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lundi 31 janvier 2011

Graham NNWC : an intersting post from Griener Blog.


Screen #1: Graham NNWC

The intent of this entry is to briefly outline the approach and logic behind Graham's Net Net Working Capital (NNWC) methodology and provide a brief overview of the results of the NNWC screen .  The results of the NNWC screen are often referred to as "cigar butts".  I, however, prefer to refer to these companies as deep value investments.

The Methodology:
One of the important lessons you can learn from Benjamin Graham is that the balance sheet of a company is where you will most likely find your margin of safety.  Security analysts who are skilled at evaluating asset classifications and liquidity scenarios often enjoy substantial returns over those who merely measure investment opportunities via cash flow or multiples.  The primary logic behind the NNWC methodology, is as follows: highly liquid assets, discounted for risk, offer investors, a buffer against uncertainty.

Without having in-depth information of asset classifications and company level accounting policy, it is often difficult for analysts to evaluate whether a company is really trading at a discount to book value.  In order to get around this fact, Graham developed the NNWC calculation to protect himself from the uncertainty associated with asset liquidation values, which is why he focuses primarily on working capital.  According to Graham,  NNWC is calculated as follows:

NNWC = Cash and Short Term Investments + (75% x Account Receivable) + (50% x Inventory) - Total Liabilities

The implied assumption here is that cash and short terms investments carried at book value are worth 100% of their carrying value in a timely liquidation (fair assumption).  It also assumes that receivables should be discounted 75% and inventories 50% under an orderly liquidation.  After you subtract out the total liabilities outstanding to the firm, you should be left with a deeply discounted value of equity that you can then use as a measure of reasonable value against the market capitalization.

Many argue that under a forced liquidation, receivables and inventory are worth substantially less than 75% and 50% respectively.  Variable risks can be accounted for in the next step to the NNWC methodology.

Once you have completed the Graham formula for NNWC, next you will need to define a comparative measure of value so you can determine whether or not this NNWC value provides any opportunities for investment.  According to Graham, the best method of doing this is to take the market capitalization value and divide it by the NNWC value.  This will then provide you with a ratio of a market value of equity over discounted book value of equity.  Traditionally Graham invested in companies that offered a 33% margin of safety.  Put another way, if the ratio of market capitalization to NNWC is less than 66%, then the target firm is a promising investment prospect.

For those who have the capacity and the resources, it is extremely useful to have a ongoing NNWC screener.  During the recession beginning in 2007, market valuations fell so far out of alignment that many firms fell into the deep value realm without any warrant or logic.  Those who had a continuous screen, were able to capitalize from these market inefficiencies.  If  for some reason you suspect that the book valuations are going to be impaired or are falsified, it is always a smart idea to adjust your formula to discount assets even further than required by Graham.  You can also demand a larger discount than the 66% implied by Grahams approach if the market is turbulent or the company is unprofitable.

NNWC Screen:
My current NNWC screen for the week has resulted in the following results:
  • Endwave Corporation (Nasdaq: ENWV)
    • Description: radio frequency products
    • Margin of Safety: ~66%
    • EBIT: -6.0 mm
    • EBITDA: -5.1 mm
    • NI: -9.5 mm
  • Neurometrix Inc. (Nasdaq: NURO)
    • Description: medical devices
    • Margin of Safety: ~58%
    • EBIT: -14.7 mm
    • EBITDA: -14.2 mm
    • NI: -12.3 mm
  • New Dragon Asia Corp.(AMEX: NWD)
    • Description: flour milling in China
    • Margin of Safety: ~69%
    • EBIT: -11.7 mm
    • EBITDA: -9.7 mm
    • NI: -14.6 mm
  • Ninetowns Internet Technology Group Company Limited (Nasdaq: NINE)
    • Description: enterprise software in China
    • Margin of Safety: ~44%
    • EBIT: -12.3 mm
    • EBITDA: -10.0 mm
    • NI: -1.3 mm
  • Peerless Systems Corp. (Nasdaq: PRLS)
    • Description: licensing rights for imaging technology
    • Margin of Safety: ~88%
    • EBIT: .8 mm
    • EBITDA: .8 mm
    • NI: 4.1 mm
Additional Commentary:
Before selecting an investment prospect based on the NNWC screen, it is critical to conduct proper due diligence.  I do not advocate buying a diversified basket of NNWC stocks as a method of diversifying away from firm specific risk.  The worst thing you can do is to buy something on a criteria without having a thorough understanding of the potential risks involved with said investment.

When looking at the list above you will notice than many of the firms are operating at a loss.  These ongoing losses will certainly eat into cash and liquid asset balances.  Under such circumstances it is critical to conduct a cash burn analysis to at least gather a relative proxy of how long it will take management to burn through the margin of safety. Conversely, businesses with potential catalysts offer substantial opportunities for enterprising investors.

Another key point to note is that many of these firms are in the deep value position for a reason.  Some companies are cheap by err, while others are cheap on a NNWC basis because they sell redundant or obsolete products, retain awful personnel and management, or have unmanageable sales, general, and administrative expenditures.  As a minority interest investor, make sure to identify any and all known risks.  Again, just because Ben Graham deep value stocks are cheap, does not mean that they are without risk.

Additional Resources:
Old School Value
The Fool
Guru Focus
Value Bull

Disclosure:  The author of this entry does not have a financial interest in any of the firms listed above.  This analysis is not representative of a recommendation to buy or sell any securities.  This entry is intended to be used solely for educational purposes.

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