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Buying Stocks Trading Below Net Current Asset Value Vs. Market Timing

Given the fees derived from selling funds to the retail public, financial institutions have little incentive to be bearish on the stock market. These financial behemoths want euphoric investors believing that Wall Street is Lake Wobegon , where every day is a sunny day and all of the stocks are above average. Following the investment strategy of remaining fully invested in stocks and not attempting to time the market does have merit. An academic paper written by Nobel Laureate William F. Sharpe showed the difficulty associated with market timing [i] . Over the study period of 1934-1972, investors who made the decision at the start of every calendar year to be in either cash or stocks had to bet correctly 83% of the time in order to outperform the Standard & Poor’s 500 Index (S&P 500®). That is a difficult hurdle to overcome. Given these poor odds of timing the market with such precision, betting black on the roulette table at a casino in Vegas looks attractive by comparison, with free drinks to boot. Should investors heed the warning of Dr. Sharpe by buying a stock index fund and abandoning any attempt at market timing? Let us take a step back for a moment before going “all in” on stocks. Is there a third way to outperform a broad market average other than choosing cash or an index fund with near-perfect timing accuracy? An alternate investment path to consider is Benjamin Graham’s value investing philosophy for the enterprising investor. Graham showed superior portfolio performance by selecting securities trading below net current asset value (NCAV). The NCAV calculation subtracts all liabilities , including preferred stock, from the current assets (the most liquid assets) on a company’s balance sheet. The NCAV calculation is converted to a per share figure, comparing the value to the company’s share price. If Mr. Market quotes the stock price below the NCAV calculation, it can be considered a buy. The chart below shows the long-term performance of restricting stock purchases to ones trading below NCAV and comparing the results to that of the S&P 500®. (click to enlarge) * Portfolio average return calculations include only stocks trading below 75% of NCAV, with no more than a 5% weighting in any one stock. Dividends and transaction fees are included in all of the calculations. As indicated on the chart, NCAV stocks outperform the index by around six percent on an average annual basis. These stellar results do not require an investor to be permanently in stocks all of the time or to engage in market timing. In approximately three of four years, part of the NCAV portfolio remained on the sidelines sitting in a money market fund. Unlike remaining fully invested in the S&P 500®, investors who restrict their stock purchases to ones trading below NCAV will at times have a portion of capital remaining in cash. These idle time periods out of the stock market due to the lack of NCAV investment opportunities occur in both advancing and declining calendar years. If the stock market moves higher for the calendar year and few stocks trade below NCAV, the portfolio will lag a fully invested index fund. If the stock market has a good year, sitting in cash turns out to be a mistake. As indicated in the chart above, temporary time periods where the NCAV remains idle in cash does not result in long-term underperformance in comparison with the S&P 500® broad market average. Embracing this form of deep value investing has the added benefit of being agnostic regarding the direction of the overall stock market. Market timing is not an issue when it comes to purchasing only stocks trading below NCAV. Investors can ignore what prognosticators on Wall Street think stocks are going to do in the future. The efficient market hypothesis implies that greater portfolio volatility must be accepted in order to achieve a greater average rate of return. There is truth to this argument. Markets are generally efficient, and the NCAV portfolio does fluctuate more than the S&P 500® does. If our measure of risk changes from portfolio volatility to worst-case return, a wrinkle in the market efficiency gospel bubbles up to the surface. We know from behavioral finance research that losses are far more painful to investors than is the satisfaction derived from an equivalent-sized gain. Using a worst-case annual return as our alternate measure of portfolio risk makes sense if money lost is more important to investors than money won in the stock market. As shown in the table below, using the worst annual stock market loss as our measure of portfolio risk, the NCAV portfolio does not suffer through as bad of a drawdown. For many years over our study period, the NCAV portfolio was not fully invested in stocks. When a portion of capital remains on the sidelines for the NCAV portfolio, it makes sense that a worst-case calendar year loss is less severe in comparison with a fully invested stock index fund, such as the S&P 500®. As already shown, this more limited exposure to stocks by investing only in securities trading below NCAV does not result in the average compounded return falling below the S&P 500® over the long term. (click to enlarge) Market timing is an exercise in futility for individual investors. As I pointed out in a previous blog , focusing on individual stock selection using a time-tested value-investing criterion, such as NCAV, is a far more productive use of an investor’s time rather than attempting to figure out the future direction of the overall stock market. Stocks trading at a deep discount to NCAV not only outperform the market over the long term but also benefit from limited downside losses when knee deep in a bad year for stocks. Although not shown in the chart, the second and third worst annual returns of the S&P 500® had a deeper drawdown than the index’s matching year NCAV portfolio return did. A patient investor willing to endure temporary time periods when deep value investing falls out of favor can still do well over the long term. This holds true without the additional requirement of prescient forecasting on the future direction of stocks. [i] Financial Analysts Journal. “Likely Gains from Market Timing” by William F. Sharpe – March/April 1975, Volume 31 Issue 2 pp. 60-69.

