Fundamental NCAV- Chapter XLIII of the 1934 Edition of Security Analysis

Today we have a guest post by Daniel Rudewicz, who is the co-founder of Furlong Samex LLC, a deep value investment partnership based on the principles of Benjamin Graham.

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Fundamental NCAV- Chapter XLIII of the 1934 Edition of Security Analysis

Benjamin Graham’s Net Current Asset Value (NCAV) method is well known in the value investing community. Studies by Greenblatt, Pzena, and Newberg (1981); Openheimer (1986); and Vu (1988) have all shown that the NCAV method of selecting stocks has outperformed the market significantly.

With the advent of technology and screening programs, NCAV opportunities became far less common. The recent market turmoil has left a large number of stocks trading below NCAV and offered investors the opportunity to apply Graham’s teachings on the subject.

In this column we decided to go back to the fundamentals: we are revisiting Chapter XLIII of the 1934 Edition of Security Analysis by Graham and Dodd.

At the beginning of the chapter Graham outlines three main points:

1. NCAV roughly estimates liquidating value
2. A large number of stocks sell for below NCAV and thus liquidating value
3. A stock selling persistently below liquidation value is illogical. There must be serious errors being committed (a) in the judgment of the stock market; (b) in the policies of the company’s management; or (c) in the attitude of the stockholders toward their property.

The liquidating value of an enterprise is the value an owner could get by selling it on a going-concern basis or by turning the assets into cash in piecemeal fashion. These scenarios are far more common in the private marketplace than they are with publicly traded companies.

When calculating liquidation value all liabilities on the books are to be deducted at face amount. The value of the assets depends on their character. Below is a replication of the asset value schedule from the book:

“In the typical case it may be said that the noncurrent assets are likely to realize enough to make up most of the shrinkage suffered in the liquidation of the quick assets.”

By applying the liquidating schedule to White Motor’s balance sheet, Graham illustrated that the current market price of $8 ($5.2MM total Market Capitalization) was far less than the current-asset value of $34/share or the estimated liquidating value of $31/share. (It is interesting to note that Graham applied a 20% value to deferred charges and Goodwill.) In fact, White Motor was selling below the cash-asset value of $11/share.

Graham concluded that stocks selling below NCAV were worth more dead than alive. Justifying the selling of stock at below NCAV is often done on the basis that a company has no intention of liquidating. Graham stated if a stock was selling below liquidating value either the price is too low or it should be liquidated. An investor should draw two conclusions from this:

1. At a price below liquidating value stockholders should question weather it makes sense to continue as a going concern
2. Management should take all step necessary to correct the gap between market price and intrinsic value (liquidating value) and justify to shareholders their reasons to continue the business

There are no sound reasons for a company to be selling below its liquidation value. For a stock to arrive at a price below NCAV the company is not likely to have a satisfactory trend in earnings. The risk in purchasing stocks below NCAV is that the assets may be dissipated to a point when the intrinsic value is no longer above the price paid. This does happen but Graham suggested looking for the following potential developments:

1. Creation of an earning power commensurate with the assets caused by a general improvement in the industry or a favorable change in operating policies
2. A sale or merger
3. Complete or partial liquidation

Graham goes on to offer several examples. When buying stocks below NCAV an investor should lean towards companies with a fairly imminent prospect of the developments listed above. Stocks that have been dissipating assets quickly and so no signs of changing should be avoided.

Graham then states that investment bargains are common stocks that are:

1. selling below liquid asset values or NCAV
2. no danger of dissipating these assets
3. have formerly shown a large earning power on the market price

Finally, Graham says it better than I ever could:

“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”

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