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This suggests the presence of many publicly traded zombie firms: undead firms that will bite the dust as interest rates rise. What could be worse than owning a money-losing firm with eroding sales and a large debt load during a period of rising interest rates? Identifying the best net-nets, then, requires us to pass on any company that has a NYSE listing. American net-net investors may be dismayed by this rule.
Quantitative ranking criteria While all firms must meet every check in the core criteria, ranking criteria is optional. The first set of ranking criteria, quantitative ranking criteria, focuses on factors that provide a statistical boost in returns. The more of these criteria a stock meets, the better it is as a statistical bet.
Investors who aim to select the best performing net-nets on a statistical basis should focus on firms that meet as many of these criteria as possible. Share buy-backs One of the best ways for net-net investors to boost returns is by selecting firms that are buying back shares. Share buy-backs are beneficial for two reasons.
Management teams that fear for the survival of their company will not waste cash on buy-backs if they feel that the firm may require significant funds to stay in business. If management spends cash on buy-backs when the business faces a drawn-out business problem, less cash will be on hand to maintain operations. Money spent on buy-backs therefore represents money that management feel they can spend without jeopardizing the survival of the firm.
Buy-backs are also beneficial because they increase per-share value by increasing the ownership percentage that each share represents. When shares are undervalued, management may use company funds to repurchase shares in order to reward remaining shareholders. When management buy back shares while they trade below NCAV, they significantly boost shareholder value. No dividends As highlighted in the discussion of net-net stock studies, dividends have a powerfully negative effect on net-net stock returns.
Net-nets that pay a dividend provide much lower average yearly returns than their non-dividend-paying peers. If dividends pull down returns so much, why not move this requirement to core criteria? We prefer to keep this criterion optional simply because some investors prefer to receive dividends to fund everyday expenses. Income investors should be aware of the trade-off they make in order to receive dividends. Insider buys Insider buying is a powerful indicator. Insiders almost always buy shares to profit through capital gains.
The more cash spent on share purchases, and the more insiders who are buying, the better the company looks as an investment. When setting the limit, we need to strike a balance between statistical returns and stock availability. Smaller firms perform much better as a group, so focusing on them makes sense.
Focusing on the best net-nets from a statistical point of view means avoiding firms with a meaningful amount of debt. The deeper the discount, the larger the return. As discussed, the relationship is not as strong as true-blue value investors would like it to be, which is why we demanded a smaller hurdle in core criteria. Still, focusing on the best performing net-nets means investing in firms that have deeper discounts, ideally as deep as possible.
We demand a much stricter standard in ranking criteria than we did in core criteria. Qualitative ranking criteria Investors who want to focus on strong quantitative criteria now have the tools needed to make smart investment decisions. By focusing on a group of net-nets that meet both the core and quantitative ranking criteria, investors can put together a strong portfolio which should provide great market-beating returns over the long run.
But not all investors are satisfied with maintaining a quantitative stance. This makes it tougher to start quantitative investing in the first place or stick to it over the long term. Math, in terms of historic performance and statistical expectations, does little to comfort an investor when a strategy fails to perform over a period of time. To address these problems, almost all investors employ qualitative checks.
This means identifying solid qualitative criteria, and maintaining strict standards when assessing a firm. The qualitative ranking criteria pulls together some of the factors I consider particularly fruitful when applying qualitative checks.
Rather than develop this set of criteria from scratch, I lifted all of it from the writings of outstanding investors such as Buffett, Graham, Seth Klarman, and Peter Lynch. It makes sense to adopt the criteria espoused by gifted investors when those criteria are relevant to net-nets. Catalyst When selecting net-nets, one of my favourite criteria is a solid catalyst. When a net-net firm is put up for sale, transactions typically take place at or near NCAV, which has a direct impact on the stock price.
Catalysts are only probable events, never certain. As Buffett pointed out, growth is a source of value. Even if growth slows or stops after an investor purchases the stock, the investor will still benefit from any increased NCAV gained after purchase.
High-quality earnings growth is more lucrative than a mere bump up in price to reflect full NCAV. Continued profit growth can cause investors to shift from seeing the firm as a mere net-net to seeing it as a growth company. Investors smart enough to buy early and hang on as the scenario unfolds stumble onto a Shelby Davis double play.
This results in fantastically large stock price appreciation. But smart investors also demand an equally rapid increase in free cash flow to help management fund operations, and they avoid firms with weak customer credit standards. Sometimes growth in revenue and shrinking losses highlight an exceptional buy.
