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Dissecting the Returns on Deep Value Investing via CSInvesting

By Jeffrey Oxman, Sunil Mohanty, Tobias Carlisle

January 4th, 2012


Following Ben Graham’s “net current asset value” (NCAV) rule for stock selection (“net net” strategy), we provide evidence that buying stocks in companies with per share NCAV greater than the current share price produced superior risk-adjusted returns over the 1975- 2010 period. The risk factors that explain the returns associated with these firms include market risk, market liquidity, a factor capturing overreaction (long-term reversal), and a relative distress factor. The only firm characteristics that drive excess stock returns for such firms are the analyst coverage, stock price per share, and turnover. Controlling for firm size and common risk factors, we find that returns are higher among net-net stocks with low analyst coverage, low stock price per share and lower trading volume.

Dissecting The Returns On Deep Value Investing – Introduction

The concept of value investing was formalized by Benjamin Graham and David Dodd in their seminal treatise on the subject Security Analysis (1934). Value investing is designed to combine safety of capital with the potential for high returns. One of the many techniques for finding such opportunities, according to Graham and Dodd, is the concept of “net net.” A firm with current share price less than the liquidation value per share is defined as a “net net” opportunity. Graham and Dodd advocate purchasing net- net assets because there is no rational reason for a firm to be selling below its liquidation value, as that is the value one should expect to receive if the firm enters bankruptcy. Thus, it is the floor of potential values of the firm as a going concern. The concept of net-net combines safety of capital (or margin of safety), since there is little room for the stock price to drop any further, and strong up-side potential since most such firms see their share prices rise eventually.

The net-net strategy has been successfully used in practice by Benjamin Graham in the early and mid- twentieth century, yielding excess returns from 1930s to 1956. A small number of studies analyzethis strategy (Greenblatt et al, 1981; Oppenheimer, 1986; and Vu, 1988) . These studies show that that the Graham’s net-net strategy for value investing has consistently generated excess returns in 1960s and 1970s. However, the interpretation of the excess returns to value strategies offered in the literature has been controversial. Some argue that the excess return associated with net-net strategy is attributed disproportionately to small firms, and therefore, what is really being observed is a small firm size effect (Vu, 1988). Others argue that value strategies are fundamentally riskier (e.g., Fama and French; 1993, 1996) because such strategies attempt to provide a risk compensation explanation of value premiums. On the other hand, many other researchers (Shleifer and Vishney, 1997; and Daniel and Titman, 1997) dispute whether the Fama and French three factor models (1993 and 1996) really measure risk induced equity return premiums. For example, Shleifer and Vishny (1997) suggest that firms that are selling below their liquidation value are likely to be those identified by as an “extreme circumstance” where arbitrage cannot eliminate the anomaly. According to Shleifer and Vishny, 1997 (pp. 50 – 51):

… increasing one’s equity position in an industry that is perceived to be underpriced carries substantial fundamental risk, and hence reduces the attractiveness of the trade. Another important factor determining the attractiveness of any arbitrage concerns the horizon over which mispricing is eliminated. … Markets in which fundamental uncertainty is high and slowly resolved are likely to have a high long-run, but a low short-run, ratio of expected alpha to volatility. For arbitrageurs who care about interim consumption and whose reputations are permanently affected by their performance over the next year or two, the ratio of reward to risk over shorter horizons may be more relevant.

Given the apparent difficulties in exploiting the net-net’ opportunity, we are interested in exploring how some investment professionals have had continued success using a net-net strategy to generate high profits..4 In this study, we argue that the excess return associated with investing in deep value stocks is due to the lack of a liquid market and the length of time required to realize returns. Since net- net issues are likely to be less liquid, price movements may be infrequent and relatively large. This leads to the potential for market moving trades, where the price impact of a buy or sell trade is large enough to wipe out any economic gain from holding the asset. There are several other possible reasons why net-net issues are likely to be mispriced. These include small firm size effect, low analyst coverage, high leverage, low institutional ownership, low price/share and low turnover. For example, if fewer analysts cover a stock, the information disseminates more slowly (e.g., Hong, Lim, and Stein, 2000). Short selling a stock is likely to be more difficult if there are few institutional investors ready to lend shares (e,g, Nagel, 2005). Similarly, a stock with low price/share and low turnover is likely to be more expensive for sophisticated investors to arbitrage (Campbell, Hilscher, and Szilagyi, 2008),. Finally, it is possible that financial distress risk associated with net net stocks may carry a premium.

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