A Dim Light Shines Out Of The Deep Value Investing Cave

One tea leaf indicator that is used to get a sense of the future direction of the overall stock market is the number of stocks moving down in price. More stocks are now trading below their 200-day moving average than above it. Some investors might view this negatively, but an increasing number of stocks falling in price is a telling sign that brighter days lie ahead for deep value investors. Falling stock prices are a necessary but insufficient condition for deep value stocks to bubble up to the surface. This may seem counter-intuitive to investors who desire an ever-rising stock market, but for value investors, the opportunity to find true bargains increases following a significant market decline. One of Benjamin Graham’s more aggressive value investing strategies was to purchase stocks trading below their net current asset value . If a stock was beaten down in price so far to where it traded below what a private owner would value it upon liquidation, investors could take advantage of the anomaly and scoop up the bargain. Holding a deep value stock until the market price exceeds its net current asset value has historically produced excellent returns over the long term. An ever greater number of stocks trending below their long-term moving average is consistent with a future environment conducive to deep value investing. Some percentage of stocks trading below their moving average will eventually reach a valuation level consistent with Graham’s original concept of a true bargain. The chart below shows the percentage of net current asset value stocks that experienced a significant price decline before making their way into a deep value portfolio. (click to enlarge) Source: V. Wendl, The Net Current Asset Value Approach To Stock Investing , (2013): p. 184 . As indicated in the chart, nearly 80% of all stocks lost money over the previous five-year period before entering the net current asset value portfolio. This holds true in both bull and bear market years over the 50-year-plus study period. As more stocks join the growing herd trading below their 200-day moving average, a certain percentage of them will fall to such an irrationally low price point that deep value investors might take an interest in them. Waiting for stocks to reach a true bargain basement price level requires patience. It is a process that unfolds gradually over time. If most stocks are in a general decline , as they are currently, the evidence shows that some will continue to fall in price to a price point below net current asset value. The chart below shows the performance of a typical net current asset value stock over the five -year period of 1955-2008 before it entered the deep value portfolio. The chart is restricted to rolling five-year time periods when the overall stock market was in decline. There existed 10 overlapping five-year periods over the past 50-plus years when the stock market dropped in value. (click to enlarge) As indicated in the chart, more than half of the stocks declined in price by more than 60% before entering the net current asset value portfolio. Over a typical five-year losing period in stocks, the ones trading below liquidation value experience close to seven times the price drop in comparison with the overall market. This unfolds over years, not months. Mr. Market is at times tenacious, forcing deep value investors to wait a long time before labeling certain stocks a true bargain. Remaining on the lookout for a crack of light peering through the financial engineering monstrosity blocking our view of true bargains is the hallmark of a true disciple of Graham’s teachings. Share this article with a colleague

Benjamin Graham’s Defensive Versus Enterprising Investor Performance Over The Dismal Decade Of 2000-2009

