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The Performance of the Net Current Asset Value Strategy in the United States

1984-2008

University of Maastricht Faculty of Economics and Business Administration Maastricht, August, 2009 Oliemans, F. i278408 International Business: Finance Master Thesis Mrs. Nadja Guenster

―Investing is most sensible when it is most businesslike‖ Benjamin Graham (N.D.)

"Ben's Mr. Market allegory may seem out-of-date in today's investment world, in which most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising 'Take two aspirins'?"

Warren E. Buffett (1987)

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Abstract

This thesis analyzes the performance and persistence of a net current asset value strategy. This strategy analyzes a portfolio of firms that trade at a market discount to liquidating or net current asset value The results show that the strategy was able to produce risk-adjusted returns over the 1984-2008 period that are in line with the study by Oppenheimer (1986). Based on the Carhart (1997) four factor model the results show that the abnormal risk-adjusted monthly returns are 2,27% for value weighted and 1,73% for equal weighted returns. It is proposed that the abnormal risk-adjusted returns are due to institutional constraints, a high individual cost basis and is strongly influenced by behavioral biases.

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Data V. References XII. Research Question and Hypothesis IV. Limitations XI. Further Research X. Literature Review III. Robustness Check VIII.Table of contents I. Appendices 5 7 18 21 23 31 45 51 56 56 58 65 4 . Introduction II. Methodology VI. Results VII. Conclusion and Implications IX.

NCAV stocks are stocks whose market value is trading at a discount to the current asset value after subtracting all liabilities and claims. Discount net current asset value stocks offer a margin of safety to equity holders. because public knowledge of the anomaly will increase the funds allocated to the specific anomaly and reduce risk-adjusted abnormal returns (Malkiel. 2008). 2005). If there are enough rational investors then this should reduce the abnormal returns present and therefore this strategy should not show persistency. The strategy. 1986). One of the tenants of the semi-strong form of market efficiency is. 2009). The main reason why this strategy needs to be revisited is to analyze the persistency of the NCAV strategy. Evidence of persistency within one market is not available for the anomaly and serves as the main reason why this strategy should be revisited. Introduction This thesis discusses the persistency of a potential market anomaly. 5 . which gives substantial protection from further operating losses and loss of principal in case of bankruptcy (Dodd and Graham. has shown to produce risk-adjusted abnormal returns (Oppenheimer. A stock trading at two thirds or less of NCAV already assumes bankruptcy and therefore any continuing positive operating value is received at no cost. (Arnold and Xiao. The strategy is a subset of the book/market anomaly except that it includes only tangible current assets and therefore intrinsic value is easier to detect (Fama and French. Furthermore according to the CAPM if a class of stocks trades above the security market line (SML) it should be bought by investors as it has a highly favorable risk/return relationship. first proposed by Dodd and Graham (2009). 1993). Thus a rational investor armed with the evidence of the Oppenheimer study would buy these stocks. stocks trading at a discount to their net current asset value (NCAV). Further arguments for this analysis are given next. It is this discount that offers significant safety against loss of invested capital while still exposing the equity holder to upside potential. 2009). (Whitman and Shubik. 1996). receivables and cash which can be distributed to shareholders without losing significant value (Dodd and Graham. A purchase of a discount NCAV stock equates to buying stocks at a discount to liquidating value. This is because current assets consist of inventories. 2006). (Bilsersee et al. that anomalies are inherently self-destructive. It is proposed that the main reason for the risk-adjusted returns are due to overreaction by investors and institutional constraints.I.

This model has since been proven to be an inadequate asset pricing model (Fama and French. indices 1984-2008? Persistent abnormal risk-adjusted returns will further support the evidence for this anomaly and potentially provide a profitable strategy for investors. The knowledge could have been used to exploit market anomalies and reduce overall returns to the NCAV strategy. 2005). 1970 to 1983 was a period when stock prices were trading at relatively low multiples and lower market to book values (Oppenheimer. 1996). The Chen and Zhang (2009) and Cremers et al (2008) models are used as robustness checks to confirm the results. 1986). Thus the results by Oppenheimer (1986) could be due to a model specification error and not true market inefficiency. Finally Oppenheimer (1983) limited his risk-adjusted analysis to the basic CAPM model. The advent of behavioral finance during the last two decades has given the public knowledge about psychological deviations from rational decision making.This thesis serves as an expansion and update of the article by Oppenheimer (1986). Oppenheimer (1986) studied the period from 1970 to 1983. (Carhart. 1997). This thesis adds to the discussion of this anomaly by including several expanded asset pricing models. This should reduce the model specification error. (Shiller. To test whether the discount NCAV anomaly has shown persistency over the 1984-2008 period the following research question is set up: What is the performance of the Net Current Asset Value Strategy versus the broad based U. 2005). There are important differences between the two sample periods. Bildersee et al (1993) showed that there is a reduction in the both the availability of discount NCAV stocks as well in the returns generated during a long-run bull market in United States. This thesis analyzes the period from 1984 to 2008. The bull market of this period increased the average price paid for securities when measured by the 10 year rolling price to earnings ratio (Shiller. 1996).S. 6 . The Fama and French three factor model as well the Carhart four factor model are used as the basis for testing the strategy (Fama and French. During the late 1980‘s until the early 21st century the stock market experienced a long run bull market.

This naturally implies that discount NCAV stocks also trade at a market discount to book value. Section VII provides a robustness test The thesis continues with a conclusion and implications section in chapter VIII. Chapter IV and V discusses the data and the methodology used. (Fama and French. The first step is to analyze the origins of this anomaly and this is done by first reviewing the basic CAPM model. Chapter III details the hypotheses that are set up. 1985). The CAPM model introduced by Sharpe (1964) and Treynor (1961). This risk. The higher the Beta the higher the non-diversifiable risk of the stock. The discount NCAV strategy is a subset of the market/book anomaly and therefore the explanations as well the origins of the market/book anomaly are important to understand. The literature and theoretical foundation are discussed in the next section. limitations in X and finally references are given in XI.1965b) is the first widely accepted model that determines the theoretically appropriate required return of an asset. It determines the rate of return by taking into account the assets sensitivity to non-diversifiable risk. 1992). (De Bondt and Thaler.To answer this question the following structure is setup: Chapter II discusses the prevalent theory. The book/market anomaly is a well documented anomaly and is incorporated into the Fama and French three factor model (Daniel and Titman. The CAPM assumes that investors perceive volatility as the main risk factor and then assumes that this is linked to expected returns. The theory will allow the reader to understand why persistency of the discount NCAV strategy can occur and why this strategy is a a direct test of the market/book anomaly. (Lakonishok et al. Thus a stock that has a beta of two is twice as volatile with respect to the market and is deemed to be twice as risky. 2009). A higher beta is equal to higher volatility with respect to the market. Literature Review: This thesis examines the persistency of a market anomaly. A firm trading at such a discount can be purchased for a price less than the book value of the sum of inventories. In the case of a beta of two the CAPM predicts returns that are twice the market return after subtracting the risk 7 . II. termed beta. stocks trading at a discount to net current asset value. 1996). receivables and cash after subtracting all liabilities (Dodd and Graham. After this section the results are presented in chapter VI . 1992). Further research is discussed in chapter IX. and extended by Lintner (1965a. measures the covariance of the asset with respect to the market compared to the overall variance of the market.

