Net Current Asset Value Effect

The net current asset value (NCAV/MV) strategy is the famous strategy popularized (and used) by the father of security analysis, Benjamin Graham, in the early twentieth century, bringing high profits from the 1930s to 1956. Per share NCAV, as defined by Graham (Graham and Dodd (1934), Graham (1976)), is the balance sheet current assets minus all the firm's (current and long-term) liabilities divided by the number of shares outstanding. Long-term asset (e.g. intangible assets and fixed assets) values are not counted. Graham found that companies satisfying the NCAV/MV strategy were often priced at significant discounts to estimates of the value that stockholders could receive in the event of the actual sale or liquidation of the entire corporation. Thus, the NCAV/MV rule not only protects capital from significant permanent loss, but also generates a portfolio of stocks with excellent prospects for an advance in price.

Fundamental reason

The NCAV rule forms portfolios filled with stocks with market capitalization lower than the amount of cash plus inventories they own. A lot of these stocks are so cheap because the companies are in distress and will eventually go bankrupt. But the rest of the stocks bought with an extreme discount statistically gain more and the overall portfolio return is highly positive.

Markets traded
equities
Confidence in anomaly's validity
Strong
Notes to Confidence in anomaly's validity
Period of rebalancing
Yearly
Notes to Period of rebalancing
Number of traded instruments
100
Notes to Number of traded instruments
more or less, it depends on investor's need for diversification
Complexity evaluation
Moderately complex strategy
Notes to Complexity evaluation
Strategy complexity depends on number of stocks investor wishes to include into his/her portfolio, as strategy could be much simpler for execution if investor picks less stocks.
Financial instruments
stocks
Backtest period from source paper
1980-2005
Indicative performance
31.19%
Notes to Indicative performance
per annum, long only portfolio, benchmark market return 20,51% (equally weighted stocks)
Estimated volatility
not stated
Notes to Estimated volatility
Maximum drawdown
not stated
Notes to Maximum drawdown
Sharpe Ratio
not stated

Keywords:

stock picking, financial statements effect, value

Simple trading strategy

The investment universe consists of all stocks on the London Exchange. Companies with more than one class of ordinary shares and foreign companies are excluded. Also excluded are companies on the lightly regulated markets and companies which belong to the financial sector. The portfolio of stocks is formed annually in July. Only those stocks with an NCAV/MV higher than 1.5 are included in the NCAV/MV portfolio. This Buy-and-hold portfolio is held for one year. Stocks are weighted equally.

Hedge for stocks during bear markets

No - Long only value stocks logically can't be used as a hedge against market drops as a lot of strategy's performance comes from equity market premium (as investor holds equities therefore his correlation to broad equity market is very very high). Now, evidence for using long-short value factor portfolio as a hedge against equity market is very mixed. Firstly, there are a lot of definitions of value factor (from a simple standard P/B ratios to various more complex definitions as in this strategy) and performance of different value factors really differ in times of stress. Also, there are multiple research papers in a tone of work of Cakici and Tan : "Size, Value, and Momentum in Developed Country Equity Returns: Macroeconomic and Liquidity Exposures" that link value factor premium to liquidity and growth risk and show that the implication is that value returns can be low prior to periods of low global economic growth and bad liquidity.

Source Paper

Xiao, Arnold: Testing Benjamin Graham's Net Current Asset Value Strategy in London
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=966188
Abstract:
It is widely recognized that value strategies - those that invest in stocks with low market values relative to measures of their fundamentals (e.g. low prices relative to earnings, dividends, book assets and cash flows) - tend to show higher returns. In this paper we focus on the early value metric devised and employed by Benjamin Graham - net current asset value to market value (NCAV/MV) - to see if it is still useful in the modern context. Examining stocks listed on the London Stock Exchange for the period 1981 to 2005 we observe that those with an NCAV/MV greater than 1.5 display significantly positive market-adjusted returns (annualized return up to 19.7% per year) over five holding years. We allow for the possibility that the phenomenon being observed is due to the additional return experienced on smaller companies (the "size effect") and still find an NCAV/MV premium. The profitability of this NCAV/MV strategy in the UK cannot be explained using Capital Asset Pricing Model (CAPM). Further, Fama and French's three-factor model (FF3M) can not explain the abnormal return of the NCAV/MV strategy. These premiums might be due to irrational pricing.

Other Papers

Damodaran: Value Investing: Investing for Grown Ups?
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2042657
Abstract:
Value investors generally characterize themselves as the grown ups in the investment world, unswayed by perceptions or momentum, and driven by fundamentals. While this may be true, at least in the abstract, there are at least three distinct strands of value investing. The first, passive value investing, is built around screening for stocks that meet specific characteristics - low multiples of earnings or book value, high returns on projects and low risk - and can be traced back to Ben Graham’s books on security analysis. The second, contrarian investing, requires investing in companies that are down on their luck and in the market. The third, activist value investing, involves taking large positions in poorly managed and low valued companies and making money from turning them around. While value investing looks impressive on paper, the performance of value investors, as a whole, is no better than that of less “sensible” investors who chose other investment philosophies and strategies. We examine explanations for why "active" value investing may not provide the promised payoffs.

Lauterbach, Vu: Ben Graham's Net Current Asset Value Rule Revisited: The Size-Adjusted Returns
https://faculty.biu.ac.il/~lauteb/data_794/Ben_Graham.pdf
Abstract:
The study demonstrates how size controls can alter the outlook of an investment strategy. The Ben Graham net current asset value rule provides excellent excess returns according to traditional performance measures. Size adjusted procedures, however, reveal that its size adjusted excess return is approximatelly zero.

Oxman, Mohanty, Carlisle: Deep Value Investing and Unexplained Returns
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1928694
Abstract:
The strategy of buying and holding “net nets” has been advocated by deep value investors for decades, but systematic studies of the returns to such a strategy are few. We detail the returns generated from a net nets strategy implemented from 1984 - 2008, and then attempt to explain the excess returns (alpha) generated by the net nets strategy. We find that monthly returns amount to 2.55%, and excess returns using a simple market model amount to 1.66%. After controlling for a variety of risk factors and firm characteristics, and imposing several filters, we find a remaining significant excess return.

Hypothetical future performance