Are the outstanding returns of negative enterprise value stocks an illusion or are there negative enterprise value best practices?
And I don’t mean the practice of passing on negative enterprise value investing.
The Problem with Negative Enterprise Value Stock Investing
In our introductory article on negative enterprise value stocks, we showed you the outstanding returns associated with this strategy by diving into Alon Bochman's 1972-2012 study. We dissected our own backtest of the strategy, breaking performance into 3 periods from 1999 to 2016.
Alon’s 40 year period was a long look back in time, long enough to give a very thorough idea of how these stocks perform as a group. His study covered American negative enterprise value stocks through the oil crisis of the 1970s, the high inflation 1980s, the 1987 stock market crash, the early 1990s recession, the Russian default and Asian financial crisis, the dot-com bubble & aftermath, plus the 2009 Great Financial Crisis.
Our own negative enterprise value study showed brilliant performance, achieving a CAGR of over 27%. This is a fantastic growth rate - among the best available for any investor.
The problem with these studies was portfolio sizing. The portfolios put together by both us and Alon did not take into account the need for a more concentrated portfolio. An investor cannot spend time managing a portfolio of 50 or 100 stocks. 20 is about as many as I can handle in any one year (and I don’t have a job!) so it’s unreasonable to expect retail investors to manage larger portfolios.
So the clear solution is just to… buy fewer negative enterprise value stocks. But as we’ve shown in our previous article, when you put together a more concentrated portfolio of plain vanilla negative enterprise value stocks, returns dive. You don’t achieve the same sort of returns you did if you don’t stick to wide diversification.
We took the liberty of highlighting this issue with a second 1999-2016 backtest. Returns were ok, at 19.06%, but fell well short of the initial study when we restricted our portfolios to just 20 stocks.
Running a concentrated portfolio is a necessity when managing your investments at home in your den but does this mean you have to face lower returns? And, if you’re going to concentrate, which negative enterprise value stocks should you pick?
I don’t think negative enterprise value investors are doomed at all and we’ve had very good success when employing additional criteria to pick high performance net net stocks. The same strategy works when trying to focus on the most promising negative enterprise value stocks so we’ve conducted extensive research to arrive at what we think are negative enterprise value best practices and recorded them in The Broken Leg’s Negative Enterprise Value Scorecard.
Negative Enterprise Value Stocks: The Broken Leg’s Scorecard
I’m going to share our scorecard's core criteria with you today and explain why we selected them so you can get a sense of how we’re achieving the results we get. If you subscribe to The Broken Leg Investment Letter you will get a full negative enterprise value Bird’s Eye View Investment Guide, plus our full Negative Enterprise Value Scorecard.
Avoid China - Selecting the best negative enterprise value stocks starts with avoiding one major source of negative enterprise value companies: China.
I Love China - I’ve been there a number of times - but I won’t buy deep value stocks that are based or operating in China. Chinese firms have been listed on western exchanges for at least the last 10 years and along with the growth of Chinese firms came a significant growth in Chinese frauds. As it turns out, deep value firms based or operating in China have a much higher probability of being frauds and tend to lower returns so we’ve elected to exclude these on our Negative Enterprise Value Scorecard.
Firm Type - In my extensive study of net net stocks, I found that net net stock studies excluded certain firms because those firms made for terrible net nets. As it turns out, negative enterprise value stocks are very similar to net nets so we’ve elected to exclude these firm types as well.
We specifically exclude: financial firms (banks, funds, brokers, etc), ADRs, real estate companies, and closed funds. Financial firms can be tough to analyze, requiring someone who is specialized in the industry. ADRs leave open the possibility of including firms located in sketchy jurisdictions which may have poor corporate governance, shareholder rights, or reporting standards. Real estate firms can quickly use up cash or take on debt, destroying negative enterprise value so excluding them is definitely a best practice. We also exclude closed funds because these are not the sort of investments we’re looking for and therefore they violate the spirit of the strategy.
Average Daily Volume - For practical reasons, we exclude firms with less than $5,000 in average daily volume. We want to make sure that we can buy an adequate amount of stock, and so can subscribers to The Broken Leg Investment Letter, our deep value investing service. Stocks with less than $5,000 USD in average daily volume can be tough to buy.