The three-factor model proposed by Fama and French (1993) included the standard CAPM but expanded to model to include two more factors. 1993). The SML factor is explained as being due to co variation in the returns of small stocks that is not captured by the market returns and is compensated in average returns (Fama and French. Although the strategy is logically appealing Daniel and Titman (1997) found evidence that the covariance‘s did not change after the firm became distressed. Their findings show that investors overreact to past information and extrapolate into the future. This causes past losers to outperform past winners. An employee in a firm under distress will be unlikely to hold capital in the firm since the returns generated from his human capital are at stake as well. To improve upon the standard CAPM model Fama and French (1993) introduce their three-factor model. These two factors are the Small Minus Big factor (SML) and the High Book to Market minus Low Book to Market factor (HML). Fama and French (1993) offer a rational explanation for the occurrence of these anomalies. Fama and French (1993) propose that distress is linked to human capital. The first factor captures the returns generated by small size firms and the second the excess returns of high book to market stocks versus low book to market stocks. This means that employees of distressed firms have an incentive not to own capital in their own firm.free rate. Their argumentation is based on rational behavior which not supported by the evidence (Daniel and Titman. A distress explanation is given for the second anomaly. Fama and French (1993) were able to explain a significant degree of cross-sectional returns by using their three-factor model. The first article relevant to the behavioral explanation of the HML factor is the article by de Bondt and Thaler (1985). Another argument made for explaining the HML factor is behavioral. The early empirical results provided by Sharpe (1964) and Treynor (1961) were promising but later research did not confirm the results. The NCAV strategy is an extreme test of the HML factor and therefore the different explanations for this anomaly are discussed further. Fama and French (1992) stipulate that the beta is insufficient in explaining expected returns between 1941 and 1990. the HML factor. which they state to be important to most investors. 1997). Behavioral finance assumes that humans do not under all circumstance behave rationally and this leads to systematic deviations in stock market returns Hirsleifer (2001). De Bondt and Thaler (1985) claim that individuals do not adhere to Bayes‘ rule but rather 8 .

Fama and French (1993) state that high book to market stocks are stocks have recently underperformed the market and is in line the loser portfolio of De Bondt and Thaler (1985). Lakonishok et al (1994) argue that while there might be a metaphysical risk attributed to value stocks. This is in accordance to the representative heuristic proposed by Kahneman and Tversky (1979). They do not mention the rational distress argument. This is again evidence of the representative heuristic of Kahneman and Tversky (1979). It is this phenomenon. This is in line with the argument of practitioners. According to Lakonishok et al (1992) institutional investors suffer from the same bias towards glamour stocks because they are deemed to be prudent investments. Institutional investors might have even shorter time horizons due to their competition with other money managers to beat the market because they can lose their jobs if they underperform over the short run. among other anomalies. it fails to specifically address the HML factor from a behavioral perspective. Lakonishok et al (1994) build on the De Bondt and Thaler (1985) article to explain. Investors could also view well-run firms as being equal to good investments and buy glamour stocks they believe they cannot lose money on. Lakonishok et al (1994) state that value investors such as Dodd and Graham (2009) have been able to outperform the market but that the reasons for this mispricing is not clear. who claim that time arbitrage will allow for abnormal returns (Pabrai. the evidence suggests a more straightforward model. Their results confirm this last statement and they conclude that investors consistently overestimate future growth rate of glamour stocks relative to value stocks. that according to the De Bondt and Thaler (1985) causes the outperformance of loser portfolios compared to winner portfolios. Individual investors might extrapolate past growth rates which are highly unlikely to persist in the future. the HML factor on the basis irrational behavior. Investors often seek short term abnormal returns within months instead of 4 percentage point over the course of 5 years. As the De Bondt and Thaler (1985) article was written before the Fama and French (1993) study.overweight recent data and underweight prior data. Where a heuristic is rule of thumb individuals use to make decisions and representativeness is equated to using recently available data. Although investing in prudent glamour stocks earns lower returns it can be a rational strategy for a money manager unwilling to put his job on the line advocating stocks that have done poorly in the past. The gap between value and glamour stocks is 10 percent per year and can be explained due to systematic behavioral deviations and institutional constraints. The third and final factor is the short time horizon of most investors. The overall 9 . 2007).

according to the author. 2001).conclusion drawn by Lakonisk et al (1992) is the tendency of investors to make judgmental errors and tendency of institutional investors to tilt their portfolios toward glamour stocks to make their life easier. The market/book factor was introduced to help explain the lack of explanatory power of the traditional CAPM model. 10 . Lee et al (1997). The issue with this is of course that among others. Thus the securities price is not necessarily equal to intrinsic value otherwise there would be a constant risk/return relationship. In order to compare the value of stock prices to the stated market price a definition is required. 2005). The overall conclusion of the market/book anomaly can now be drawn. This is in line with the EMH. state that there is widespread consensus among financial economists that intrinsic value is equal to the present value of its future dividends and cash flows. They claim that academics view the securities price as the best estimate of intrinsic value and view fundamental analysis as a futile exercise. It does so specifically for the market/book value but on the basis of only tangible current assets. The behavioral explanation provided by Lakonishok et al (1994) reports that overreaction. institutional constraints and a short term horizon are likely to cause the systematic deviation between price and value in the case of the HML factor. To test the persistency of systematic deviation from underlying value. a discussion is required of how to measure this value. The evidence for the irrational and institutional constraints hypothesis is. The behavioral explanation is rooted in experimental psychology Kahneman and Tversky (1979) whereas the institutional constraints were investigated in Lakonishok et al (1992). Lakonishok et al (1992) have found widespread abnormal returns on the basis of valuation criteria. stronger than the rational explanation. Therefore a model for measuring intrinsic value is required. Fama and French (1993) posited a rational distress explanation for the anomaly but the evidence reported by Daniel and Titman (1997) did not support the distress situation. which evidence has proven not to be the case. This thesis tests the persistency of these systematic deviations from an underlying risk/return relationship. The definition used in this thesis is intrinsic value. (Beechey et al. which states that if a market is semi-strong form efficient fundamental analysis is useless (Malkiel. According to Lee et al (1997) there are only few studies focusing on the problem of intrinsic value.

