A trader hangs Christmas decorations on a trading post on the floor of the New York Stock Exchange in New York City on Nov. 29.BRENDAN MCDERMID/Reuters
Tax loss season is a time when many investors choose to part company with stocks that have been a disappointment to them. They are anxious to complete the trade before year end so that the loss can be claimed on this year’s tax return, so there may be a temptation to dump the stock without regard for the best price. This presents an opportunity for bargain hunters looking for value in washed-out stocks.
How do we identify these potential bargains? It is difficult to imagine a stock screen more focused on deep value than Ben Graham’s “net-net” working capital screen. I have written about this selection process for a decade or more, but here is a quick reminder of the steps involved.
Take current assets (typically cash and short term investments, accounts receivable and inventory) and deduct not only current liabilities, but all liabilities. We are left with net-net working capital. (I suppose we double up on the “net” to emphasize you’re deducting all the liabilities – not just current.) Divide this by the number of shares outstanding and we have net-net working capital per share. The screen looks for stocks with a market price below this figure. Graham, the dean of value investors, thought of this as the liquidation value per share on the assumption that you could sell all the current assets at 100 cents on the dollar, pay off all the liabilities at the same rate and you still have cash left over. Plus, you haven’t even touched the long term assets such as plant and equipment, patents and goodwill and real estate, surplus or otherwise.
The global stock market indexes are down in the range of 4 per cent to 15 per cent this year to date but they are, of course, dominated by the big cap stocks. The indexes that track smaller and microcap stocks have fallen much more, so it is likely this sector will harbour the tax loss bargains. To find out, I recently asked David Sandel, head of operations of Simcoe Capital Management in New York, to run a net-net screen on his global database. I wasn’t disappointed – there was a total of 1,265 names on the list. And it was certainly global: If I could read the Cyrillic alphabet there were four stocks listed in Bulgaria. More practically, there were 36 names in Canada, 326 in Japan, 314 in the United States, 123 in South Korea and 38 in China.
As usual, the devil is in the details. Of the 36 Canadian names, 11 were mines, metals and precious metals, which are tough to analyze for the traditional value investor. The median market cap of the entire group was only $10-million, so even an individual investor will find them illiquid. Ranked by decreasing market cap, the top 10 Canadian net-net stocks range from $375-million down to $24-million. They are listed below in the same descending order.
Neo Performance Materials Inc. (NEO), Thinkific Labs Inc. (THNC), Velan Inc. (VLN), Goodfellow Inc. (GDL), Cardiol Therapeutics Inc. (CRDL), Buhler Industries Inc. (BUI), McCoy Global Inc. (MCB), Medicenna Therapeutics Corp. (MDNA), Aeterna Zentaris (AEZS), and Neovasc Inc. (NVCN). Of the 10 stocks, I already own McCoy Global as part of my lottery-ticket basket of oil service stocks, so I will probably buy more. Some of the others such as Velan and Goodfellow are such perennial attendees on this list that it is tempting to classify them as value traps, but they are legitimate candidates and deserve attention.
Most investors have access to the U.S. stock markets on their brokerage platform, so I also looked at that listing of 314 names. To my surprise almost half were biotech or pharmaceutical companies. The median market cap of the entire list was only US$25-million – once again, we are dealing primarily with microcap stocks. Many of the biopharma stocks are trading not just below net-net working capital per share but also net cash value per share. In other words, the entire company is valued at less than the cash in the bank. Do not be tempted. In these situations, it is crucial to calculate the “burn rate,” that is, the rate at which the company is running through its cash reserves, typically through R&D spending. The answer is usually expressed in months, not years. With no revenues to speak of, a company has to discover a cure for the targeted disease within this time frame (and deliver it to the market) or the stock price follows the cash balance to zero. The same sequence of events is true for many resource exploration plays, which is why most value investors give them a pass.
The U.S. listing did contain an interesting cluster of eight big cap names in one sector that is very much out of favour and worthy of additional research: homebuilders. The market caps range from a high of US$3-billion to a low of US$200-million and are listed below in the same order.
Meritage Homes Corp. (MTH), KB Home (KBH), M.D.C. Holdings Inc. (MDC), Tri Pointe Homes Inc. (TPH), Century Communities Inc. (CCS), M/I Homes Inc. (MHO), Beazer Homes USA Inc. (BZH), and Landsea Homes Corp. (LSEA). The last two companies, Beazer Homes and Landsea Homes, are by far the cheapest in the group, probably because the balance sheets are more leveraged.
To be realistic, the net-net screen may not be ideal for assessing value in the homebuilder group. Their current assets are dominated by inventory, which includes homes under contract and under construction, unsold homes and home sites finished and under development. Some of this is not very liquid and prone to dramatic markdown in a housing recession. I am inclined to put these names on a watch list and wait until the Federal Reserve has finished the upward cycle in interest rates before developing a conviction to buy.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.