Price on Value
October, 2000

The NCAV Strategy of Benjamin Graham

John Price,  Ph.D.

Most investors realize that book value is a poor method for deciding whether to buy stock in a company. But Benjamin Graham suggested a variation that can give a boost to your profits.

The common equity or net worth of a company is defined as the assets of a company minus the liabilities. (For simplicity we assume that there are no preferred shares.) Dividing the result by the number of shares outstanding gives the book value. It is the amount that appears in the accounts or the books on a per share basis if the assets were sold and all liabilities were paid.

Comparison of the share price with the book value is a ratio that is often quoted. For example, Dell has a book value of $2.06. Since its current price is $36.50, its price-to-book ratio is 17.7. A completely different company with a high price-to-book ratio is Amazon.com. Its book value and current price are $0.77 and $45.00 and so its price-to-book ratio is 58.44. In contrast, the book value and price of Borg-Warner are $39.61 and $33.50 so its price-to-book ratio is 0.84.

Examples such as these show that the price-to-book ratio on its own is a poor indicator of value. It can, however, be a useful guide when it is tracked over time for an individual company or when it is used as part of a comparison between companies in the same sector.

Instead of using book value, Benjamin Graham suggested that we disregard non-current assets in the calculations. In 1973 in his book The Intelligent Investor he wrote, It always seemed, and still seems, ridiculously simple to say that if one can acquire a diversified group of common stocks at a price less than the applicable net current assets alone-after deducting all prior claims, and counting as zero the fixed and other assets-the results should be quite satisfactory.

Specifically we define the net current asset value NCAV of a stock as the current assets less all liabilities with the calculations done on a per-share basis. Usually the NCAV is negative. Occasionally it is positive. Even more rarely it exceeds the share price. These are the shares that Graham suggests buying.

Reporting in the Financial Analysts Journal in 1986, Henry Oppenheimer described a study over the period 1970 to 1983 involving the NCAV. Each year a portfolio was formed consisting of companies that had a share price no more than two-thirds of its NCAV. After each twelve months the portfolios were liquidated and new ones formed.

The results were remarkable. If $10,000 was invested in the NCAV portfolio at the start of the study, by the end of 1983 it would have grown to $254,973. In contrast, if the same amount of money was invested in benchmark portfolios selected from the New York Stock Exchange and the American Exchange it would have grown to $37,296. If invested in a small firm index, it would have grown to $101,992.

In percentage terms, this represents annual growth rates of 28.3 percent, 10.7 percent and 19.6 percent.

A parallel study with similar results was carried out by Joseph Vu using stock from Value Line over the period 1977 to 1984.

How easy are these stocks to find? Oppenheimer found about 50 each year during his study. But in today's overheated market there are none. (A few year's ago I had some success with Intertan and Blair using this method.)

The type of companies that tend to be picked up using this method are those with a lot of inventory but which are having a tough period with depressed sales and little or no earnings. If the company pulls through, then there will be quite a boost in earnings and hence the share price. If it doesn't, it goes into bankruptcy and the inventory is sold off at bargain prices.

A company that could meet the NCAV criterion in the foreseeable future is OfficeMax. Its current assets are $1,528m while all its liabilities are $1,159m. Since the number of outstanding common shares is 120.5 million, this gives it a NCAV of $3.06. Its current price is $4.70 leading to a price-to-NCAV ratio of 1.53. Back in July it had a low of $3.75 so its price-to NCAV ratio was 1.2. This is still quite a long way from the required level of 2/3 or even 1. But in a less over-heated market it is easy to imagine that it could have dropped to those levels.

OfficeMax is typical of the type of companies that could satisfy Graham's NCAV criterion. They are usually companies that have a large amount of inventory but have undergone a major drop in earnings. If they manage to turn around, then the inventory will be able to be sold for its proper value. But if they do not recover, the inventory is likely to be sold for a few cents on the dollar.

In the case of OfficeMax, in 1996 it had EPS of $1.04. Now it is $0.09. Last quarter the company suffered a loss of $0.22 per share. Over that time the share price has dropped from a high of $17 in 1998 to around $4.00. Its inventory makes up 83 percent of its current assets. This is an acceptable level for a viable office supply company. But it becomes a worry when the company is finding it hard to make a reasonable return on its equity.

Buffett's initial apprenticeship with Benjamin Graham involved looking for companies satisfying the NCAV and related criteria. They were referred to as cigar butts-companies that had a few "puffs" left in them. One drawback was that their stock prices tended to be very volatile. At a recent annual meeting of Berkshire Hathaway Buffett explained that they would hold two or three hundred cigar butts in order to smooth out the volatility. He continued by saying that it was no fun waiting to see if a company was going into bankruptcy or was going to make a substantial profit.

Perhaps, as Buffett said, it was no fun, but Oppenheimer's and Vu's studies showed that, at least in the past, you could make a very healthy return using this strategy.
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In next month's article I will look at another strategy suggested by Benjamin Graham. It is slightly more involved than the NCAV strategy above but again gives a very good yield.