Our Stock Picking Performance Using the CNAV Investing Strategy
We pick stocks to beat the market returns. If not, why should we even bother to spend time and effort to look through the companies’ financials? Might as well just buy an index ETF and get market returns?
I know some would argue that they buy stocks for dividends to generate passive income and they are not interested to beat the market. So be it. That’s your choice and not ours.
We hold ourselves to the word and we measure the investment portfolio in the stocks that we pick. We adopted the Conservative Net Asset Value (CNAV) approach to pick these stocks. We will detail this approach in subsequent paragraphs if you read on.
The CNAV Portfolio was started in 23 Aug 2013 and have 22 stocks (16 listed on SGX and 6 listed on KLSE). Let’s review the investment performance of the CNAV Portfolio below, excluding dividends. The performance only consists of Singapore stocks as the KLSE stocks were just added to the Portfolio and should not be benchmarked against STI ETF.
In percentage terms, on a year-on-year basis, here is how we match up:
(Updated 28 Feb 2017)
|Year||CNAV Portfolio||STI ETF||KLCI ETF|
|Annual Compounded Rate||+11.6%||-0.2%||-5.8%|
Wait… Isn’t The Stock Market Efficient?
There is a belief that the stock market has priced all the available information and it is not possible for anyone to take advantage of price discrepancies. In other words, stocks are always fairly priced and it is not possible for an investor to buy below the value or a trader to short above the value.
This is also known as the Efficient Market Hypothesis.
While we believe this is largely true for most stocks for most of the time, we stand on the side of behavioural economists and believe that some stocks can be mispriced. This is because the assumption of Economics that all participants act in their self-interest is not true. Most investors sabotage themselves by making investment decisions based on feelings, and not objective judgements. Investors would exhibit biases with their stock selection, favouring some stocks while disdaining others. Such asymmetric preference for stocks would result in undervaluing the unfavourable stocks and overvaluing of favoured stocks. Mispricing occurs and present an opportunities for stock pickers.
Don’t Take My Word… Ask The Professors
Nobel prize winner, Eugene Fama, was a key theorist of the Efficient Market Hypothesis. Subsequently he and Kenneth French found out that small companies and value stocks tend to generate higher returns. It became the Fama-French Three Factor Model.
That was a lot of technical stuff I threw on you! Okay, all you need to know is that small companies tend to give higher returns than big companies. Value stocks, as determined by stocks trading at a much lower price as compared to the assets the companies own (Low Price-To-Book), tend to have higher returns than those stocks with high Price-To-Book ratio stocks. This suggests that Price-To-Book ratio is a key financial ratio in our stock selection process. And small companies tend to have lower Price-To-Book ratios than bigger companies.
The two Professors did not debunk the Efficient Market Hypothesis, but they used Modern Portfolio Theory to explain that the smaller companies and value stocks get a higher return because they are inherently riskier. See diagram below.
We are not here to argue with the Professors whether these small cap value stocks are risky or not. Most importantly they tend to give higher returns.
Before Them, There Was Benjamin Graham
The problem of knowledge is that there are many more books on birds written by ornithologists than books on birds written by birds and books on ornithologists written by birds. ~ Nassim Taleb
Nassim Taleb once said that a lot of knowledge are written by people who observed what others have done for a long time. Birds learn to fly and then humans theorise about flight.
Benjamin Graham had been practising value investing before it was even called value investing. He was coined as the Father of Value Investing many years after he had successes in the stock market.
Besides being a Professor at the Columbia School of Business, he had an investment firm, Graham-Newman Partnership, which he managed money. Warren Buffett revered Benjamin Graham and the former enrolled into Graham’s undergraduate program and subsequently worked in the firm.
Graham lived through the Great Depression in the United States and seeing companies going bankrupt week after week, he developed a very conservative strategy known as the Net-Net. What this approach essentially meant was that he was looking for companies to buy at a price that was way below the Book Value of the companies, such that even when these companies go into liquidation he could get his money back and even some profits!
The Great Depression really shaped his investment philosophy and weigh on the conservative side. He avoided speculative approaches like manipulative, technical analysis, and even growth stocks that require some guessing of future earnings. In his greatest work written about 70 years ago, Security Analysis, he drew up the following figure which is even so true today. I would like you to focus on his categorisations between speculation and investment.