In a previous blog (see Benjamin Graham’s Value Investing versus the Robo-advisor ), I illustrated included a chart outlining the performance of the United States stock market over the course of every decade covering during the past 100 years. Stock performance over the past decade (2000-2009) was not only a net loser, including the paltry dividend income received, but it even underperformed the 1930’s depression era. If the typical investor had known this information at the start of the year 2000, I’m confident he or she would have remained on the sidelines in cash. Let’s assume that Mr. Market held a gun to your head, forcing you to buy and hold stocks over the coming decade. Further assume that you knew the performance in stocks would be terrible. Given few good options against the wrong end of Mr. Market’s gun, one might find some solace by turning to the value investing teachings of Benjamin Graham. How did value stocks perform over the dismal decade from 2000-2009? In Graham’s first edition of The Intelligent Investor , he outlined several approaches to stock selection. One approach was designed for the defensive investor, involving the selection of only stocks that met a conservative set of buying criteria with safety of principal as the primary concern. Another stock selection approach was designed for the more enterprising investor, one willing to assume more risk with the hope of gaining a larger profit. The defensive investor approach to stock selection recommends the following buying criteria: Benjamin Graham’s Stock Selection Rules for the Defensive Investor 1) Diversify your portfolio across at least 10 different securitie s, with a maximum of about 30. Over the decade from 2000-2009, we’ll review the range of portfolio returns for both a “10” and a “30” stock portfolio that met all of Graham’s criteria for the defensive investor. 2) Each company should be large, prominen t, and conservatively financed. We’ll put a company on the defensive investor list only if it had a market cap of at least $350 million. That’s about the size of a larger company in 1949 on an inflation-adjusted basis when Graham published The Intelligent Investor. Graham defined a company as “prominent” if it ranked in the upper-quarter to upper-third in size within a particular industry. We’ll give as many companies the benefit of the doubt as being “prominent” provided they were in the upper-third in size within a particular industry. A “conservatively financed” company according to Graham had total debt under half of its total market capitalization. We’ll screen out all stocks that are leveraged beyond this defensive-investor threshold. 3) Each company should have a long record of continuous dividend payments. The first edition of The Intelligent Investor was published in 1949. Graham was reluctant to exclude companies on the defensive list that discontinued their dividend payments during the 1931-1933 period. After all, that time period occurred shortly after the Dow Jones Industrial Average declined 85% in value, including the dividend income received. Graham must have felt that keeping stocks off of a defensive list simply because the dividend payments were temporarily discontinued during that awful time period was a bit restrictive. As a compromise, Graham allowed all companies to be on the defensive stock list provided that a continuous dividend payment took place on every stock back to the year 1936. That’s a historical 13-year dividend-paying history from the date of Graham’s book publication. We’ll follow a similar approach and require all stocks on our defensive list to have paid an uninterrupted dividend over the previous 13-year period. 4) The price paid for a stock should be reasonable in relation to its average earnings. Graham recommended purchasing only stocks that had a price-to-average-earnings ratio below 20. Average earnings was calculated using the previous five years of data from the income statement of each public company. We’ll follow the same approach and keep off of the defensive list any expensive stocks with a price-to-average-earnings ratio greater than 20. The charts below shows the performance of the best-and worst-performing stocks meeting Graham’s defensive stock criteria covering the worst-performing decade over the past century. The number of stocks at the start of the year 2000 that met all of Graham’s defensive selection criteria totaled 111. Ten Best – and Worst – Performing Defensive Stocks, Including Dividend Income… (click to enlarge) Thirty Best – and Worst – Performing Defensive Stocks, Including Dividend Income… (click to enlarge) As already mentioned, Graham recommended holding between 10 and 30 stocks that met the rigorous defensive stock criteria. As shown in the two charts above, quite a bit of variation in performance existed depending on what stocks were chosen from the defensive list. Diversifying across 30 defensive stocks instead of only 10 improved your worst-case portfolio return over the dismal decade, but it also reduced your potential best-case return. In general, following Graham’s value investing instruction of purchasing a number of defensive stocks stood a good chance of outperforming the broad stock market average over the course of the worst decade in history. Benjamin Graham’s Stock Selection Rules for the Enterprising Investor Graham outlined four broad categories available for the enterprising investor. 1) Buying in low markets and selling in high markets. 2) Buying carefully chosen “growth stocks” 3) Buying bargain issues of various types 4) Buying into “special situations” Choices one and two from the list are highly problematic to implement in real time. Many analysts on Wall Street have attempted to forecast the overall movement of the stock market or the future earnings of a particular company, with mixed results. Option four is a technical branch of investment, and according to Graham, “…only a small percentage of our enterprising investors are likely to engage in it.” We’ll put the microscope over choice number three on the list and look at the performance of buying only bargain issues over the past decade when stock returns scraped the bottom of the barrel. Graham’s bargain approach to stock selection involved either purchasing a stock that traded at a price below some multiple of estimated earnings or selecting securities priced below net current asset value . In a previous blog, we showed how difficult it was to estimate future earnings (see ” Does Earnings Growth Matter When it Comes to Stocks Trading below Liquidation Value? “). Given the challenges of forecasting company earnings, we’ll limit ourselves to only selecting stocks for the enterprising investor list that traded below net current asset value. Stocks that made it on to the enterprising investor list were purchased at a market price below 75% of net current asset value. No more than a 5% weighting was allocated to any one stock. If few stocks could be found meeting our rigorous value criterion, the balance of cash remained in U.S. Treasury Bills. The chart below compares the performance results of Graham’s enterprising investor approach to stock selection with the defensive approach over the dismal decade (2000-2009). Annual rebalancing took place once at the beginning of every yea r, and the capital gains taxes was assumed to be zero. Armed with the knowledge that equity performance over the previous decade (2000-2009) was horrible, you might think a defensive investor had the upper hand over an enterprising investor. In an environment hostile towards stock investing, one might assume that being as conservative as possible would be the better route to take. As illustrated in the chart below, the results are counterintuitive. (click to enlarge) Over the course of the dismal decade, bargain issues using the enterprising approach toward stock selection outperformed defensive stocks by a wide margin. Even if an investor managed to select the top-performing 10-30 stocks that met Graham’s defensive criteria, the portfolio still wouldn’t have outperformed a portfolio of stocks purchased below net current asset value. Negative-return years were more prevalent for the enterprising value investor, but not by much. Aggressive investors endured two negative-return years over the course of the dismal decade, while defensive investors endured only one. A chapter in the book, The Net Current Asset Value Approach to Stock Investing , reviewed the performance over the course of the dismal decade (2000-2009) using a maximum 10% portfolio weighting in any one net current asset value stock rather than the 5% weighting shown in the chart from above. Either way, the average annual return results are about the same and clobber the defensive approach to stock investing. Assuming an investor is willing to stomach greater monthly volatility, it pays to be aggressive even if the overall market provides few value investing opportunities as it did over the course of the period from 2000- 2009 .