1996). If this occurs then this implies an inefficient market. Buffett (2009) and Dodd and Graham (2009) note that the higher the uncertainty of the business the higher the uncertainty of the intrinsic value of the common stocks and underlying business. The models of intrinsic value provided by mainstream academics is in line with Dodd and Graham (2009). It is claimed by Dodd and Graham (2009) that it is not necessary to achieve a precise figure in order to 11 . dividends. the originators of the NCAV strategy and more importantly the concept of intrinsic value. earnings. Among these facts are the assets. If these models are correct in valuing a firm then firms trading below this price would yield abnormal returns whereas firms trading above this price would yield subnormal returns. Thus a correct model of pricing intrinsic value should pick up on high market/book stocks because these stocks would have a higher intrinsic value than the current market price. It is this discrepancy between intrinsic value and market price that causes the eventual abnormal returns for the high market to book firms. These three models have in common that they rely on the facts provided by accounting figures to provide a measurement of intrinsic value. they argue intrinsic value is independent from the current market price. definite prospects and others. They state that the intrinsic value of a security is determined by facts. It is said that the calculation should not include the price quotation because it can fluctuate on the basis of psychological excess. Where Dodd and Graham (2009) and practitioners as Warren Buffett (2009) differ from mainstream academia is that the calculation of an intrinsic value based on the facts is an inherently imprecise calculation. (Frank and Lee. Therefore a calculation of intrinsic value entails a range of estimates of the discounted cash flows that can be received from the firm.Frankel and Lee (1996) posit that the basis for measuring the intrinsic value of the firm is book value as well as expected earnings. In line with the belief that there is an independent intrinsic value to firms. Penman and Sougiannis (1997) do so on the basis of residual income. Book value can be used to generate cash flows to the shareholders if the firm is (partially) liquidated or if the assets are sold off. The HML factor is linked to intrinsic value because book value is part of the value of the firm . which is in line with the arguments provided by Lakonishok et al (1992). The stated book values can be worth less than the actual book values or the past earnings can prove to be inherently unreliable in predicting the future. Campbell and Shiller (1988) base their calculation solely on earnings to predict future dividends.

If the current market value per share is lower than the NCAV per share then this security is trading at a discount to NCAV. What is needed is for a range of estimates to be sufficiently below the current market prices to warrant a purchase and to satisfy the safety criteria proposed by Graham. From the perspective of Graham (2003) and Buffett (2009) the stock price is merely a benchmark one can use to compare the valuation of the business with. They also state that higher volatility reduces risk because it allows the investor to buy a larger portion of the same firm at a lower price. Buffett (2009) believes that valuations are done on the basis of valuing a firm as a private business owner and comparing that to the current market price. stocks that trade at a sizeable discount to their NCAV should be profitable if sold to another firm or liquidated. This implies that if firms trade at a discount of market/net current asset value there is a discrepancy that will cause abnormal returns to be generated in the future. First proposed by Dodd and Graham (2009). A discount NCAV stock can be seen as an inherently low risk strategy because the tangible book value should already produce a profit for the investor. Dodd and Graham (2009) explain that no private 12 . Thus in most cases the larger the market to book value the larger the discrepancy between intrinsic and market value. To analyze why net current asset value is closely linked to intrinsic value a discussion is given next. According to Graham. Net Current Asset Value is calculated by taking current assets and subtracting all short and long term liabilities. The original concept of intrinsic value was introduced by Benjamin Graham (2003) and he considered there to be a strong relationship between net current asset value and intrinsic value.purchase a security. Note that this last statement requires the market to inefficient otherwise no such safety criteria would exist. the Net Current Asset Value approximates the liquidation value of the firm. Campbell and Shiller (1988) and Perman and Sougiannis (1997). Long term assets are not included. The models of intrinsic value argue there is a definite value to firms which can be derived from publicly available information. This value is closely related to the HML factor because book value is part of the intrinsic value of the firm. In line with Frankel and Lee (1996). This total net current asset value is divided by the shares outstanding which gives the net current asset value per share.

business owner would sell their assets at such a low price to another investor. 2. 13 . A business or industry with a record of low profitability can improve because competition is reduced or the economics of the business improve. 1. When earnings go up the return on assets will increase thereby often increasing the share price. A mean reversion to normal levels of returns often occurs according to Dodd and Graham (2009). The firm might be sold to a competitor who is able to utilize the assets more efficiently than the current operators. The earnings power of the firm can increase. A gradual reduction in firm value due to poor business economics or mismanagement causes investors to price the share at a discount to NCAV. the EMH predicts that the firm will continue to diminish the capital base of the corporation. The competitor will at least pay the liquidation value of the assets. In one of his last interviews Graham (1976) is quoted as saying this about the NCAV strategy: ―<The NCAV strategy> appears severely limited in its application.‖ The EMH predicts that stocks that trade at distressed prices incorporate extra risk (Fama and French. I consider <the NCAV strategy> a foolproof method of systematic investment--once again.. If a firm trades at a discount to NCAV. Another reason for an increase in earnings is due to a change in operating policy. not on the basis of individual results but in terms of the expectable group outcome. Dodd and Graham (2009) argue that there are several developments that can take place to prevent this gradual reduction. 1996). A gradual reduction may occur but is unlikely to do so because. This can either be done voluntarily or they can be forced to change their policy by the shareholders. Unprofitable businesses can be closed down or (new) management can change the strategy of the business. but we found it almost unfailingly dependable and satisfactory in 30-odd years of managing moderate-sized investment funds.

If a diversified group of discount NCAV stocks is purchased there is a high probability that the value of the discount will be unlocked. 1976). has never released the official data but claims to have produced returns equal to 20 percent over a 30 year period with this strategy (Graham. the first known advocate of the strategy. the author considers this discrepancy to be due to behavioral and institutional constraints (De Bondt and Thaler 1985).3. This implies that it is a direct test of these phenomena and a test of deviations from intrinsic value. The amount of liquid assets limits the downside risk in case of a bankruptcy while leaving the very real chance that the earnings power of assets will increase. According to Dodd and Graham (2009) it is irrational to trade below liquidating value because it assumes that continuing business operations have an overall negative effect on the firm. The unique aspect of this test is that it is very straightforward to observe that the pricing of the stock is irrational. The firm is already trading at a discount to NCAV and therefore liquidation would be profitable. Since Graham has not 14 . The next section will discuss the previous tests of the strategy. Graham. This can also be the case for firms trading below M/B value but this value can contain illiquid assets or intangible assets that do not hold value or cannot be liquidated without continuing operations. the forces counteracting this trend should lead to satisfactory results within a diversified portfolio of discount NCAV stocks. In the case of a discount NCAV stock the intrinsic value is very likely to be higher than the current share price. The arguments advocating why a NCAV should pay off have now been given. While the continued diminishing of assets might occur occasionally. This liquidation would release the value of the tangible current assets. Although some discount NCAV firms will continue to diminish the assets of the stockholder. This is well in excess of the market returns over this period. The NCAV strategy only takes into account current assets and does not include assets that are difficult to value. The liquidating value is equal to a discount to net current asset value of at least 1/3. It could be the case that long term assets have far higher book values than true economic value. Lakonishok et al (1994). The discontinuation of the business.