As revenue increases, the firm finds it easier to cover fixed costs, which eventually leads to rapidly growing profits. Firms that shift from net-net to growth stock are as rare as they are profitable. More often than not a firm will seem attractive from a growth perspective only to see that growth fizzle out. Especially attractive to small investors are cyclical stocks that seem to have rapidly growing earnings and a low PE ratio.
But rather than benefiting from this positive trend, investors can be left with heavy losses as the cycle begins its downturn. To complicate matters, a low PE ratio does not necessarily signify a cheap market value. Earnings can be inflated for a number of reasons. One-time gains on asset sales, for example, can artificially inflate earnings and make an otherwise expensive firm appear cheap.
But investors who can get past the noise to identify firms with high-quality earnings, and a low PE can really benefit. If growth picks up, or ongoing profits seem likely, investors may revalue the net-net on an earnings basis, leading to a significant boost in stock price. Significant past earnings In mid-career, Graham favored net-net firms that had significant past earnings. The more the company made, the better. The utility of this check is in assessing whether a profitable company has simply stumbled and may regain its footing.
When assessing net-nets based on this criterion, investors should look for firms that were significantly profitable in the recent past, ideally no more than ten years prior. Investors should also prefer firms that have retained their ability to produce this level of profit. Companies that sold the divisions responsible for that profit, or profited on the back of a fad, such as a hit toy Cabbage Patch dolls, Beanie Babies, Pogs, etc.
Past price above NCAV Value investors are rightfully skeptical of the impact past prices have on their ability to profit in the future. The main tenet of value investing, after all, is that stock prices tend to come back to fair value eventually. Past stock price behavior seems to have little to do with value investing. Rather than try to predict the future from past price behavior, my criterion mainly aims to sidestep a common net-net pitfall.
Not all managers act as trustworthy stewards of shareholder value. Firms with lackluster or disinterested management typically trade at depressed prices as investors expect the situation to drag on indefinitely. While a newly minted net-net may slip into this pattern, a chronically depressed stock is strong evidence that management either do not care or do not have the skill needed to right the situation. But the historic record can also help pinpoint stocks with large, fast swings in price.
Some issues contain more speculative enthusiasm investor sentiment that shifts rapidly than others. This rapid shift in enthusiasm can help investors unload shares bought well below fair value as the stock price surges. Investors can also benefit from a speculative capital structure or tiny public float. Companies that have, for example, a large issue of preferred shares relative to their common stock may see extreme and rapid movements in their common stock price.
Similarly, a small number of investors rushing to buy stock in a company that is mostly held by insiders or institutions can rapidly boost the stock price, allowing a deep value investor to exit with a large profit. Insider ownership Insider ownership refers to share ownership by management or directors. Rather than assess a holding size relative to the size of the company or number of shares outstanding, look for an ownership amount that would be meaningful on a personal level.
Much is made of insiders having majority control of a company. When assessing insider ownership, I look for a dollar amount that would provide insiders with a meaningful personal stake in the success or failure of the business. But while a material personal stake acts like a motivating factor, insiders with majority ownership may take advantage of their position to benefit family members or treat the company as their own personal piggy bank. Majority control also prevents activist investors from pressuring managers to make needed changes and steer the company in a more promising direction.
Insider ownership is likely more effective when insiders own large personal stakes but do not have a majority control of the company. But the focus here is on identifying insiders who draw unusually large salaries. Sometimes management and directors will have a firm grip on the company, resulting in uncomfortably large salaries.
NCAVPS is a key metric for value investors and is arrived at by subtracting a company's total liabilities including preferred stock from its current assets and dividing the total by the shares outstanding. But Graham believed that by comparing the net current asset value per share NCAVPS with the share price, investors could find bargains.
Essentially, net current asset value is a company's liquidation value. A company's liquidation value is the total worth of all its physical assets, such as fixtures, equipment, inventory, and real estate. It excludes intangible assets , such as intellectual property, brand recognition, and goodwill. If a company were to go out of business and sell all its physical assets, the value of these assets would be the company's liquidation value.
So a stock that is trading below NCAVPS is allowing an investor to buy a company at less than the value of its current assets. And as long as the company has reasonable prospects, investors are likely to receive substantially more than they pay for. One such strategy, defensive stock investing , means the investor will purchase stocks that provide stable earnings and dividends regardless of what is going on in the overall stock market and economy.
These "defensive stocks" are especially appealing because they protect the investor during times of recession, giving the investor a cushion to weather downturns in the markets. Examples of defensive stocks can often be found in the consumer staples, utilities, and healthcare sectors. These stocks tend to do better during a recession because they are non-cyclical , meaning they are not highly correlated with the business and economic cycles.
However, Graham made it clear that not all stocks chosen using the NCAVPS formula would have strong returns, and that investors should also diversify their holdings when using this strategy. Graham recommended holding at least 30 stocks.