Negative Enterprise Value Less Than $0 - This is a no-brainer criteria. We’re aiming to buy firms that fit the strategy, so only look at firms that are true negative enterprise value stocks. Having significant net cash, or trading near net cash, is not enough to spark our interest. We just want to look at companies that pay us to take ownership of their shares.
Large Current Ratio - A current ratio is a classic test to see how easily a company can cover its short term liabilities. We usually start analyzing a strategy’s performance by tinkering around with various current ratios and debt to equity ratios. In the case of negative enterprise value stocks, cash more than covers total debt so there’s little reason to look at debt to equity ratios.
But, when looking at current ratios, we’ve found that an adequate current ratio is associated with higher returns. In this case, we’ve selected a current ratio of 1.5x as our hurdle. If a firm has a higher current ratio than our 1.5x hurdle, all the better. We found that selecting firms that this criterion boosted returns by about 2% (for example, from a hypothetical 10 to 12%). Yes, most negative enterprise value firms have decent current ratios, but not every firm. I suspect that this criterion helps eliminate some of the big losers that drag down returns so it's a solid addition.
Low Capital Expenditures - Every company needs to spend money on capital, the infrastructure needed to run the business, in order to stay in business. Negative enterprise value firms are no different. But, if a negative enterprise value firm requires a significant amount of capital in order to keep its business running, it can quickly use up the cash on its balance sheet.
We looked at the effect of reducing the amount of money earmarked for capital expenditures and decided on capping it at no more than 50% of cash on the books over the most recent 12 months. Now the firms we select have a more robust negative enterprise value.
Not Aggressively Growing Basic Share Count - We don’t like firms that sell shares when undervalued. Still, sometimes a company will increase its share count due to stock options. For that reason, we’re allowing a small increase in the company’s basic share count which, under testing, had no negative effect on returns. Our basic share count growth cap is 5% growth over the most recent 12 months.
Small Market Capitalization - When it comes to deep value investing, most strategies perform much better with smaller companies. In fact, the smallest market capitalizations often produce the best returns. This is probably because professional investors managing hundreds of millions or billions of dollars just can’t buy them. These companies are either not liquid enough or too small for professionals to put much money to work to be worth while.
When it comes to negative enterprise value stocks, we set our limit at $100 million USD in market cap. This is small enough to help concentrate on the best performing market caps but large enough to provide flexibility when buying negative enterprise value stocks.
$5 Million USD Market Cap Minimum - You might ask, why are we excluding firms with market caps below $5 million USD when we just finished telling you that the smallest market capitalizations produce the best results? As it turns out, while these stocks add some performance, they lead to very high standard deviation, volatility, and have a larger number of losers when running a more concentrated portfolio of 12 to 20 stocks. At least when it comes to a more concentrated negative enterprise value portfolio, avoiding these tiny firms produce a better result.
Market caps between $5 and 50 million USD produce the nicest result but we’ve put this stricter <$50 million USD criteria in our ranking criteria. This allows us to achieve good results with the core criteria we’re discussing here, while allowing our ranking criteria to really concentrate on the exceptional picks.
Performance Of The Broken Leg’s Negative Enterprise Value Core Criteria
So, how do all of these additional criteria affect the performance of a more concentrated negative enterprise value portfolio? Let’s take a look…
A basic negative enterprise value stock screen produced a 19% compound annual return - not exactly the exciting returns deep value investors expect from these sorts of stocks. Our aim was to fix this, so let’s look at how our 20 stock portfolio performs when incorporating our core criteria.
Looking at a 20 stock portfolio, our compound annual growth rate jumps from 19% to 29% - an outstanding jump in performance! This comes at very little cost to our maximum drawdown or standard deviation.
Remember, the results above are the result of filtering based on our core criteria, only. We have not begun to filter these stocks through our ranking criteria which consist of even stricter criteria and different sorts of criteria to identify the most promising negative enterprise value stocks. But, we're at the end of our series so I'll send out the full breakdown to The Broken Leg Investment Letter subscribers as a Bird's Eye View Investment Guide.
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