Over this period a discount NCAV portfolio worth 10.973 dollars whereas the NYSE-AMEX index grew to 37.296 dollars and the small-firm indices to $101. This thesis will research the US stock market during the period from 1984-2008 to analyze if the discount NCAV strategy continued to produce abnormal riskadjusted returns. regret aversion and hindsight bias. have been written about the topic. These results were achieved by buying a portfolio of securities that is at most two thirds of NCAV. The mean monthly returns for this period were 2. This thesis serves as an update and expansion of the paper written by Oppenheimer (1986). Oppenheimer (1986) undertook this analysis during the 1970-1983 period in the United States.000 dollars would have grown to 254. This section will summarize the three papers that.992 dollars.75% respectively. Oppenheimer (1986) claims that this argument does not hold for this specific sample. The results also show that the lower the purchase price and therefore the higher the discount to NCAV the higher the abnormal risk adjusted returns are. Therefore this paper will be discussed first.96% and 1. The overall results shows that discount NCAV firms are able to produce consistent abnormal risk adjusted returns and that the degree of undervaluation is important. The research that is available shows positive abnormal risk adjusted returns if there are enough discount NCAV stocks available to form a representative portfolio. The research was limited to the United States. I will rely on the scarce academic tests that are available.45% for the NCAV portfolio whereas the NYSE-AMEX and the Small Firm indices produced 0. The results show that the 13-year risk adjusted returns were significantly greater than the market portfolio returns. 15 . Taking into account riskadjusted returns the NCAV portfolio outperformed the NYSE-AMEX by 19% on a yearly basis and the small firm index by 8%. as is this thesis. to the authors‘ knowledge. He undertook this study because of the lack of academic analysis on this topic. Firms without positive earnings and profitable firms omitting dividend payments show higher returns. Although the US market will be investigated. Graham (2009) stated that in order to achieve adequate risk adjusted returns the firms should be relatively profitable and have consistent dividends. Although not discussed by Oppenheimer (1986) one can argue that the greater the undervaluation the greater the effect of the representative heuristic. other markets have been tested as well.released his results.

16 . This thesis also tests a period with relatively high valuations and it will be interesting to see if there are enough discount NCAV stocks available in the United State from 1984-2008. The three articles that have analyzed the NCAV strategy show that this strategy is able to produce abnormal risk adjusted returns. The sample period partially overlaps the sample of this thesis and the London market is almost as liquid as the United States stock market. The working paper by Arnold and Xiao (2008) analyzes the NCAV strategy in London from 1981 until 2005. A less stringent test implies that the underlying value is not as a liquid and the value of the balance sheet is less certain. Each article analyzes a different market and a different time period. It is interesting to note that the higher the overall price level of the market the fewer opportunities there are to invest in discount NCAV stocks. The results are not as robust as the Oppenheimer study. This paper is interesting because it analyzes a liquid stock market during a period of high stock returns. This sample coincides with one of the largest bull markets of the past century. The results show that stocks trading at a discount to NCAV value produce significantly positive market-adjusted returns.5 NCAV.Bildersee et al (1993) examined the performance of Japanese common stocks in relation to their NCAV. The results are dependent on the holding period of the sample. The results are up to 19. Even though the authors had to stretch the parameters the results still showed that the NCAV strategy produced abnormal risk adjusted returns. They conclude that the premiums that these stocks provide can be due to irrational pricing by investors. The NCAV strategy produces positive abnormal returns regardless of the location of the market or the pricing of the stock market. Their sample ranged from 1975 until 1988. The authors posit that the lack of discount NCAV stocks is due to structural difference but it can also be due to the large bull market which increased the prices of all stocks. This allowed a representative portfolio to be formed.7% percent per year. The last paper discusses a more recent test of the NCAV strategy in London. During this period the number of firms trading below NCAV was almost non-existent and therefore they test all firms which traded at values of 1. They wanted to research whether the discount NCAV strategy held in a country which is different from the United States. The authors conclude that the results are not due to the ‗size effect‘ and nor is the CAPM and the Fama and French three-factor model able to explain the results.

The HML factor also takes into account tangible and intangible long term assets which may or may not have a definite value. 2009). The NCAV strategy offers a unique measurement of intrinsic value because it takes into account only liquid current assets which are easy to value and more importantly easy to convert to cash. (Dodd and Graham. Lakonishok et al (1994) argue that investors are not pricing in extra risk but that the returns are due to investor irrationality and institutional constraints.The article by Bildersee et al (1993) showed that there were not enough discount NCAV stocks available to form a portfolio during the bull market in Japan. The literature review has given the reader insight into the relevance of the NCAV strategy as a test of intrinsic value and systematic deviations from the risk/return relationship. Conclusion of the literature review: The literature review has shown that traditional volatility is insufficient in explaining the expected returns of stock market returns. These arguments give credence to the outperformance of high book/market stocks. Thus the NCAV test is a more thorough test of the systematic deviations based on behavioral biases and institutional constraints. 2009). These stocks still produced abnormal risk adjusted returns but the results were not as robust when compared to the articles by Oppenheimer (1986) and Arnold and Xiao (2008). as well as very successful practitioners have attempted to measure intrinsic value but have difficulty in estimating a single value due to the uncertainty of future earnings (Buffett. but evidence by Daniel and Titman (1997) has shown that the rational risk argument posited by Fama and French (1993) is insufficient. 1996). It is proposed that these stocks have an intrinsic value that is higher than the market price. (Frankel and Lee. Overall one can conclude that the results of these three articles provide evidence that the NCAV strategy produces abnormal riskadjusted returns. Academics. The next chapter will explain the need for this study and why there should be a persistency test of this anomaly. The authors stretched the original criteria to select stocks that were trading at relatively low premiums to NCAV. 17 . By expanding the model to include other factors the predictability is improved.

III. Research Question and Hypothesis

Oppenheimer (1986) analyzed the NCAV performance in the United States between 1970 and 1983. This study showed the strategy yielded abnormal risk-adjusted returns. The main reason why this strategy needs to be revisited is to analyze the persistency of the NCAV strategy. One of the tenants of the semi-strong form of market efficiency is, that anomalies are inherently selfdestructive, because public knowledge of the anomaly will increase the funds allocated to the specific anomaly and reduce risk-adjusted abnormal returns (Malkiel, 2005). No evidence is yet available on the persistency of the anomaly and this thesis aims to provide this evidence. A test of persistency is important, especially because of the differences between the two sample periods.

1970 to 1983 was a period when stock prices were trading at relatively low multiples and lower market to book values (Oppenheimer, 1986), (Shiller, 2005). During the late 1980‘s until the early 21st century the stock market experienced a long run bull market. The bull market of this period increased the average price paid for securities when measured by the 10 year rolling price to earnings ratio (Shiller, 2005). Bildersee et al (1993) showed that there is a reduction in the both the availability of discount NCAV stocks as well as in the returns generated during a longrun bull market in Japan. If the same relationship holds in the United States then the results will not be persistent.

The release of the article by Oppeheimer (1986) provided the public information about the lucrative returns of this strategy. According to the EMH this public knowledge should reduce the abnormal returns as more funds are allocated to inefficient strategies (Malkiel, 2005). Furthermore according to the CAPM if a class of stocks trades above the security market line (SML) it should be bought by investors as it has a highly favorable risk/return relationship. Thus a rational investor armed with the evidence of the Oppenheimer study would buy these stocks. If there are enough rational investors then this should reduce the abnormal returns present and therefore this strategy should not show persistency.

