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edition o “Security Analysis,” whichhe coauthored with David Dodd. Inthe book, (net) current asset value isdened as:“current assets alone, minus allliabilities and claims ahead o theissue.” The common denition o NCAV is:

NCAV = current assets – [total liabilities +preerred stock]

Current assets consist primarily o cash and cash equivalents, receiv-ables, and inventories. Basically, theseare assets that are already cash or areconvertible into cash within a rela-tively short period o time (usuallyless than a year). Net current assetsexclude not only the intangible assetsbut also the xed and miscellaneousassets. In addition, Graham believedthat preerred stock belongs on theliability side o the balance sheet,not as part o capital and surplus. In“Security Analysis,” preerred stock is dubbed “an imperect creditorshipposition” that is best placed on thebalance sheet alongside unded debt.Net current assets dier romworking capital in that workingcapital is current assets less currentliabilities, thereby ocusing only onthe current segments o the balance

Benjamin Graham’s Net CurrentAsset Value Approach

By Wayne A. Thorp, CFA

“From 1970 to 1983,an investor could haveearned an average return o 29.4% by purchasing stocksthat ulilled Graham’srequirement and holdingthem or one year.”

sheet. In contrast, NCAV deductstotal liabilities (current and long-term) rom current assets. However,Graham used the terms interchange-ably.Compared to book value, theNCAV method is a more rigorousstandard. Book value can includeintangible assets, many o which maybe impaired in some manner. Fur-thermore, book value includes land,property and equipment, which areignored altogether by NCAV. How-ever, over time, the on-the-book valueo such assets is more than likely notan accurate representation o theiractual worth.

NCAV & Market Value

In “Security Analysis,” theauthors note that net assetvalue, or book value, seem-ingly was o little importanceto investors looking at “indus-trial companies,” citing theact that stocks can sell at highmultiples or at mere ractionso book value. Investor rea-soning was that share prices,by and large, are driven by acompany’s earning power anddividend payments, which ingeneral have no close relation-ship to the asset value (ex-cluding utilities and nancial rms). Thereore, investors and speculatorsalike had, or the most part, come toignore asset value.Beginning in the 1930s, ollowingthe market crash o 1929, Grahamand Dodd noticed a large numbero stocks selling below their currentasset value, meaning that the shareprice o a company is less than theper share value o current assets.During this period, the low prices tonet asset values were primarily drivenby poor earnings, which in turndrove stock prices down. Perhaps notsurprisingly, according to Grahamand Dodd, the market greeted thesestocks with uncertainty and indi-

utside o Warren Buett,perhaps no other investor isas well-known as his mentor Benja-min Graham. Considered by most tobe the ather o value investing andoten credited as the creator o thestock analyst proession, Graham’svalue-oriented investing methodolo-gies have been the topic o countlessarticles and academic studies. In act,AAII tracks three dierent Grahammethodologies at the Stock Screensarea o AAII.com. However, his origi-nal stock selection approach has notgarnered the same attention as hislater concepts.Graham developed andtested the net current assetvalue (NCAV) approachbetween 1930 and 1932. Ac-cording to private investingrm Tweedy, Browne Com-pany: “The net current assetvalue approach is the oldestapproach to investment ingroups o securities withcommon selection character-istics o which we are aware.”Graham reported that theaverage return, over a 30-yearperiod, on diversied porto-lios o net current asset stockswas about 20%. An outsidestudy showed that rom 1970to 1983, an investor couldhave earned an average return o 29.4% by purchasing stocks thatullled Graham’s requirement andholding them or one year. The topic o two “First Cut” col-umns by John Bajkowski in the AAIIJournal (September 2007 and April2009), the NCAV approach is moreully explained in this CI Online Ex-clusive, highlighting how you can usecomputerized stock screening toolsto identiy stocks meeting Graham’scriteria.

