At this time of year, many investors review their portfolios for tax loss sale candidates. We should do this on a regular basis throughout the year, of course, but most of us wait until the last minute. From time to time, the combination of motivated vendors and a looming year-end deadline will generate attractive buying opportunities for intrepid value investors, so how can we identify these deep value bargains?
In my view, the iconic Ben Graham’s “net-net” working capital per share screen is a great starting place, and I have written about it on a regular basis for a decade or more. Mr. Graham, the dean of value investing, saw this as a measure of stocks trading below liquidation value per share, which he calculated as follows: Take current assets – typically cash and short-term investments, accounts receivable and inventory – and deduct not just current liabilities, but all liabilities. This leaves us with net-net working capital. Divide by the number of shares outstanding to calculate net-net working capital per share. We are looking for companies where the current stock price is below this figure.
Mr. Graham’s logic was that you could sell all the current assets for 100 cents on the dollar, pay off all the liabilities at the same rate and still have cash left over. Plus, you haven’t even begun to sell the fixed assets such as plant, equipment, real estate and intangibles such as patents and goodwill!
With this as background, I asked David Sandel of Simcoe Partners in New York to run a net-net screen on his global database this time last year. Back then, there were 1,265 names on the list in countries from Bulgaria to Vietnam, but the majority were in Japan and the United States. Of the 36 Canadian names, 11 were junior resource plays, and the median-market cap of the entire Canadian list was a minuscule $10-million. Even an individual investor would consider them to be too illiquid. I did, however, list the top 10 by market capitalization, as they ranged from $375-million down to $24-million.
In descending order, the names were: Neo Performance Materials Inc. NEO-T, Thinkific Labs Inc. THNC-T, Velan Inc. VLN-T, Goodfellow Inc. GDL-T, Cardiol Therapeutics Inc. Class A CRDL-WT-A-T, Buhler Industries Inc. BUI-T, McCoy Global Inc. MCB-T, Medicenna Therapeutics Corp. MDNA-T, Aeterna Zentaris Inc. AEZS-T and Neovasc Inc. Before you read any further, you should ask yourself: How familiar are you with any of these names? And when did you last see a brokerage report on these companies? This is the reality of net-net investing: the stocks are obscure, boring and have a checkered history.
The 12-month returns to mid-November last year were widely dispersed, ranging from a loss of 56 per cent with Aeterna Zentaris to a stunning gain of 211 per cent for Neovasc as a result of a takeover offer. Velan also soared as a result of a proposed takeover, but the deal fell through, so the stock essentially did a round trip.
For the 10 names, the average gain was 39 per cent, heavily influenced by the Neovasc takeover, but the median gain was still a healthy 23 per cent. This was during a period when the big-cap S&P/TSX Composite Index was essentially unchanged.
In previous articles, I have posed the question: When you have a list of candidates based on a rigorous valuation screen, should you buy all the names or cherry-pick the list to identify the winners? The academic evidence strongly suggests you should buy all the names. Do I follow my own advice? No. The only name which I already owned on this list was McCoy Global, which was up a healthy 64 per cent.
Turning to this year’s crop of candidates, as of mid-November the global list is almost the same length, with 1,231 names, again heavily dominated by the U.S. and Japan. There are 36 Canadian names, mainly small cap and only 11 of them are listed on the main TSX board. The median market cap of the group is only $9-million, so once again it is sensible to confine our interest to the top 10. These range from a high of $1-billion to a low of $35-million, for a median market cap of $105-million. They are listed below in descending order of market cap.
Cronos Group Inc. CRON-T, Neo Performance Materials, OrganiGram Holdings Inc. OGI-T, Velan, Goodfellow, Andean Precious Metals Corp. ANPMF, Aclara Resources Inc. ARA-T, Buhler Industries, High Arctic Energy Services Inc. HWO-T and Satellos Bioscience Inc. MSCL-X.
Four of them are carry-overs from last year: Neo Performance Materials, Velan, Goodfellow and Buhler Industries. Also, note that all of them have a stock quote and market cap in Canadian dollars, but five of them report their financial statements in U.S. dollars, so be sure to gross up the balance sheet dollar values when doing your research. I don’t own any of the stocks on this list and once again will ignore my own advice and attempt to cherry-pick the winners.
As always, do you own research on any stocks generated by a computer screen. Sometimes the database is based on old financial statements, stocks have split but not the underlying financials, or there may have been a highly dilutive stock issuance since the latest financial report.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.