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The advent of behavioral finance during the last two decades has given the public much knowledge about psychological deviations from rational decision making. The knowledge could have been used to invest more money in value stocks and increase the public interest in anomalies such as the discount NCAV strategy. Finally Oppenheimer (1986) limited his riskadjusted analysis to the basic CAPM model. This model has since been proven to be an inadequate asset pricing model (Fama and French, 1996). Thus the results by Oppenheimer (1986) could be due to a model specification error and not true market inefficiency. The factor that should reduce the abnormal returns is the HML factor, of which the NCAV strategy is a subtest. NCAV stocks intrinsically trade at a deep discount to market value and therefore it is important to know whether the HML factor is able to explain the returns of this strategy. This thesis adds to the discussion of this anomaly by including several expanded asset pricing models. The Fama and French three factor model as well the Carhart four factor model are used as the basis for testing the strategy (Fama and French, 1996), (Carhart, 1997). The Chen and Zhang (2009) and Cremers et al (2008) models are used as robustness checks to confirm the results. This should reduce the model specification error. In order to test whether the discount NCAV anomaly has shown persistency over the 1984-2008 period the following research question is set up:

What is the performance of the Net Current Asset Value Strategy versus the broad based U.S. indices 1984-2008?

To analyze this persistency, the stocks will be selected at a 2/3 of MV/NCAV value if there are sufficient stocks available. The value of 2/3 of MV/NCAV is selected because this is the value originally prescribed by Dodd and Graham (2009). This value offers considerable safety from loss of capital. If the amount of available 2/3 MV/NCAV stocks is below 5 then a portfolio of MV/NCAV discount stocks is selected instead. The selection is only done if there are not a sufficient amount of stocks available to form a portfolio and therefore the next best option is selected. A robustness check is also run to test the performance of all stocks trading at a discount to NCAV. Depending on the sufficient availability of discount NCAV stocks, it is expected that the stocks will continue to deliver abnormal risk-adjusted returns. The arguments for the expected abnormal risk adjusted returns are given next. 19

During a long-run bull market risk-adjusted returns are expected to continue because of the safety from loss of principal inherent in a portfolio of discount NCAV stocks (Dodd and Graham, 2009). The article by Oppenheimer (1986) could have caused more money to be invested in NCAV stocks but as the publication was 22 years ago, it is not expected to have greatly influenced the returns of NCAV stocks. The publication could have caused a decrease in the availability of NCAV stocks, thereby eliminating the strategy as a possibility but is not expected to do so for the whole sample period. The public knowledge might have caused a temporary switch in investment strategies but over the long run it is believed that behavioral biases and institutional constraints will prevail as they are inherent to human nature and industry design. The advent of behavioral finance has given the public information about systematic deviations in human nature. Behavioral funds have been launched by academics to profit from this deviation (Lakonishok et al 1993), (Haugen and Baker ,1996). It is not expected that these funds will have an impact on the NCAV strategy, because the strategies differs from the approach of the LSV and Haugen funds. Although public knowledge is available about systematic deviations from rational behavior, it is not expected that investors as a group will be able to change their behavior. Indeed the book/market anomaly has performed strongly from 1977-2004, even with the knowledge available to the public (O'Shaughnessy, 2005). As this thesis is an extreme test of the book/market anomaly, the results are expected to be in line with the book/market anomaly. Finally, the results of the study by Oppenheimer (1986) could be due to model misspecification. It is not expected that the introduction of improved asset pricing models will significantly reduce the abnormal risk-adjusted returns. The study by Arnold and Xiao (2008) showed that the NCAV strategy still produced abnormal risk-adjusted returns when using the Fama and French three-factor model (Fama and French, 1996). The above given arguments make a clear case for why the NCAV strategy should continue to produce riskadjusted abnormal returns during the 1984-2008 period. This leads to the following main hypothesis:

H1 (a) A portfolio of stocks trading at a discount to Net Current Asset Value yields abnormal risk-adjusted returns during the period of 1984-2008.

20

the NYSE. This main purpose is to test the performance of the discount NCAV portfolio. The ancillary hypothesis is: H2 (a) Higher relative stock market prices leads to fewer discount NCAV stocks available for purchase To test the main and ancillary hypotheses the data and methodology will need to be explained next. IV. Discount NCAV stocks are stocks that have a depressed value and a higher overall stock market is predicted to lift the prices of all stocks and reduce the availability of NCAV stocks. The data selected covers three markets in the United States. One of the reasons why the topic requires an update is the long bull market during the sample period. 1. Data The data for this thesis is segmented into three parts : 1. The gathering of comparable index returns and factor loadings to run the required analysis 3. AMEX and NASDAQ. Financial Statement and Monthly Stock Return data 2. Financial Statement and Monthly Stock Return data The sample period of this thesis lasts from June 1984 until December 2008. The United States was chosen as it is the world‘s most liquid market with strong financial regulation to prevent 21 . It is expected that higher relative stocks prices will lead to a lower amount of discount NCAV stocks.Using the arguments given. Data with respect to the relative price of the stock market required to answer the ancillary hypothesis. Various tests will be run to detect whether or not stocks trading at a discount the their Net Current Asset Value conform to expectations. It is expected that the strategy will yield abnormal risk-adjusted returns.

High leverage reduces the margin of safety concept proposed by Benjamin Graham. the impact was concluded to be negligible. The factor loadings for the Fama and French three-factor model (1992) and the Carhart (1997) momentum factor were downloaded from the Kenneth French site (http://mba. There are some differences between COMPUSTAT and CRSP with respect to the CUSIP identifier but after a random sample analysis of the data.net/data. Extensive definitions can be found in appendix 1.dartmouth. The risk free rate is the 30 day treasury bill rate.html). I have excluded financial firms from the analysis due to the high leverage ratios that are inherent to this industry.dartmouth.edu/pages/faculty/ken. Stock market returns were retrieved from the CRSP (Center for Research in Security Prices).erroneous reporting.html). The COMPUSTAT data contains identifying information as well as the required balance sheet information. The dataset includes only domestic companies as international regulating standards might differ and this thesis attempts to analyze only the United States stock market.petajisto.wustl.tuck.html).tuck. Financial accounting data was retrieved from COMPUSTAT. also in line with Arnold and Xiao (2008). 22 . Factor data The risk free rate were downloaded from the Kenneth French site (http://mba.edu/pages/faculty/ken. The CRSP data includes the price of the stock (PRC) and the number of stocks outstanding (SHROUT) This data was merged using the CUSIP identifier as well the date.olin.french/data_library. The exact selection criteria for both COMPUSTAT and CRSP can be found in appendix 2. All Liabilities (LT) and Preferred Stock/Preferred Capital stocks (PSTK). The data was merged using the CUSIP identifier.edu/faculty/chenl/linkfiles/data_equity. The required balance sheet data are: All Current Assets (ACT).french/data_library.html). The Cremer et al (2008) is retrieved from the personal site of Antti Petajisto (http://www. The data for the Chen and Zhang (2009) model is retrieved from the personal site of Lu Zhang (http://apps. See limitations for a further explanation. This is in line with the study by Arnold and Xiao (2008). It does so because a relatively small fluctuation in the value of assets and/or liabilities can eliminate the net current asset value of the firm.