Technical Analysis and Chart Reading
If you are engaging in technical analysis, Graham will consider you a speculator. But do not misunderstand him. When he said speculative, it doesn’t mean you won’t make money. He meant to say it is risky and harder to make money consistently. The very good traders make money from speculation but this is going to be a very small pool of people.
Big Boys and Syndicates
We have a belief that the stock prices are manipulated by a group of rich men. Such ‘pump and dump’ stories are aplenty.
Graham would likely shake his head if you tell him that you are going to join a group of big boys to manipulate stock prices. Push up the prices within 3 months and off load the shares to unknowing but greedy retail investors when the price starts to triple.
He didn’t explain his disapproval but I guess there are two reasons. One, not all syndicates make money. It is important everyone sticks to the game rules and play along. It just takes one member to break his promise and the whole plan collapses. Big Boys are not invincible. Second, it is illegal to manipulate the markets and you may just get caught by the authorities.
The society is taught to evaluate a stock or business by projecting its future earnings and cash flow, and calculate the net present value to compare with the current stock price. It is also said that we need to estimate the company’s ability to remain competitive and assess the management ability to grow the business and do many things right going forward.
However, this model of investing would be classified as partly speculative by Benjamin Graham, due to the guesswork about the future.
Focus On Intrinsic Value Factors
If all of the above are speculative, what should you do then?
Graham would prefer you to use intrinsic value factors like earnings, dividends and assets etc to value an investment.
However, the word ‘Intrinsic’ has been layered with various meanings through the decades. Some would think that intrinsic value as present value of future earnings. Some would take intrinsic value as current valuation. Some use historical trending.
It doesn’t matter what it means. Most importantly Graham meant that you should not be engaging in any projection to determine today’s value. Or just follow Graham’s words dearly,
The value of analysis diminishes as the element of chance increases.
Then There Was Warren Buffett
Warren Buffett is undoubtedly the most successful investor in the world as his net worth got him on the top ten richest man in the world by Forbes for many years. This was achieved through a 19.4% average annual returns from 1965 to 2014, a phenomenal track record.
Warren Buffett started as a Benjamin Graham’s student at Columbia School of Business. After receiving his Degree, Buffett went on to work at Graham’s analyst firm for a while before going solo. He was a keen follower and successful applicant of Benjamin Graham’s strategy. He was getting high investment returns in his early days.
It was until he met Charlie Munger, who challenged Buffett about Graham’s investment philosophy. Buffett was resistant at first, but eventually became a convert to adopt a strategy that we see today.
- Graham advocated a quantitative approach but Buffett emphasized qualitative factors like economic moat and management.
- Graham advocated diversification but Buffett went for very concentrated positions.
- Graham preferred to buy fair companies at wonderful prices but Buffett preferred to buy wonderful companies at fair prices.
These were strong divergence from Buffett’s teacher. It didn’t matter because Buffett proved that it was a right move with the amount of wealth he had gathered applying his new found strategy together with Charlie Munger.
Buffett’s success gathered many admirers and wannabes, and Graham’s philosophy was less practised over time. However, there were successful Graham practitioners like
- Walter Schloss who had made an average returns of 15.3% in 45 years;
- Bill Ruane who started the Sequoia Fund in 1970, and the Fund had an average return of 14.65% as at 2015. Ruane first closed the Fund in 1982 and subsequently a new group of fund managers reopened it in 2008 and closed again in 2013. Warren Buffett had redirected his investors to Bill when Buffett closed his early partnerships.
- More of them can be found in The Superinvestors of Graham-and-Doddsville, Warren Buffett’s tribute to the 50th anniversary of the publish of Security Analysis
Despite these good results shown by Graham’s disciples, the Warren Buffett name continue to outshine all of them.
It is evident of the Warren Buffett brand when you look at the overwhelming titles of Warren Buffett in the investing section of any bookstore. Stealing a phrase from Nassim Nicholas Taleb, rewords in [ ]:
The problem of [investing] knowledge is that there are many more books on [Warren Buffett] written by [Warren Buffett Wanabes] than books on [Warren Buffett] written by [Warren Buffett] and books on [Warren Buffett Wanabes] written by [Warren Buffett].
If Benjamin Graham’s Approach Was Profitable, Why Did Warren Buffett Switch His Investment Strategy?
Buffett answered this question in a few occasions. The latest reply was found in Berkshire Hathaway’s 2014 shareholder’s letter.
“My cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performance.”
