Negative Enterprise Value Stocks Crazy Outperformance by Jae Jun, Old School Value

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In case you missed it, take a look at the 2013 half yearly results of the OSV value stock screens.

At the end of Q2, the leading screen is the Increasing Net Net Working Capital (NNWC) which searches for companies that are increasing in cash, accounts receivables and inventory at a much higher rate than debt.

All fundamentally positive signs for any company.

However, another screening strategy is getting all the attention. One that I’ve written about since 2009. That is negative enterprise value stocks.

Negative Enterprise Value Stocks

This is an article from the CFA Institute blog discussing the performance of negative enterprise value stocks between the period March 30, 1972 and September 28, 2012. Greenbackd also did a good follow-up.

Before getting into the performances and the stocks, what are negative enterprise value stocks?

There are two main characteristics with negative EV stocks.

  1. Hated
  2. Loaded with cash

And you have to like both. Not just one or the other.

If you try to analyze any negative EV stock, the numbers are horrible. 99% of the time, you will throw it into the CRAP (Can’t Realize a Profit) pile.

Enterprise Value Definition

The way I define EV is

Enterprise Value = Market Capitalization + Total Debt – Excess Cash

For a stock to have a negative enterprise value, the excess cash part must be bigger than both market cap and total debt.

Yes, excess cash.

Not total cash and equivalents. Only the cash that is not required to run day-to-day operations.

Compare that to the CFA’s article using the proper enterprise value definition.

EV =
Market cap
+ Preferred equity at market value
+ Minority interest at market value, if any
+ Debt at market value
+ Unfunded pension liabilities and other debt-deemed provisions
– Associate company at market value, if any
– Cash and cash-equivalents.

By selecting stocks based on the above definition, the performance results of the study is below.

Negative Enterprise Value Stocks
Returns on Negative Enterprise Value Stocks | CFA Institute

The best performers come from the < $50m market cap companies but many companies are tiny micro caps that you can’t buy no matter how hard you try.

Negative Enterprise Value Stocks
Negative Enterprise Value Stocks Returns by Country

Just as Japan is known for being the land of the rising Net Nets, Ireland and Israel should be known as the country of negative enterprise value stocks.

It is interesting to see how USA is only in the middle of the pack.

Is it Possible to Achieve Such Gains?

The majority of the returns are coming from micro caps < $50m. Those stocks will be extremely difficult to buy even if you know how to buy illiquid shares.

Plus, you don’t have a team of people going through every company in the universe and manually calculating negative EV the way the CFA institute describes it.

The biggest difficulty will be calculating debt at market value. The other pieces of information you will have to grind out from the 10-K.

It will take you about 20-30 minutes to do this for one stock and there is no way you can go through enough stocks to buy a basket of negative EV stocks.

You need a practical and quicker way, and that’s why I use the following formula.

Enterprise Value = Market Capitalization + Total Debt – Excess Cash

Excess Cash = Total Cash – MAX(0,Current Liabilities-Current Assets)

Use a screener like Portfolio123 in combination with the OSV stock analyzer and you’ll have a list of negative EV stocks in no time.

Real World Performance of Negative Enterprise Value Stocks

I constantly emphasize that real returns are important for any backtest and screen. The research by the CFA Institute shows that negative enterprise value stocks outperform, but the results are just theoretical.

To really gauge the performance, the stocks have to have enough volume, be listed on major exchanges, account for proper fees and be above a certain sticker price.

The negative enterprise value performance looks like this from 2000 to 2012.

Negative Enterprise Value Stocks
Negative Enterprise Value Performance

At the end of Q2 2013, the screen achieved 31.96%.

As of today, the performance has jumped to 43.13%.

Negative Enterprise Value Stocks
Negative Enterprise Value Stocks Performance Stats

2013 Negative Enterprise Value Stocks

The year started off with 19 stocks on the list. Here are their respective performances so far.

Negative Enterprise Value Stocks
2013 Negative EV stocks

As of today, that number has dwindled down to six, but IGOI should be taken off the list as it is being bought out. That brings it down to five.

Negative Enterprise Value Stocks
Latest Negative EV stocks

QLT Inc (QLTI)

A biotechnology company that develops ocular products.

Recently distributed a dividend of about 50%. Even tiny companies flush with cash can be shareholder friendly but this also means that the negative EV calculated by the screen can be incorrect as it didn’t account for the dividend.

Does not rank highly on fundamentals or quality.

Some basic numbers I look through.

Negative Enterprise Value Stocks
QLTI Fundamentals

Transcept Pharmaceuticals (TSPT)

A lot of biotech and pharma companies make this screen because these types of companies are heavily funded with cash and continue to raise and plow money. Horrible returns, but trading at cheap multiples.

Negative Enterprise Value Stocks
TSPT Fundamentals

AVEO Pharma (AVEO)

AVEO quality scores are rock bottom.

Accruals are horrific, Piotroski scores are in the basement, and there is a huge spike in the warning flag for the Beneish earnings Manipulation score.

Negative Enterprise Value Stocks
Shocking Accruals and Piotroski
Negative Enterprise Value Stocks
Huge Warning Sign in the Beneish M Score

Maxygen (MAXY)

Another biotech company, but unlike the previous three, this one has positive earnings and is the best out of the bunch.

Negative Enterprise Value Stocks

NEUROMetrix (NURO)

The last of the five is a medical device company but this company is still in the dumps. Lost money every year since 2007.

The Altman Z score is flashing signs that the business will go under.

Negative Enterprise Value Stocks
Dire Altman Z Score

No wonder it is hated.

So How Do You Pick Negative EV Stocks?

You don’t.

There are only three ways to make this work.

  1. Buy a basket of 20 stock to diversify
  2. Don’t try to pick your own
  3. Trust the system

You need a lot of guts to buy and hold these stocks. There will be many that go to zero, but the few that shoot up 100+% will make all the difference. Look at the 2013 results so far as evidence.

Remember, no matter how hard you try, you won’ t be able to select negative enterprise value stocks at a winning percentage.

You are essentially trying to find gold in a pile of CRAP

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