(http://www. Although this dataset measures the price/earnings ratio of the S&P 500 instead of the NYSE/AMEX/NASDAQ. The 1/3 discount is taken because this was prescribed by Benjamin Graham as his original strategy (Dodd 23 .econ. Relative stock market price data The 10 year price to earnings ratio was retrieved from the website of Robert Shiller. Methodology This section will explain the methodology that is used to analyze the retrieved data.yale. Domestic firms are firms which are incorporated in the United States and operate from the United States.The factor loadings for the various asset pricing models are compatible with the NCAV dataset as they cover the same sample period and the same equity market. the author is of the opinion that the S&P 500 gives representative measurement of the overall pricing of the American market and can therefore be used to analyze the effect that the 10 year rolling P/E ratio has one the amount of NCAV stocks available. This excluded all financial firms and only took into account domestic firms.edu/~shiller/data/ie_data. The total stock count is equal to all stocks remaining in the sample which was repeated for every year. The calculations and procedures required to achieve the results will be discussed in sequence. To count the amount of NCAV stocks in a given year. 1. The methodology is for a large part in line with the procedure adopted by Arnold and Xiao (2008). The selection criteria is based on stock trading at a 1/3 discount to Net Current Asset Value as well as the total sample of a NCAV discount NCAV stocks (NCAV < 1). V. the NCAV portfolios needed to be formed. Total Stock and NCAV Portfolio Count The merged data from CRSP and COMPUSTAT allowed for the calculation of the total stock sample from which the NCAV portfolios were formed.xls). ADRs and firms with only a stock listing in the United States are therefore excluded.

This leads to a total overview of discount stocks as well the total selected sample of stocks trading on the AMEX/NYSE/NASDAQ. Stock Price (PRC). all liabilities (LT) and preferred/preference stock (PSTK). The robustness check analyzes this total sample. number of shares outstanding (SHROUT). These three calculations lead to a ratio which gives the market value relative to its Net Current Asset Value. The main test is run using stocks that trade for at least a 1/3 discount to NCAV.and Graham. The NCAV portfolio are formed at the beginning of June and held until the end of May. three years or five years) To arrive at a value for NCAV the following calculations are done: This calculation is in line with the original formula prescribed by Dodd and Graham (2009). Yearly Returns NCAV Portfolio versus NYSE/AMEX/NASDAQ To give an overview of the returns generated by the NCAV portfolios. To achieve holding period returns the following calculation is applied: 24 . The holding period returns are calculated using monthly returns. The balance sheet data is taken from the previous year and is coupled to monthly stock price data starting in June 1984 and ending in May 2008. all current assets (ACT). the following data from the merged dataset is required. If there are less than 5 stocks available that meet this criteria then a portfolio is formed on the basis of stocks trading at an absolute discount to NCAV. the yearly holding period returns are calculated. This procedure is then repeated for the length of each holding period (one year. This would be the total sample of discount NCAV stocks instead of the selection of discount NCAV stocks trading at at least a discount of 1/3. 2. 2009) In order to calculate this value. The weighing is done on an equal and value weighted basis. The next step is to calculate the raw returns for each year.

This data gives an overview of the raw returns. By performing these calculations the holding periods returns for a specific year are arrived at. The setup of this analysis is discussed next. By adding up all the market weighted returns for the individual stocks. Equal weighted portfolios are calculated as follows: The value weighted portfolio is calculated by multiplying the holding period return for an individual stock in the NCAV portfolio with the market value of the stock. Cumulative Portfolio Returns for Different Holding Periods. Following this the weightings of the portfolios are calculated. The equal weighted returns are calculated by adding all the holding period returns for the stocks in the NCAV portfolio. 25 . The calculation is as follows: This gives the holding period return for the total portfolio of discount NCAV stocks for each period on a value and equal weighted basis. 3. This value is then divided by the total market value of the NCAV portfolio. it does not give any information about the relative performance of stocks vis-à-vis the market or about mean returns of the different holding period returns.This is done for each stock that meets the requirements of the NCAV portfolio. the returns for the portfolio are arrived at.

Before continuing with a risk analysis. 4. The formula for the geometric mean for the Equal Weighted returns and Value Weighted returns is as follows: After this a t-test is run see if the returns are significant. The next step is to calculate the CAPM.The next analysis is used to get an overview of the overall mean return of the NCAV strategy. It does not however give any indication of the risk profile of such a stock. The mean return for the specific holding period is calculated. CAPM 26 . This is done by applying the following ttest formula. 3 year and 5 year holding period. All holding periods are created at the beginning of June until the end of May at the end of the holding period. If this mean is significantly higher then any downward risk will still yield higher returns than the portfolio. Standard deviation of Portfolio and Market A calculation of the standard deviation will show the relative dispersion among the mean. but with fewer different holding periods.. the standard deviation is analyzed. all 24 years are used in the calculation of the mean returns (where year 1 is p1. Thus in the in the case of the 1 year holding period. It implies risk but only in so far as the mean of the portfolio is similar to the market. Thus caution needs to be taken when comparing the results. The raw returns and the statistical significance give an indication statistical significance of the returns that can be generated by holding a diversified portfolio of NCAV stocks. 5. There are three main holding periods: A 1 year. year 2 is p2). For the other holding periods the same procedure is used.

These are often stocks who have underperformed the market. The following CAPM model is set up analyze both value weighted and equal weighted returns.tuck. Fama and French Three Factor Model The three factor model takes into account the premia for small and high book-to-market stocks. Once the results have been calculated the following regression is run: Rit R ft ai bi ( RMt R ft ) eit On the left hand side of the equation R ft is the monthly risk free rate. we arrive at the following regression: Rit R ft ai bi ( RMt R ft ) si SMB hi HML eit 27 .french/data_library. This is in line with the NCAV strategy as these stocks have extremely high book-to-market values and have often underperformed the market in the past. By including these factors and keeping to the same procedure as the CAPM. bi is the sensitivity of the asset returns to market returns. The next step is to include the Fama and French Three-factor model. Rit is the monthly return generated by the portfolio.edu/pages/faculty/ken. Fama and French stipulate that these factors compensate for inherent risk. The standard CAPM gives information on risk adjusted returns but solely on the basis of the volatility of the portfolio and the correlation with respect to the market.The first analysis that incorporates risk adjusted returns. the Book-to-Market and Small Minus Big factors which are predictive of value premia.dartmouth. utilizes the standard asset pricing model. Whether or not this is true it does take into account. The factors loadings are retrieved from the Kenneth R. French online database (http://mba. eit is the error term. the capital asset pricing model.html) and the calculations for these factors are in line with Fama and French (1996). ai is the alpha. 7. The risk-adjusted returns are calculated on the basis of monthly returns. On the right hand side of the equation.