“Even then, however, I made a few exceptions to cigar butts, the most important being GEICO. Thanks to a 1951 conversation I had with Lorimer Davidson, a wonderful man who later became CEO of the company, I learned that GEICO was a terrific business and promptly put 65% of my $9,800 net worth into its shares. Most of my gains in those early years, though, came from investments in mediocre companies that traded at bargain prices. Ben Graham had taught me that technique, and it worked.”
“But a major weakness in this approach gradually became apparent: Cigar-butt investing was scalable only to a point. With large sums, it would never work well.”
Although Warren Buffett could get high returns with a smaller investment fund, his current fund has grown too large for him to replicate the same system he used previously.
In the past, he could easily identify small, undervalued companies that he could buy a small stake of. Even Buffett has admitted that the ability to play in the world of small companies is more enticing compared to that of large companies. This was what Warren Buffett said in 1999 to Businessweek:
“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”
“The universe I can’t play in [i.e., small companies] has become more attractive than the universe I can play in [that of large companies]. I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in.”
But as retail investors, we have the very advantage that Warren Buffett has lost
Compared to Warren Buffett, retail investors lack the knowledge, network and time to research deeply into every potential company. Thus we are unlikely able to beat the S&P index (or any other index) consecutively for many decades. Most of us will be better off investing in a fund that tracks the index.
On the other hand, retail investors can invest in companies that are small, relatively unknown and hence undervalued by the market. Many of these companies are engaged in stable businesses with good earnings. Retail investors would only need to invest in a few in order to get good returns. We are not faced with the same set of problems Warren Buffett faces.
Hence, the opportunity for high returns remain wide open to smart and savvy retail investors who are willing to put in their time and effort to look out for undervalued companies.
You Won’t Be Comfortable Buying Graham-Type Stocks Because They Are Lesser known And Have Problems
Why Buy Losers When You Can Buy Winning Companies?
Behavioural economists, De Bondt and Thaler, came to the realisation that people do not make decisions rationally. Their decisions were distorted by the vast amount of cognitive errors they have to contend with.
They were keen to discover how much of this is translated into stock prices. Are stocks priced correctly at all? Do investors overreact when it comes to stock prices? If they do, does it mean that stocks that exposed to good news have become over-priced? Could it be that stocks that have had a bad run are actually undervalued in comparison with the general market? They set out to test their hypothesis.
They did so by mining price data for the New York Stock Exchange (NYSE) from January 1926 to December 1982. In the process, they created ‘Winner’ and ‘Loser’ portfolios of 35 stocks each. These are the top and bottom performing stocks for the entire market at each rolling time period.
The hypothesis is straightforward. If there is no overreaction involved, the winners will continue to outperform while the losers will continue to languish. However, if human beings being the imperfect decision makers they are display overreaction to stock price on the basis of good or bad news, the winners will eventually perform in a worse off fashion than the general market. And stocks in the loser portfolio will eventually catch up.
This is what they found.
To quote directly from the paper
“Over the last half-century, loser portfolios of 35 stocks outperform the market by, on average, 19.6%, thirty six months after portfolio formation. Winner portfolios earn about 5% less than the market. This is consistent with the overreaction hypothesis.”
From the outcome, there is little doubt investors get caught up with euphoria and over pay for stocks having a good run. They also become fearful of poor performing stocks, selling them and causing their prices to fall beyond what is reasonable.
Two other details about the study caught my attention.
De Bondt and Thaler choose the time frame of 36 months because it is consistent with Benjamin Graham’s contention that ‘the interval required for a substantial undervaluation to correct itself averages 1.5 to 2.5 years’.
As the graph has shown, most of the reversal took place from the second year onwards. This is consistent with Graham’s observations. It takes time for the market to eventually function as the proverbial weighing machine.
Secondly, the overreaction effect is larger for the loser portfolio than the winner portfolio. Stocks that have been beaten down due to investors overreacting to their bad performance eventually recovered faster and more than stocks whom investors have overvalued.
In a second study in 1987, Debondt and Thaler found that investors focused too much on short term earnings and naively extrapolated the good news into the future, and hence caused the stock prices to be overvalued.
They repeated the experiment in the first study, examining the 35 extreme winning stocks (Winner Portfolio) and the 35 worst performing stocks (Loser Portfolio), and track the change in earnings per share over the next four years.
