Ben Graham was the first to demonstrate that stocks that trade at large discounts to their net current asset values can generate strong returns for shareholders. Since then, many in the field have undertaken their own studies of this phenomenon with similar results. However, while this group of stocks may be expected to outperform the market, not every stock within the group will do so; some companies generate negative returns, thus bringing down the average. Investors, therefore, needn't invest in such stocks indiscriminately. Instead, investors can improve on the returns of the studies by avoiding the stocks with the highest risk.
By Saj Karsan, Thursday, June 3, 2010, 6:16 AM | Graham net-net | 0 comments »
Consider I.D. Systems (IDSY), provider of RFID technology for the management of heavy-duty mobile assets. A couple of months ago, the company was rather attractive from a net current asset perspective, trading at just $35 million versus net current assets of almost $50 million. But several risk factors combined to severely reduce the attractiveness of this investment.
First of all, the company has not shown that it can make money. It has not been profitable in any of the last four years, racking up operating losses of $35 million in the process.
While shareholders are shouldering these losses, they are also being diluted. The company hands out claims on its shares like candy, with restricted stock and options currently outstanding representing almost 30% of the company's actual shares!
Furthermore, the company is heavily reliant on a few customers for its revenues. Customers like Wal-Mart, that make a living from squeezing everyone with whom it does business (except consumers).
Management has also shown that it would rather spend the large cash reserve it has rather than return it to shareholders. The company recently partook in a $15 million acquisition that essentially removed the margin of safety on the company's discount to its net current assets.
Not all stocks trading at discounts to their net current asset values are bargains. Several troubled companies are on this list, and investors would do well to eliminate those that have great downside risk versus those that show potential for minimal downside risk.