The momentum factor measures the premium of stocks that have performed well in the past and because of this performance continues to do so. eit is the error term. a i is the alpha of the model.edu/pages/faculty/ken. There are two factors that attempt to explain the returns. Thus firms with lower 28 .tuck. On the right hand side of the equation. 9. The inclusion of this factors leads to the following regression analysis: Rit R ft ai bi ( RMt R ft ) si SMB hi HML i MOM eit On the left hand side of the equation R f is the monthly risk free rate. a i is the alpha of the model. i MOM is the momentum factor. The expected return decreases with an increase in investment to assets. R ft is the monthly return of the 30 day risk free rate.On the left hand side of the equation R f is the monthly risk free rate. si SMB is the small minus big factor. On the right hand side of the equation. R j is the monthly return generated by the portfolio.html) calculation prescribed by Chan and follows the et al (1996). The first is the investment factor. RMt is the monthly return of the market. si SMB is the small minus big factor. R j is the monthly return generated by the portfolio. 8 Momentum To momentum factor introduced by Chan et al (1996) is the last asset pricing model to be introduced.dartmouth. French online Database (http://mba. Chen and Zhang improved Three-Factor Model This three factor model takes a different approach from the traditional asset pricing models. RMt is the monthly return of the market. R ft is the monthly return of the 30 day risk free rate. hi HML is the high minus low factor.french/data_library. The momentum factor is also retrieved from the Kenneth R. hi HML is the high minus low factor. eit is the error term.

bi is the sensitivity of the asset returns to market returns. RMt is the monthly return of the market. which stipulates that firms with higher expected ROA should generate higher expected returns (Chen and Zhang. On the right hand side of the equation. b MKT is the sensitivity of the asset returns to market returns. R ft is the monthly return of the 30 day risk free rate. RMt is the monthly return of the INV market. b variable. 1996) makes it difficult for small-cap value investors to earn alphas and easy for large cap growth stocks to outperform. On the right hand side of the equation. The second factor is the return on assets factor. R ft is the monthly return of the 30 day risk free rate. Therefore the models is expanded to included 7 factors. The authors claim that the Fama and French three-factor model (Fama and French. b ROA is the investment to assets is the return on assets variable. 2009). R j is the monthly return generated by the portfolio. R j is the monthly return generated by the portfolio. si RMS 5 is the mid minus large 29 . This leads to the following asset pricing model: Rj Rf aq b rMKT b MKT INV rINVit b ROA rROA e On the left hand side of the equation R f is the monthly risk free rate. eit is the error term. a q is the alpha of the model.investments have higher expected returns. The model is listed below: Rit R ft ai bi ( RMt liUMD R ft ) si RMS 5 hi R 2 RM eit ii S 5VS 5 g ji RMVRMG k i r 2vr 2 g On the left hand side of the equation R f is the monthly risk free rate. The model strives to eliminate benchmarks from generating alpha. 10 Alternative factor model by Cremers et al (2008) The alternative factor model by Cremers et al (2008) is the last model that is discussed. a q is the alpha of the model.

liUMD is the momentum factor. hi R 2 RM is the small versus large cap factor. Price/Earnings ratio S&P 500 and availability of NCAV stocks The last analysis is used to answer the ancillary hypothesis. As the P. It can be compared directly.cap factor. Information can be drawn from the absolute values of the S&P 500 P/E ratio and the amount of NCAV stocks available but we cannot draw any statistical conclusions. To draw conclusions the relative change of P/E needs to be compared to the relative change in NCAV stocks. ii S 2VS 5 g is the large cap value minus growth factor. ji RMVRMG is the midcap value minus midcap growth factor.E is an indication of the relative price level it offers no predictive power and therefore it does not need to be lagged in order to compare to the relative change in NCAV stocks. which tests the relationship between the amount of NCAV stocks available and the rolling ten year P/E ratio for the S&P 500. the is done as follows: The next step is to measure the correlation between these two factors to measure the impact a change of the P/E has on the NCAV. To calculate the relative change the natural logarithm is taken of both the S&P and NCAV. The formula for the correlation between these two factors is: 30 . 11. eit is the error term. ki r 2vr 2 g is the mid versus large cap factor.

The first results are the total stock and NCAV count. It will discuss all the analyses that were described in the methodology section. bi is the independent variable. These results will serve as a basis to answer the main and ancillary hypothesis. ai is the alpha or negative/positive returns generated beyond the predictive capacity of the model. The results are posted below 31 . The following regression is run. VI. On the right hand side of the equation. eit is the error term. R ai bi eit On the left hand side of the equation R is dependent variable. Results This section will discuss the results of this thesis.A regression is also run to test the predictive power of the relative price of the market indices on the amount of NCAV stocks available.

Excludes financial firms. During the first years of the sample the amount of discount NCAV stocks was limited even though the market traded at relatively low multiples. During this period the low amount of NCAV stocks available made the formation of a diversified portfolio difficult because all invested capital had to be spread among at the most 4 firms. No strong conclusions can be drawn from this table but observations can be made.67 1 0 0 1 4 5 18 14 15 11 12 14 9 14 20 22 25 91 72 28 5 7 3 3 31 Table 1: Total numbers of listed companies in the sample. The minimum amount of stocks was 6.Table 1: Total Sample and Discount NCAV Portfolio Count Year Listed Companies MV/NCAV < 1 1984 5486 6 1985 5494 13 1986 5537 6 1987 5566 6 1988 5601 22 1989 5690 24 1990 5750 38 1991 5836 43 1992 5898 45 1993 5985 40 1994 6053 50 1995 6140 38 1996 6172 28 1997 6216 42 1998 6262 46 1999 6272 68 2000 6276 75 2001 6292 163 2002 6307 162 2003 6284 85 2004 6267 16 2005 6256 22 2006 6267 19 2007 6252 18 2008 6264 89 MV/NCAV < 0. AMEX and NASDAQ stocks. This is why for the years 1984 to 1988 all firms traded at a discount of MV/NCAV were used to form the portfolio.67) of MV/NCAV value.67) MV/NCAV value. investment trusts and non US based firms. Discount NCAV stocks are taken at formation date starting 1984 on the first trading day of June The first table lists the amount of listed companies included in the total sample as well as the firms trading at both a discount to MV/NCAV and at the most 2/3 (or 0. The aim of a discount MV/NCAV portfolio is to maintain a large diversified portfolio of stocks and not to concentrate holdings among a few firms. This is especially the case for firms trading below a 2/3 (or 0. Includes US based NYSE. which according to Greenblatt (1998) Professor 32 .

