Everybody loves a bargain, but some bargains seem too good to be true. How can we figure out which bargains are for real, and which ones are not?
I rely on time-tested analysis to improve my odds: Analysis that relies more on a company’s history, than on unreliable predictions of future operation. I also look at the background and success of the person who devised the analysis.
There is no better analyst to turn to than Benjamin Graham, the father of value investing and the creator of the stock analyst profession. Mr. Graham created several investing methodologies, which are well documented in his most famous books: Security Analysis, co-authored with David Dodd in 1934, and the Intelligent Investor, which was first printed in 1949.
One of Benjamin Graham’s earliest analyses, created and tested 75 years ago, is the Net Current Asset Value (NCAV) approach. The objective of the NCAV formula is to find the minimum value a company would fetch if it was liquidated. The formula is:
Net Current Asset Value (NCAV) = cash and short-term investments + (0.75 * accounts receivable) + (0.5 * inventory) – total liabilities – preferred stock
The resulting value can then be divided by the number of common shares outstanding to find the NCAV per share. If the current stock price is less than the NCAV per share, the stock is a bargain. However, further analysis is necessary to determine if the company is prosperous.
Companies with earnings deficits or with erratic earnings histories are likely to become less prosperous and should be avoided. Companies in the financial sector should also be avoided, because their balance sheets are not comparable to those of other companies.
Finding profitable companies selling below their NCAV is a simple process. However, not many companies are selling below their Net Current Asset Values. I screened 9,000 companies and found only 12 companies selling below their NCAV. And most of the companies are not very prosperous.
Back in 2003, I used the NCAV formula to find bargain stocks, and in March 2003, 15 stocks clearly qualified. The number of qualified companies dwindled during the year until 12 months later, no stocks qualified. However, during the 12 months when some stocks qualified as bargains, the stocks tripled in price!
Most stocks that qualify as NCAV bargains are small companies, which usually are risky investments. However, Benjamin Graham surmised that any companies selling below their NCAV values carry lower risk: “They are indubitably worth considerably more than they are selling for, and there is a reasonably good chance that this greater worth will sooner or later reflect itself in the market price. At their low price these bargain stocks actually enjoy a high degree of safety, meaning by safety a relatively small risk of principal.”
When should you sell a bargain stock? Benjamin Graham held his stocks until a 50% gain was realized but no longer than two years. Mr. Graham also advocated investing in as many NCAV bargain stocks as possible. The more stocks you invest in, the more you can reduce your risk.