NCAV Dened

Graham rst discussed net cur-rent asset value (NCAV) in the 1934

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erence. The number o companiestrading below current asset valueagain spiked during the post-warperiod rom 1947 to 1950. How-ever, this time, high earnings orcedworking capital levels above laggingstock prices. However, the marketonce again ignored these “bargainissues.”Graham and Dodd pointed out,however, that when stocks tradebelow the company’s current assetlevel they are, in eect, trading belowthe company’s liquidating value. As-suming a company’s workingcapital is conservativelystated, it is reasonable toassume that most companiescan be sold o or at least thevalue o these assets. Further-more, they elt it was alsoreasonable to expect that thecompany’s remaining assets—plant, property, equipmentand other miscellaneous as-sets—would etch enough tooset “shrinkage” in currentassets resulting rom con-verting them into cash.Using net current assets asa proxy or liquidating value,Graham and Dodd were ableto create an actual relation-ship between the market priceo a stock and the realizablevalue o a company’s assets.When they ound companies tradingwell below their liquidating values,they bought them in bulk.

Buying “Bargain Issues”

In the 1949 edition o his book “The Intelligent Investor,” Grahamoered this denition o a “bargainissue”:“To be as concrete as possible, letus suggest that an issue is not a true‘bargain’ unless the indicated valueis at least 50 percent more than theprice.”He goes even urther when it comesto stock price relative to a company’snet current asset value:“…i a common stock can be

bought at no more than two-thirdso the working-capital alone—disregarding all other assets—andi the earnings record and prospectsare reasonably satisactory, thereis strong reason to believe that theinvestor is getting substantially morethan his money’s worth.”Graham’s need or a “margin o saety” shines through in this ex-ample. First o all, he isn’t interestedin the total assets o a company.Instead, he is only interested in themost liquid assets on the balancesheet. In “The Intelligent Investor,”Graham points out that a businessshould be worth to any private ownerat least the amount o the workingcapital, since the business ordinarilywould be expected to etch that muchat liquidation. Furthermore, Grahamwasn’t satised with merely buyingrms trading at less than net cur-rent asset value. He required an evengreater margin o saety and onlylooked at stocks whose prices wereless than two-thirds o net currentasset value.

Risks o “UndervaluedStocks”

Graham and Dodd were keenlyaware that some investments in low-price-to-NCAV stocks would ail. In“Security Analysis,” they suggestedtwo possible reasons why buyingstocks below current asset value mayail:1) Changing intrinsic value; or2) Market behavior. The “market-behavior problem,” asthey termed it, relates to the act thatthere is nothing that says that a stock price must adjust to the value ananalyst places on it. The authors alsoargue that intrinsic value is alwayschanging based on the developmento the business—earnings, dividends,etc. Thereore, i a companytrading below current assetvalue loses money or sub-stantially reduces its workingcapital, its intrinsic value willlikely be less than it was whenit was initially evaluated.As a result o this decline inintrinsic value, the stock mayno longer be undervaluedand, in act, may now beovervalued.Graham and Dodd elt that,given the market’s reactionto stocks selling below netcurrent asset value, investorswere avoiding these issuesor ear that the companies’prospects were so poor thatworking capital would declinein the uture. However, inanalyzing companies thatwere selling below current asset valuein 1932, 1933, 1938, and 1939,Graham and Dodd discovered thatthe market’s indierence was mis-placed. They concluded that:“…stocks selling below workingcapital and showing a air record o earnings and dividends are likely tobe ‘bargain’ issues and are likely toturn out to be unusually satisactorypurchases.” To oset the potential o investingin individual stocks that turn out tobe unprotable, Graham suggestedholding at least 30 stocks at a time.

Screening on NCAV

Table 1 summarizes the Grahamapproach to NCAV stock selec-

“Using net current assetsas a proxy or liquidatingvalue, Graham and Doddwere able to create an actualrelationship between themarket price o a stock andthe realizable value o acompany’s assets.”

