interim Payment under which the insurers made a non-refundable interim payment of $28 million to Lazare Kaplan in January of this year. After making the $28 million payment, the insurers abruptly reversed course and refused to acknowledge coverage or to pay any covered losses under the policies. The complaint alleges, among other things, that the insurers, which also issued separate policies to Lazare Kaplan under English law, created a virtual coverage “whipsaw” by denying coverage under the English policies on the ground that Lazare Kaplan does not have an insurable interest in the largest portion of the property at issue while at the very same time asserting under the New York policies that there is no coverage because Lazare Kaplan insured the same property under the English policies. Lazare Kaplan expects to conduct broad-ranging discovery around the world in the course of the lawsuit.

Jon asks the obvious questions:

What happened to the diamonds? Why isn’t the company willing to speak with it’s shareholders on the issue? Why are the insurers unwilling to pay? And again, what happened to the diamonds?

This is why investing in net nets will always be pure Gonzo investing. Even though the situation with the missing diamonds is ugly, if LKI trades again it might be an interesting lottery ticket. With a market capitalization of $21M, success in the $640M suit represents a 30:1 payout.

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Since last week’s Japanese liquidation value: 1932 US redux post, I’ve been attempting to determine whether the historical performance of Japanese sub-liquidation value stocks matches the experience in the US, which has been outstanding since the strategy was first identified by Benjamin Graham in 1932. The risk to the Japanese net net experience is the perception (rightly or not) that the weakness of shareholder rights in Japan means that net current asset value stocks there are destined to continue to trade at a discount to net current asset value. As I mentioned yesterday, I’m a little chary of the “Japan has weak shareholder rights” narrative. I’d rather look at the data, but the data are a little wanting.

As we all know, the US net net experience has been very good. Research undertaken by Professor Henry Oppenheimer on Graham’s liquidation value strategy between 1970 and 1983, published in the paper Ben Graham’s Net Current Asset Values: A Performance Update, indicates that “[the] mean return from net current asset stocks for the 13-year period was 29.4% per year versus 11.5% per year for the NYSE-AMEX Index. One million dollars invested in the net current asset portfolio on December 31, 1970 would have increased to $25,497,300 by December 31, 1983.” That’s an outstanding return.

In The performance of Japanese common stocks in relation to their net current asset values, a 1993 paper by Bildersee, Cheh and Zutshi, the authors undertook research similar to Oppenheimer’s in Japan over the period 1975 and 1988. Their findings, described in another paper, indicate that the Japanese net net investor’s experience has not been as outstanding as the US investor’s:

In the first study outside of the USA, Bildersee, Cheh and Zutshi (1993)’s paper focuses on the Japanese market from 1975 to 1988. 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 an NCAV/MV ratio greater than zero. They found the mean market-adjusted return of the aggregate portfolio is around 1 percent per month (13 percent per year).

As an astute reader noted last week “…the test period for [the Bildersee] study is not the best. It includes Japan’s best analog to America’s Roaring Twenties. The Nikkei peaked on 12/29/89, and never recovered:”

Many of the “assets” on public companies’ books at that time were real estate bubble-related. At the peak in 1989, the aggregate market price for all private real estate in the city of Tokyo was purportedly greater than that of the entire state of California. You can see how the sudden runup in real estate during the bubble could cause asset-heavy companies to outperform the market.

So a better crucible for Japanese NCAVs might be the deflationary period, say beginning 1/1/90, which is more analogous to the US in 1932.

To see how the strategy has performed more recently, I’ve taken the Japanese net net stocks identified in James Montier’s Graham’’s net-nets: outdated or outstanding? article from September 2008 and tracked their performance from the data of the article to today. Before I plow into the results, I’d like to discuss my methodology and the various problems with it:

  1. It was not possible to track all of the stocks identified by Montier. Where I couldn’t find a closing price for a stock, I’ve excluded it from the results and marked the stock as “N/A”. I’ve had to exclude 18 of 84 stocks, which is a meaningful proportion. It’s possible that these stocks were either taken over or went bust, and so would have had an effect on the results not reflected in my results.
  2. The opening prices were not always available. In some instances I had to use the price on another date close to the opening date (i.e +/1 month).

Without further ado, here are the results of Montier’s Graham’’s net-nets: outdated or outstanding? picks:

The 68 stocks tracked gained on average 0.5% between September 2008 and February 2010, which is a disappointing outcome. The results relative to the  Japanese index are a little better. By way of comparison, the Nikkei 225 (roughly equivalent to the DJIA) fell from 12,834 to close yesterday at 10,057, a drop of 21.6%. Encouragingly, the net nets outperformed the N225 by a little over 21%.

The paucity of the data is a real problem for this study. I’ll update this post as I find more complete data or a more recent study.

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