They found out that the Loser Portfolio have their earnings per share increased by 234.5 percent in the following four years while the Winner Portfolio have decreased earnings per share by 12.3 percent.
Eyquem Investment Management LLC plotted DeBondt and Thaler’s figures in a chart. The following diagram was taken from Tobias Carlisle’s book, Deep Value, Figure 5.2.
In the same paper, Debondt and Thaler went on to select the stocks based on their Price-to-Book ratio, instead of how well their stock prices have performed in the past. They divided the stocks into 5 groups, from the lowest to the highest Price-to-Book ratios. The lowest ratio were determined as the Undervalued Portfolio and the highest ratios were determined as the Overvalued Portfolio.
Again, Eyqeum Investment Management LLC plotted the performance of these two portfolios and the following diagram was taken from Tobias Carlisle’s Deep Value book:
The Undervalued Portfolio which had their Earnings Per Share dropped 30%, went on to improve their earnings by by 24.4 percent in the following four years. The Overvalued Portfolio, which had 43 percent gain in Earnings Per Share in the past three years, only managed to get 8.2% in the next four years.
This imply that earnings also tend to revert to the mean.
Life Cycle of Companies
We kept saying about buying undervalued stocks. What kind of stocks are these?
The probability of a business failing is the highest in the first 3 years of operations. Many companies have to test the demand for their products or services in the marketplace. Those businesses which gained traction would be able to survive while the rest would fade away eventually.
The angel investors and venture capitalists are willing to put money in start ups as the gains can be astronomical if the businesses become successful.
The failure rate is so high that often investors spread their capital over several start ups to reduce their dependency on one company which has a high degree of uncertainty with regard to her success.
Companies who have survived the Start Up phase will enter a growth stage.
The company would be expanding in terms of revenue, headcounts, and market share.
The companies will need a lot of capital to implement their expansion plans. One of the ways to raise money is to list their business in a stock exchange. Prior to Initial Public Offering (IPO), bankers can sell pre-IPO shares at discounted rates to high net worth clients. Retail investors would only get to pay IPO price by bidding for the shares.
Companies that are successfully listed are trading at very high Price-to-Earnings (PE) and Price-to-Book (PB) because many investors are willing to pay for the potential future profits of these companies.These companies are also unlikely to give out dividends because they need the capital to grow their businesses.
Most people invest in this phase are believers of these growth stories. Unknowingly they have taken a long shot and assumed higher risks in the process. This is because many growth stories fizzle out many years later.
The companies at this stage have almost reached the maximum potential and growth had started to slow.
The familiar brands become the stalwarts in the industry and the stock market. These are the big cap blue chip stocks which are prestigious and powerful. They are able to turn in steady profits and give out regular dividends.
Many investors have their eyes on these stocks and believe nothing will go wrong with them. Analysts watch these stocks with keen eyes and churn reports after reports about them.
The smaller companies in the mature stage are often overlooked with no analyst coverage. They are less sexy than the big caps, and there were no more exciting growth stories about them. As such, the stock prices of these small companies are depressed and undervalued.
We pick our CNAV stocks from this group because the mature stage is the most stable stage (lower risk) and these stocks are very undervalued (potential higher returns).
This is the stage which every company tries to avoid.
Big caps can also enter the Decline stage if their businesses deteriorate. Undervalued small caps can also become cheaper if problems arose and persist.
For a video explanation of the lifecycle of a company, go to BigFatPurse’s Youtube Channel –> http://youtu.be/ImmZFRbT5t0
>Undervalued But Thin Volume And No Price Movements = Lousy Stocks?
It is true that earnings is the key driver of stock price. But I will challenge that it is because the entire investment community and the financial industry paid too much attention on earnings that it became the most important driver of stock price. Any factor can be a key driver to stock price as long as majority of the investors focuses on it.
The common worry for investing in companies with discount to their assets but have poor earnings, is that the stock price may never reflect the value of the companies and even if it does, the wait might be very long.
Walter Schloss said that when you buy assets, three things will go in your favor:
- Earnings turn around and the stock appreciates significantly
- Someone buys control of the company (buyout)
- The company begins buying its own stock
Any of these 3 things happen and the stock price will go up. That will be an opportunity to realise the profits. And yes, you have to wait for these 3 things to happen and you will never know when.