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But if a target company already has a large debt burden, a potential acquirer may not be able to use the debt to fund the purchase. This ultimately reduces the likelihood of a takeover. To add to the mess, since interest rates were at near-historic lows in , many firms carried debt they could not afford under normal economic conditions.
This suggests the presence of many publicly traded zombie firms: undead firms that will bite the dust as interest rates rise. What could be worse than owning a money-losing firm with eroding sales and a large debt load during a period of rising interest rates? Identifying the best net-nets, then, requires us to pass on any company that has a NYSE listing. American net-net investors may be dismayed by this rule. Quantitative ranking criteria While all firms must meet every check in the core criteria, ranking criteria is optional.
The first set of ranking criteria, quantitative ranking criteria, focuses on factors that provide a statistical boost in returns. The more of these criteria a stock meets, the better it is as a statistical bet. Investors who aim to select the best performing net-nets on a statistical basis should focus on firms that meet as many of these criteria as possible. Share buy-backs One of the best ways for net-net investors to boost returns is by selecting firms that are buying back shares.
Share buy-backs are beneficial for two reasons. Management teams that fear for the survival of their company will not waste cash on buy-backs if they feel that the firm may require significant funds to stay in business. If management spends cash on buy-backs when the business faces a drawn-out business problem, less cash will be on hand to maintain operations.
Money spent on buy-backs therefore represents money that management feel they can spend without jeopardizing the survival of the firm. Buy-backs are also beneficial because they increase per-share value by increasing the ownership percentage that each share represents. When shares are undervalued, management may use company funds to repurchase shares in order to reward remaining shareholders. When management buy back shares while they trade below NCAV, they significantly boost shareholder value.
No dividends As highlighted in the discussion of net-net stock studies, dividends have a powerfully negative effect on net-net stock returns. Net-nets that pay a dividend provide much lower average yearly returns than their non-dividend-paying peers. If dividends pull down returns so much, why not move this requirement to core criteria? We prefer to keep this criterion optional simply because some investors prefer to receive dividends to fund everyday expenses.
Income investors should be aware of the trade-off they make in order to receive dividends. Insider buys Insider buying is a powerful indicator. Insiders almost always buy shares to profit through capital gains. The more cash spent on share purchases, and the more insiders who are buying, the better the company looks as an investment. When setting the limit, we need to strike a balance between statistical returns and stock availability. Smaller firms perform much better as a group, so focusing on them makes sense.
Focusing on the best net-nets from a statistical point of view means avoiding firms with a meaningful amount of debt. The deeper the discount, the larger the return. As discussed, the relationship is not as strong as true-blue value investors would like it to be, which is why we demanded a smaller hurdle in core criteria. Still, focusing on the best performing net-nets means investing in firms that have deeper discounts, ideally as deep as possible.
We demand a much stricter standard in ranking criteria than we did in core criteria. Qualitative ranking criteria Investors who want to focus on strong quantitative criteria now have the tools needed to make smart investment decisions. By focusing on a group of net-nets that meet both the core and quantitative ranking criteria, investors can put together a strong portfolio which should provide great market-beating returns over the long run.
But not all investors are satisfied with maintaining a quantitative stance. This makes it tougher to start quantitative investing in the first place or stick to it over the long term. Math, in terms of historic performance and statistical expectations, does little to comfort an investor when a strategy fails to perform over a period of time.
To address these problems, almost all investors employ qualitative checks. This means identifying solid qualitative criteria, and maintaining strict standards when assessing a firm. The qualitative ranking criteria pulls together some of the factors I consider particularly fruitful when applying qualitative checks. Rather than develop this set of criteria from scratch, I lifted all of it from the writings of outstanding investors such as Buffett, Graham, Seth Klarman, and Peter Lynch.
It makes sense to adopt the criteria espoused by gifted investors when those criteria are relevant to net-nets. Catalyst When selecting net-nets, one of my favourite criteria is a solid catalyst. When a net-net firm is put up for sale, transactions typically take place at or near NCAV, which has a direct impact on the stock price.
Catalysts are only probable events, never certain. As Buffett pointed out, growth is a source of value. Even if growth slows or stops after an investor purchases the stock, the investor will still benefit from any increased NCAV gained after purchase. High-quality earnings growth is more lucrative than a mere bump up in price to reflect full NCAV.
Continued profit growth can cause investors to shift from seeing the firm as a mere net-net to seeing it as a growth company. Investors smart enough to buy early and hang on as the scenario unfolds stumble onto a Shelby Davis double play. This results in fantastically large stock price appreciation.
