Net Current Asset Value Strategy: Is 30% Per Annum Returns Over 25 Years Possible?
Is there a simple and powerful investing formula that could make you rich?
That is the question I have been asking myself lately while diving deep into the literature surrounding Benjamin Graham’s Net Current Asset Value (NCAV) Strategy.
According to several studies, this strategy returned more than 30% per annum over 25 years.
For context, this turns a principal of $10,000 to over $7 million after 25 years.
TL;DR: Grow Your Wealth With The NCAV Strategy
The NCAV formula is very easy to implement.
All you need to do is buy shares that are trading at less than two-thirds of the net current asset value and hold them for a specified period.
Market Cap < ⅔ Net Current Asset Value
Sounds a bit too good to be true right?
But first, let’s try to understand the strategy and see if such returns can still be replicated in our portfolios.
Benjamin Graham: The Father Of Value Investing
You may not know who Ben Graham is, but you probably know his most famous student: Warren Buffet.
To say that Ben Graham’s work shaped the investment landscape today is an understatement.
His magnum opus, Security Analysis, which was written in 1934, is a required read for many value investors.
His other book, The Intelligent Investor, written in 1947, is perhaps the most popular investment-related book in the world.
The NCAV Formula
This super formula which I mentioned earlier was developed by Ben Graham in his book, Security Analysis.
One variation of the formula is this:
Market Cap < ⅔ Net Current Asset Value
Graham argued that we should buy stocks that had market capitalisations less than two-thirds of the net current asset value.
He also advised buying shares from companies that had satisfactory earnings and are in sound financial health. Graham would hold these shares until they returned at least 50%, or after he had held them for two years.
Quite a simple strategy, right?
Before we get to its performance, let’s break down the formula’s constituents.
Market Capitalisation (Market Cap) is obtained by taking the number of shares outstanding and multiplying it by the share price.
Market Cap is one way to determine the size of the company relative to its peers.
Net Current Asset Value
Net Current Asset Value (NCAV) is calculated by taking Current Assets and deducting Liabilities.
NCAV = Current Assets – Liabilities
In case you’re wondering:
- Current Assets are cash and other assets that are expected to be converted to cash within a year. They are usually made up of Cash, Inventory, and Receivables. Inventory includes raw materials, components of products, incomplete products, as well as finished products. Receivables are mainly money that others owe to the company.
- Liabilities are simply what the company owes to other parties, which could include suppliers, employees and other parties that they do business with.
How Does The NCAV Strategy Work?
NCAV is simply an approximation of the liquidation value of a firm, or how much a firm is worth if it liquidates.
In a hypothetical liquidation, Current Assets of the firm (cash, inventory etc) are used to pay off all its liabilities (what the company owes).
Whatever value is left, would thus be what remains for the shareholders for the firm.
If a company’s market capitalisation is less than this liquidation value, it could mean that the shares are undervalued and that the share prices should increase over time.
As some investors have put, such companies would be worth more dead than alive.
Additionally, Ben Graham stipulated that the Market Cap should be less than two-thirds of this liquidation value. This was so that the investor would be provided with a margin of safety.
This safety buffer reduces the chances that we make a bad investment, while potentially increasing our returns.
This might go against the grain of the common wisdom that higher returns mean that you need to take higher risks, as you are taking less risk but with the potential for higher returns by applying a margin of safety.
For some of you who might have read our other articles, you might be wondering why we are not taking into account the fixed assets of a company.
Unlike current assets, fixed assets would be used or converted to cash more than a year later and are much less liquid.
These assets could include buildings, machinery, land, and even intangible assets. Although some of these assets can be sold off for cash, it would take much longer to do so and you most likely would need to sell them at a lower price.
Performance Of The NCAV Formula
This is probably the part that you are most excited about… multiple studies and back-tests have shown that this formula works exceedingly well.
Tobias E. Carlisle, a famous deep value investor, back-tested this formula from 1983 to 2008, and found that it returned on average, 35.3% every year for 25 years. This would have turned $10,000 in 1983 to more than $18 million in 2008.
Another famous value investor, James Montier, conducted a back-test which purchased stocks from 1985 to 2007 in all developed markets globally and found that it returned an average of 35% as well.
Henry Oppenheimer, professor of finance at the State University of New York, similarly found an average return of 29.4% per year from 1970 to 1983. A $10,000 investment in this strategy would have increased to $285,197 within 13 years.
Combining this study with that of Tobias E, Carlisle, this would have returned almost 30% annually from 1970 to 2008, a period of 38 years. To illustrate, $10,000 invested in 1970 would have returned almost a mind-boggling $214 million by 2008.
Criticisms Of The Strategy
At this point, the sceptic in you might be screaming that this is too good to be true.
Indeed, this strategy, though championed by many strong proponents of value investors, has strong criticisms from other famous investors as well.
In fact, Warren Buffet has said that such a strategy is foolish and gave two criticisms:
- First, he argued that for these shares to be trading at such a large discount relative to its NCAV, the business fundamentals of the company would probably be bad.
- Second, he argued that the share prices might only start to rise much later only, and so you would be much better off investing in somewhere else first.
Seth Klarman, another famous value investor, had also warned that there are businesses which rapidly consumes their current assets. This means that the NCAV would deplete very quickly and that soon the share prices might not be trading at a discount to its NCAV.
James Montier, also found that the universe for net-net stocks globally is relatively few (median of 65 globally) and was concentrated in companies with very small market caps (median of US$21 million). This creates two issues:
- First, there may not even be enough stocks for you to invest in to reap the full benefits of the formula. Sure, you can invest in just a few stocks, but that would be quite risky as your portfolio would be very volatile. Even Ben Graham admitted that this was a flaw of the strategy and that he had a hard time finding such stocks that fit the criteria when the markets were doing well.
- Second, these small to micro-cap stocks tend to be very thinly traded with low liquidity, which would make it challenging and more expensive to invest in such stocks as compared to stocks from larger companies.
Additionally, you would need a cast-iron gut to trade these stocks as you would be essentially investing in companies you most likely would have never heard of and are not doing too well.
The strategy has also been found to be more volatile, so you would need to be disciplined and stick with the strategy despite wide swings in share prices.
Lastly, there is that famous phrase that past returns are not indicative of future results.
Famous investors such as Warren Buffet and Aswath Damodaran have criticised such strategies for not diving deep enough into a company’s fundamentals.
Some investors may also feel uncomfortable putting their money in shares based on just a simple formula, without much research or analysis.
Despite the many valid criticisms of Ben Graham’s NCAV investing, there are still many adherents of it who point to the multiple back-tested studies to prove the potency of the strategy. Indeed, this is one of the oldest investing strategies, dating back to 1934, with a track record of 85 years.
Ultimately, I do think that every investor needs to apply a strategy that best fits their risk appetite and financial goals. This strategy might have worked well for some investors, but it doesn’t mean we should all follow suit.
Professor Damodaran, known as the Dean of Valuation, suggested that apart from just mere financial analysis, we also need to have faith in our investment strategy. And for some of us, it is hard to find faith in a mere formula.
The NCAV strategy is only of many investing strategies that we can apply.