Let us examine examples from the 3 scenarios:
Example of An Earnings Turn Around – Fu Yu
Fu Yu is a small cap stock with $146m market capitalisation as of 28 May 2015. It was one of the fallen and an ugly stock that nobody likes. As a plastic moulding company, Fu Yu is not in the sexiest business and it does not have the highest earnings in the market. We can witness the low liquidity and transaction volume preceding the crazy run up since March 2015. Most investors will shun this stock and go for something with higher volume, saying this is a value trap. As counter-intuitive as it is, the best time to buy is when most people are not buying. It is easy to say but very difficult to do. Few want to be the true contrarians in the stock market.
Based on their 31 Dec 2014 report, 32% of their total assets were in cash, and another 30% in receivables. The Net Asset Value (NAV) of Fu Yu was $0.24. If we discount receivables by 50%, in case of bad debts, the company is still worth $0.14 conservatively (CNAV).
We have not taken the future earnings of this company and it had already gave us a CNAV discount of 30-40% from today’s valuation.
As you can see from the stock chart above that there is this red line, and that indicated the conservative valuation of the company and investors had plenty of time and opportunity to get into this low liquidity stock.
Despite the good value, there were common ‘excuses’ why investors should not buy the stock and here they are:
#1 The stock has no liquidity, I cannot buy it and if I do, I would be stuck with the stock for a long time with no one to sell to. My response to this is do not look at supply and demand as a static situation. The levels of supply and demand will change due to myriad reasons. A low liquidity period is a temporal. In fact, it is a sign that the value of the stock has not been discovered by most people yet.
#2 The management doesn’t give dividends. The last dividend that was given out was in 2005. Most dividend investors would not even want to look at this stock. Remember that total return is inclusive of both dividends and capital gain from the stock price. But think about this, if you have invested in Fu Yu for 5 years with no dividends, but you have doubled your invested capital through the price gain, you would have made close to 15% per year on the average. This would be much more than someone who have invested for 5% dividends in the past five years.
Fu Yu reported positive earnings and had enough cash to clear up all the accumulated losses via a capital reduction (cash payouts to shareholders). This became a catalyst for the stock price to rise to reflect the fundamentals of the company.
Example of Someone Buys Over Control Of The Company – LCD Global Investments
LCD Global Investments is the property development counterpart of Lum Chang, which is a construction company. The former was trading at a deep discount and like many other property counters, mainly due to the cooling measures that the Singapore Government had implemented since 2012. The CNAV was at $0.18 while the price was in the range of $0.14 to $0.15.
The directors of the company decided to make a voluntary cash offer of $0.17 to gather more shares for themselves (buying under their own names). This became a catalyst and investors begin to pour in their capital to buy the stock, as we can see the rise in the share price. It was evident that the market believed the offer of $0.17 was too low and very few shareholders will sell their shares to the directors. The offer price has to increase to entice shareholders to sell. The buying interest was high and eventually pushed the share price to the NAV of the company.
An Example of A Company Buying Its Own Stocks – Powermatic Data
Powermatic Data Systems have been buying back their stocks since Aug 2014, which gave support to the stock prices. Buying back the stocks below the value of the company is an indirect way to remunerate shareholders other than the direct way of distributing dividends. Although most shareholders would prefer the latter, the former would usually result in higher share prices to reward the shareholders.
An in-depth video and written analysis has been done for Powermatic, using the CNAV strategy. Click here to request for the full report here
What Is The CNAV Strategy?
The CNAV strategy is a form of value investing strategy, focusing on stocks with their price trading below their asset value (less liabilities). It is a quantitative method to keep our biases at bay in the process of stock selection. The strategy consists of two key metrics and 3-step qualitative analysis.
Determining the Conservative Net Asset Value
If you have read the first part of this guide, you would have know that we are likely to focus on the asset value of a stock in order to make the buy decision.
One of Benjamin Graham’s most famous strategies was the Net Current Asset Value (Net-Net) whereby an investor can find bargains in stocks which are trading below two-thirds of net current assets (defined as Current Assets minus Total Liabilities).
Walter Schloss had kept that philosophy close to his heart and applied it throughout his investment career and he had a good point to make about investing in assets,
“Try to buy assets at a discount than to buy earnings. Earnings can change dramatically in a short time. Usually assets change slowly. One has to know how much more about a company if one buys earnings.”