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Table 1. The Graham NCAV Stock Selection Process in Brie

Philosophy and Style

The Graham net current asset value approach is one o theoldest documented stock selection methodologies, datingback to the 1930s. Net current asset value, or NCAV, looksat current assets minus total liabilities and preerred stock.Graham also termed NCAV a company’s “liquidation value.”His rationale was that this was the minimum value a companywould be able to garner i its assets were sold o. Grahampurchased large numbers (rom 30 to as many as 100) “bar-gain” issues to limit the risk o any one individual issue.

Universe o Stocks

No restrictions. By their nature, however, the stocks typicallypassing this screen are small-capitalization stocks, or evenmicro-caps.

Primary Criteria

Bargain price with a margin o saety: Price no more than two-thirds the company’s net current asset value.

Secondary Factors

•

“Reasonably satisactory” earnings record and prospects:Companies that are losing money or have an erratic earn-ings history are likely to see their intrinsic value decline,making them less undervalued or potentially overvalued.

•

“Sound nancial condition”: As a test or nancial strength,Graham suggests looking or companies with total stock-holder’s equity (common and preerred equity) greaterthan the total o current liabilities and long-term debt.

Stock Monitoring and When to Sell

•

Graham held large numbers o companies trading belowtheir net current asset value to mitigate individual com-pany risk, suggesting as many as 30. His Graham-Newmanund held as many as 100 o these issues at a time.

•

When he bought a stock trading at 67% o its net currentasset value, he would hold it until he had a 50% gain on itor until he had held it or two years.

tion. Now that we have denedhis requirement or buying stocksbased on net current asset value, weturn our attention to nding stocksthat meet that requirement. Theeasiest and quickest way to identiycompanies sharing similar nancialcharacteristics is by using either aWeb- or sotware-based screeningtool. We used AAII’s Stock InvestorPro undamental stock screening andresearch database to develop ourGraham NCAV screen. As o January22, 2010, the Stock Investor databaseconsisted o 9,874 companies tradedon U.S. exchanges.Graham’s NCAV approach beginsby identiying stocks trading at adiscount to the company’s net currentasset value per share; specically, atleast one-third below net asset value.We are not awareo any screeningservices that allowyou to screen orthis specic cri-terion. However,with Stock InvestorPro, you can createcustom elds thatyou can then use inthe screening process. Thereore, wecreated a custom eld that deductstotal liabilities and preerred stock rom current assets (all rom thelatest scal year) and divides this bythe average number o shares out-standing over the last scal year. (See Table 2 or the ormula.)Using this custom eld and re-quiring that the latest weekly closingprice is not more than 66.7% o netcurrent asset value per share, we ar-rive at 456 companies as o January22, 2010.Even though we have eliminatedover 95% o the companies in thecurrent database, we still haveover 400 candidates rom which tochoose. Furthermore, many o thesecompanies are cheap or a reason—perhaps either because o underlyingproblems with the company itsel orproblems with its industry. Grahamadmitted that not all stocks chosenin this manner will have excessivereturns, which is why he stressed theneed or adequate diversication. Inan article published in 1975 or aseminar, Graham states that the port-olio at his investment rm Graham-Newman oten included more than100 bargain issues at a time.In order to winnow our group evenurther, and to potentially weed outsome o the duds, some qualiyinglters are required.

Protable Operations

In “The Intelligent Investor,”Graham suggests buying stocks thatare priced below net current as-sets only i the company’s “earningsCustom Field Name Formula

Net Curr Assets per Shr Y1 ([Current assets Y1]-[Total liabilities Y1]-[Preerred stock Y1])/[Shares Average Y1] Total Equity Y1 [Equity (common) Y1]+[Preerred stock Y1]Curr Liab + LT Debt Y1 [Current liabilities Y1]+[Long-term debt Y1]

Stock Investor Pro subscribers can download a text le o these elds at www.aaii.com/ci/201002/customelds.txt or cuttingand pasting into the Custom Field Editor.

Table 2. Graham NCAV Custom Fields or Use With AAII’s Stock Investor Pro