But smart investors also demand an equally rapid increase in free cash flow to help management fund operations, and they avoid firms with weak customer credit standards. Sometimes growth in revenue and shrinking losses highlight an exceptional buy. As revenue increases, the firm finds it easier to cover fixed costs, which eventually leads to rapidly growing profits.
Firms that shift from net-net to growth stock are as rare as they are profitable. More often than not a firm will seem attractive from a growth perspective only to see that growth fizzle out. Especially attractive to small investors are cyclical stocks that seem to have rapidly growing earnings and a low PE ratio.
But rather than benefiting from this positive trend, investors can be left with heavy losses as the cycle begins its downturn. To complicate matters, a low PE ratio does not necessarily signify a cheap market value. Earnings can be inflated for a number of reasons.
One-time gains on asset sales, for example, can artificially inflate earnings and make an otherwise expensive firm appear cheap. But investors who can get past the noise to identify firms with high-quality earnings, and a low PE can really benefit. If growth picks up, or ongoing profits seem likely, investors may revalue the net-net on an earnings basis, leading to a significant boost in stock price.
Significant past earnings In mid-career, Graham favored net-net firms that had significant past earnings. The more the company made, the better. The utility of this check is in assessing whether a profitable company has simply stumbled and may regain its footing. When assessing net-nets based on this criterion, investors should look for firms that were significantly profitable in the recent past, ideally no more than ten years prior.
Investors should also prefer firms that have retained their ability to produce this level of profit. Companies that sold the divisions responsible for that profit, or profited on the back of a fad, such as a hit toy Cabbage Patch dolls, Beanie Babies, Pogs, etc. Past price above NCAV Value investors are rightfully skeptical of the impact past prices have on their ability to profit in the future.
The main tenet of value investing, after all, is that stock prices tend to come back to fair value eventually. Past stock price behavior seems to have little to do with value investing. Rather than try to predict the future from past price behavior, my criterion mainly aims to sidestep a common net-net pitfall. Not all managers act as trustworthy stewards of shareholder value. Firms with lackluster or disinterested management typically trade at depressed prices as investors expect the situation to drag on indefinitely.
While a newly minted net-net may slip into this pattern, a chronically depressed stock is strong evidence that management either do not care or do not have the skill needed to right the situation. But the historic record can also help pinpoint stocks with large, fast swings in price.
Some issues contain more speculative enthusiasm investor sentiment that shifts rapidly than others. This rapid shift in enthusiasm can help investors unload shares bought well below fair value as the stock price surges. Investors can also benefit from a speculative capital structure or tiny public float. Companies that have, for example, a large issue of preferred shares relative to their common stock may see extreme and rapid movements in their common stock price.
Similarly, a small number of investors rushing to buy stock in a company that is mostly held by insiders or institutions can rapidly boost the stock price, allowing a deep value investor to exit with a large profit. Insider ownership Insider ownership refers to share ownership by management or directors.
Rather than assess a holding size relative to the size of the company or number of shares outstanding, look for an ownership amount that would be meaningful on a personal level. Much is made of insiders having majority control of a company. When assessing insider ownership, I look for a dollar amount that would provide insiders with a meaningful personal stake in the success or failure of the business.
But while a material personal stake acts like a motivating factor, insiders with majority ownership may take advantage of their position to benefit family members or treat the company as their own personal piggy bank. Majority control also prevents activist investors from pressuring managers to make needed changes and steer the company in a more promising direction.
In , she became editor of World Tea News, a weekly newsletter for the U. In , she was hired as senior editor to assist in the transformation of Tea Magazine from a small quarterly publication to a nationally distributed monthly magazine. Katrina also served as a copy editor at Cloth, Paper, Scissors and as a proofreader for Applewood Books. Before working as an editor, she earned a Master of Public Health degree in health services and worked in non-profit administration.
A key metric for value investors , NCAVPS is calculated by taking a company's current assets and subtracting total liabilities. Graham considered preferred stock to be a liability, so these are also subtracted. This is then divided by the number of shares outstanding. NCAV is similar to working capital , but instead of subtracting current liabilities from current assets, total liabilities and preferred stock are subtracted.
NCAVPS is a key metric for value investors and is arrived at by subtracting a company's total liabilities including preferred stock from its current assets and dividing the total by the shares outstanding. But Graham believed that by comparing the net current asset value per share NCAVPS with the share price, investors could find bargains.
Essentially, net current asset value is a company's liquidation value. A company's liquidation value is the total worth of all its physical assets, such as fixtures, equipment, inventory, and real estate. It excludes intangible assets , such as intellectual property, brand recognition, and goodwill. If a company were to go out of business and sell all its physical assets, the value of these assets would be the company's liquidation value.