Dr Michael Leong, the founder of shareinvestor.com, stated in his book Your First $1,000,000 Making it in Stocks, that he prefers to invest in ‘free’ businesses. Free businesses come by when the company’s cash and properties are worth more than the total liabilities. An investor won’t be paying a single cent for future earnings. The way he frames the perspective is brilliant! In other words, pay a fraction for the good assets that the company owns, instead of paying a premium for future earnings.
The academics research have always used Price-To-Book ratio to define under- or over-valuation of stocks. These research have shown the low Price-To-Book stocks tend to do better than the average market returns in the long run.
Hence, the important principle we can gather from these brilliant people is to pay a very low price for very high value of assets.
Going one step further, we do not just take the book value of a company as we know that not all the assets are of the same quality. For example, cash is of higher quality than inventories. The latter can expire after a period of time.
Hence, we only count the full value of cash and properties, and half the value for equipment, receivables, investments, inventories and intangibles (income generating intangibles such as operating rights and customer relationships. Goodwill and other non-income generating intangibles are excluded).
This means that the CNAV will always be lower than the NAV of the stock. This additional conservativeness adds to our margin of safety.
It is easy to find many stocks trading at low multiples of their book value but many of them deserve to be due to their poor fundamentals. Hence, we need to further filter this pool of cheap stocks to enhance our probability of success.
Calculating The POF Score
Imagine you are in a fashion shop. The latest models get the most attention and are sold at a premium (think hot stocks or familiar blue chips). In a corner there is a load of clothes which belong to the previous season and are trading at big discounts (cold and illiquid stocks).
But not all the clothes in this bargain pile are nice as they must be relatively less attractive such that no one buys them in the first place. However, you can find nice ones (value stocks) sometimes if you are willing to search in the pile.
Although conceptually shopping for clothes and picking stocks are similar, the latter is actually more complex to understand and execute properly.
We turn to Dr Joseph Piotroski’s F-score to find fundamentally strong low price-to-book stocks that are worth investing into. He used a 9-point system to evaluate the financial stability of the lowest 20% price-to-book stocks and found that the returns are boosted by 7.5% per year. You can read his full research paper.
As we have already added conservativeness in our net asset value, we do not need to adopt a full 9-point F-score. A proxy 3-point system known as POF score would be used instead and detailed in the following paragraphs.
While we emphasised on asset-based valuation, we look at earnings as well. The company should be making profits with its assets, indicated by a low Price-To-Earnings Multiple. Since we did not pay a single cent for earnings, the earnings need not be outstanding. Companies making huge losses would definitely not qualify for this criteria.
We have to look at the cashflow to ensure the profits declared are received in cash. A positive operating cashflow will ensure the company is not bleeding cash while running its business. The operating cashflow give us a better indication if the products and services are still in demand by the society. If not, the business should not stand to exist. A negative operating cashflow would mean that the company needs to dip into their cash to fund their current operations, which lowers the company’s NAV and CNAV. The company may even need to borrow money if their cash is insufficient and this raises further concerns for the investors.
Lastly, we will look at the gearing of the company. We do not want the company to have to repay a mountain of debts going forward, especially if interest rate rises, it may dip into their operating cashflow, or worse, depleting their assets. Equity holders carry the cost of debt at the end of the day and hence the lower debt the better.
3-Step Qualitative Assessment
Step 1 – Check announcements and corporate actions since the data of Annual Report
Each annual report is dated and usually only available to investors three to four months after the reported date. The delay is to facilitate the auditing of the financial statements.
The figures of the company could have changed in a big way during the time difference between the day you look at the financial data and the date the statements were reported. Hence you need to go through the company announcements to ensure nothing major event has happened that could change your calculations.
Some of the key events that will affect CNAV calculations are:
- Changes in number of shares (rights issue or convertibles that dilutes shareholders’ interests)
- Large dividend distribution (significant cash is removed and lowers CNAV + NAV)
- Large acquisition (above NAV) or divestment of assets (below NAV)
- Issue of debt securities like corporate bonds (increase debt and lowers NAV)
Step 2 – Determine the major assets that you are buying
As our focus in CNAV strategy is to buy assets cheaply, it is thus important to know what assets we are actually buying.
The calculation of CNAV would classify the assets into the following 6 types, shown in the diagram below:
After you have determined the assets that you are buying, dig further into the details of these assets. For example, if it is properties that you are buying, find the locations of these properties and note the valuation dates. If the valuation of these properties coincide with property boom, you may want to discount these properties further.
If the company have high receivables, it is good to question whether they have an issue chasing their customers to pay. It is also crucial to make sure if a company has lots of inventories, they should not have short lifespan like perishables.
Bottomline, this step 2 qualitative assessment is to check if the assets are justifiable as the numbers presented them to be.
Step 3 – Establish the Trustworthiness of the Management
Our investment decisions hinge on the calculations and our calculations depend on the accuracy of the numbers reported in the annual reports. Hence, by inductive reasoning, our investment success depends on the management’s honesty in reporting these numbers.
This is a difficult item to measure and the best way we have found is to evaluate the management’s ‘Skin in the Game’. This simply means that we would check the management’s ownership of the company. A significant ownership in the company speaks louder than the words in their letters and their interest should be more aligned with shareholders since they are the biggest shareholders if they own more than 50%.
However, there have been cases whereby owner-cum-management short changed the minority shareholders by offering a very low price to buy up the remaining shares and delist the company.
To combat this is to consider a shareholder do not own more than 70% of the company. This is because of the delisting rules in SGX – The offeror needs to hold an EGM and receive at least 75% of the shareholders’ approval to delist the company and not more than 10% of the shareholders disapprove the delisting. Without more than 75% votes secured, it is unlikely the major shareholder would dare to low-ball other shareholders.
Diversification Is Prudent Risk Management
Benjamin Graham has always preached a well-diversified portfolio of stocks, on top of the margin of safety that can be achieved from each stock.
This is because an investor neither know which stock would rise in price in order to weigh a lot of capital prior to the price movement, nor does the investor know which stock would deteriorate in the fundamentals to warrant a sell off.
In fact, you would just need a few stocks with big runs to contribute to the overall returns in your portfolio. Walter Schloss had large number of stocks and still achieved 15.3% returns per year and Warren Buffett praised Schloss for that,
Walter has diversified enormously, owning well over 100 stocks currently. He knows how to identify securities that sell at considerably less than their value to a private owner. And that’s all he does. He doesn’t worry about whether it it’s January, he doesn’t worry about whether it’s Monday, he doesn’t worry about whether it’s an election year. He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me. And he does it over and over and over again. He owns many more stocks than I do — and is far less interested in the underlying nature of the business; I don’t seem to have very much influence on Walter. That’s one of his strengths; no one has much influence on him.
How Many Stocks To Diversify Into?
The following question is that how many stocks in a portfolio is considered diversified? We turned to the academics for the answers.
We have to define two types of risks.
- Systematic Risk: This is also known as the market risk. You would experience that good stocks can come down in price if the overall stock market is weak and stocks with bad fundamentals can still go up if the stock market is bullish. Hence, regardless what stocks you have pick, their price movements are also affected by the overall market sentiment.
- Unsystematic Risk: This type of risk is more stock- or industry-specific. For example, a company is fraudulent in nature and the effect of the collapse of this company only affect the shareholders of this stock and not the entire stock market. Or it can be a particular industry that is undergoing a bear cycle and hence most, if not all, the stocks in that industry would be affected.
With reference to the chart below, it is evident that the systematic risk of the stock market is the minimum risk we must accept when we invest in stocks. This risk cannot be diversified away.
However, if we are able to build a portfolio of stocks that are of various industries, we would be able to reduce the our investment exposure to unsystematic risks. As we add more stocks, the unsystematic risk reduces exponentially. This means that we do not need a lot of stocks to achieve a good diversification.
In the book, Investment Analysis and Portfolio Management, Frank Reilly and Keith Brown reported that “…about 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks.” This number of stocks is very manageable to retail investors. There isn’t a need to monitor closely or understand these companies fully because the asset-approach is more quantitative than qualitative.
If more people adopt your strategy, wouldn’t it stop working?
Why are you sharing it?
The truth is, not many people are psychologically prepared to invest in CNAV stocks because it is very unnatural and uncomfortable to do so.
For example, everybody knows the strategy to keep lean and fit is to exercise more and eat less. But not many people can execute this strategy to achieve what they want.
Unfamiliar stocks. CNAV stocks tend to be the unknown companies which many investors have never heard of. It is easier to buy a stock with a familiar brand, which adds confidence to the investors that the company is hard to fail. On the other hand, the unfamiliar names do not give the sense of assurance to the investors, and subconsciously think that these companies are more likely to collapse than the big brand names.
Problems Present. These undervalued stocks tend to have problems that scare investors. The business may be making losses, the industry may be in a downturn, or simply the earnings are just not sexy enough. There are many reasons not to like the stock. On the other hand, it is much easier to invest in stocks that present the good news – growing earnings, record profits, all-time high stock price, etc. Investors are willing to pay for good news in anticipation of better news. Isn’t investing about buying the good companies with no problems? The problem is a second-level one. The good news and even potential good news have been factored into the price, and in fact, investors have overcompensated the good news without realising it.
Low Liquidity. To make things worse, there is little liquidity in CNAV stocks. The lack of volume increase the doubts about these small companies. We are wired with the herd instinct and intuitively believe such stocks are lousy because few investors are invested in it. We have always based our judgement on the effect of crowd. We want to buy books and watch movies with lots of good reviews. We like to try the food with the longest queue. We also apply the same crowd effect on the stock market to determine if a stock is ‘good’.
High Volatility. Due to the low liquidity, the bid and ask spread tends to be wider. This means that a little buying or selling can move the stock price by large percentages. Such large fluctuations do not bode well with investors as most are unable to handle volatility. Investors tend to overestimate their tolerance for volatility. They want 0% downside and 20% on the upside. Such investments do not exist in this world. It is a naive demand projected on stock market reality. Sadly, the only outcome is disappointment for the investor.
The reason why value investing works in the first place is because majority of the investors are unable to do the above, resulting in lower interest for and underpricing of value stocks.
Hence, even if we teach it, we are confident that not many people are able to execute the strategy, regardless if they understood the merits of it.
Finding CNAV Stocks
The CNAV strategy is methodical and largely quantitative in nature. Hence it is easy for beginners to learn the steps and apply to their investment.
That said, it still requires about 15 minutes to calculate the CNAV of a stock and given about 800 stocks in Singapore, an investor will need to dedicate 200 hours to complete the calculations, excluding the qualitative assessments to be conducted. This cycle will repeat yearly as new annual reports would be published.
One of the short cuts is to use a stock screener to eliminate those stocks that will clearly fail the CNAV criteria. This would reduce a considerable pool of stocks and leave with about 20 percent of the stocks (approximately 150 stocks in SGX) to calculate the CNAV. Even so, most investors will still find it daunting and draining to do so.
Since we have already calculated the CNAV of all the stocks listed on SGX, and put them into a web-based database, we offer this to our Value Investing Club members which they could directly screen for CNAV discounts and POF score. As these criteria are determined by us, no other stock screeners would be able to filter with such accuracy.
On top of the stock screener, the qualitative assessments have been completed for all the identified CNAV stocks and presented in the member site, thereby reducing the research time for our members.
Dr Wealth conducts several classes per month, to educate attendees about the CNAV strategy and the actual steps to calculate the CNAV of the stocks. We urge you to sign up for Value Investing Mastery Course (VIMC) at a very undervalued price of S$128, and we are confident you will have a very fruitful day of learning ahead. We know it because many before you have told us so.
In short, CNAV stocks are stable small companies which are overlooked by most investors. These smaller companies offer a higher potential return because they are more undervalued than their bigger counterparts.
This is consistent with the Fama-French Three Factor Model, whereby the two professors found that (1) small caps and (2) low price-to-book stocks tend to do better than the market as a whole. But these stocks are ugly and not sexy at all. It isn’t glamorous to own them. Investors want the ‘Louis Vuitton’ stocks.
Often we are blinded by ‘good’ companies and having the tendency to invest in them. But we must practise second order thinking. If everyone likes a ‘good’ company, and if the company is obvious to most that it is a ‘good’ company, there must be little chance for us to make good profits from investing in it. Therefore, we took a path less travelled.
Learn the Entire Conservative Net Asset Value (CNAV) Strategy
Dr Wealth reveals the entire CNAV strategy at our flagship Value Investing Mastery Course.
At this 1-day course, you will:
- Learn the entire, functional CNAV strategy
- Discover how to determine buy and sell prices
- Discover how to conduct qualitative analysis – to determine if a company is really sustainable
- Find out more about your personal investing style and how you make investing decisions via a realistic simulation
- Receive a Full Set of Course Notes
All these will NOT require a 4 or 5 figure course fee. Instead, a ticket to the 1 day Value Investing Mastery Course only cost you just $128.