stocks can both trade are exuberantly high as well as exceptionally low prices. This situation did not continue and the amount of stocks increased after 1988. 2007). It is also interesting to note that the evidence is not in line with Arnold and Xiao (2008) nor Bildersee et al (1993). With the exception of the last analysis the remainder of this chapter will discuss the returns and the compositions of the returns for a portfolio trading at the most 2/3 (or 0. Another observation is that the amount of available NCAV stocks increased significantly during the latter part of the stock market internet bubble. For our main test the number of firms trading at MV/NCAV < 0. it does not hold for NCAV stocks. They showed a decrease in the amount of stocks trading at a discount of NCAV when the market traded at relatively high multiples.of value investing at Columbia. This is not compatible with the logic of the Pastor and Veronesi (2009) model. Market‖ parable based on behavioral arguments offers a better explanation. The bubble caused an overall increase in the prices of stocks and severe overvaluation among most sectors (Shiller. and the publication of this strategy. 2005). This decrease could be due to the publication of the Oppenheimer study in 1986. For the whole sample of discount NCAV stocks the period of low availability ceased in 1988 where after there have always been at least 16 firms available whose stocks have traded at a discount to NCAV. Pastor and Veronesi (2009) claim that this is due to the high uncertainty inherent in the future profits of the firm. It is therefore interesting to note that during the same time that most stocks might have been overvalued there were also a large amount of stocks trading at depressed levels. the inverse of the results shown here. the ―Mr. Although the argument is logical. should offer enough diversification. The relationship between the price level of the market and the amount of NCAV stocks is discussed at end of this chapter. the higher the certainty of the underlying assets. There was a decrease in availability after 2003 but the market downturn in 2008 has once again increased the amount of stocks trading at a substantial discount to their net current asset value. The EMH predicts that when public knowledge is available of a stock market anomaly more capital is attracted and this will reduce the abnormal risk adjusted returns of the availability of the stocks (Ross et al. This is also in line with Ross et al (2007). A large downward revision coupled with high uncertainty leads to a large fall in stock prices. It seems that during a time of stock market irrationality.67) of 33 . The lower the price of NCAV stocks. Although more difficult to quantify.67 increased significantly after 1989.

76% Equal weighted 31.2253 0.92% 29.78% 17.50% 10. investment trusts and non US based firms.92% Equal weighted 81.27% Value weighted 23.26% Equal weighted -4.50% Statistics Value NCAV Equal NCAV Aritmethic Average 0.0460 0. Table 2: Yearly Discount MV/NCAV < 2/3 returns and Total market Sample Returns Discount NCAV Market Discount NCAV 1984 1996 Value weighted 26.53% Equal weighted 38.17% 23.33% 8.17% Value weighted 8.25% Maximum 72.86% 22.51% Equal weighted 11.12% 21.1765 0.84% Equal weighted -9.70% 1995 2007 Value weighted 25.92% 1985 1997 Value weighted 13.12% Equal weighted 19.16% 13.74% Equal weighted 24.08% Equal weighted 42.68% Value weighted -31.29% 1.57% Value weighted 24. This procedure is repeated for each year up to and including 2007.85% 16.18% 10.62% 15.58% 20. but observations can be made.2350 6.05% 12.22% Equal weighted 16. If there are fewer than 5 firms trading for at the most 2/3 MV/NCAV the whole sample of absolute discount NCAV stocks is selected (MV/NCAV < 1).20% 1990 2002 Value weighted 5.66% -0.25% Market 22.16% Equal weighted 16.2919 Standard Deviation 0.36% Equal weighted -18.58% 1987 1999 Value weighted 0.03% -1.94% Value weighted 35.11% Value weighted 2.36% Equal weighted 1.13% 5.56% Equal weighted 30.95% 1993 2005 Value weighted 43.12% 111.98% 19.36% 6.68% Value weighted 36.84% 29.05% Equal weighted 35.50% Value weighted -5.60% 1991 2003 Value weighted -1.3216 Minimum -31.38% 4.58% Equal weighted 111.58% 34.53% 31.48% -10.08% 18.93% 12.58% 25.05% 45.74% -13.39% Equal weighted 40.MV/NCAV value (with the exception of years with fewer than 5 stocks where the whole sample of NCAV stocks is selected).90% -11.59% 24.84% Sum 4. This first observation is that the performance of both the value weighted and equal weighted discount NCAV portfolios is in the majority of cases higher than the comparable 34 .9823 Count 24 24 Table 2: 1 year holding period returns. The average raw returns generated are the subject of the next table and thus the discussion is based on generalized finding.12% Equal weighted 46. Based on equal weighted and value weighted returns.16% -37.85% -6.33% 24.82% Equal weighted 67.16% Value weighted 5.15% Equal weighted 57.0657 Median 0.04% 1986 1998 Value weighted 51.23% 30.08% 17. No statistical conclusion as yet can be drawn from this table.02% 11. The portfolios are formed at the beginning of June in 1984 and held for 12 months.48% Equal weighted 48.91% -4.72% 16.94% 11.65% -12.35% Value weighted 40.00% 5.12% 9. AMEX and NASDAQ stocks.49% Equal weighted 27.51% 1988 2000 Value weighted 17.11% 10.33% Equal weighted 17.46% -6.54% 1994 2006 Value weighted 1.08% Value weighted 72.83% Equal weighted -37. The first is a list of yearly raw returns based on a 12-month holding period. Excludes financial firms.03% 1989 2001 Value weighted -5.1558 0.2909 Standard Error 0.24% 11.32% Value weighted 1.84% 1992 2004 Value weighted 32. The portfolios includes US based NYSE.49% 10.50% 41.

51% while the market generated 45.50% while the value weighted returns are also strong but weaker than the equal weighted returns. The returns listed are geometric averages for the 26 years. Statistical signficance: *** Significant at 1% level ** Significant at 5% level * Significant at 10% level The table describes the raw equal weighted portfolio returns of the NCAV portfolio as well as the raw market adjusted returns for the NCAV portfolios. non-US firms and investment trusts.49% 32. This could be due to the small size premium.25% Equal Weighted market returns 11. The results for table 3 a) will be discussed first. Average raw and market adjusted are calculated for portfolios that are held for 1. The 1 year results for the NCAV portfolio is higher for both the value weighted NCAV stocks and the equal weighted NCAV stocks. the average raw returns as well as excess raw returns are shown below in the next table.88% Equal weighted discount NCAV Stocks 23.84% and for 1999 they are 67.403279 1.50% 42. The returns are split into 1 year.160067874 NYSE/AMEX/NASDAQ stocks are selected for the discount NCAV portfolio of their MV/NCAV is lower than 2/3 at the beginning of june 1984 and for each portfolio formation until end of may 2008. For the yearly returns 2008 is excluded because only 6 months of data is available.market indices. Table 3: Raw Returns and Market-Adjusted Returns for Discount at combination of 2/3 and 1 Discount NCAV portfolios Table 3 A: Average raw buy and hold returns Value weighted discount NCAV stocks Value weigthed market returns 1 Year 14.24% t-test 0.54% t-test 0.28% 3 year 37. for 3 and 5 year holding periods 2008 is included. An alternative could be that there is less liquidity for small firms and that trading costs are higher and that the returns generated here 35 .47% 61. 3 year and 5 year holding periods. who also showed that equal weighted returns also generated returns in excess of 100%. index value weighted 3. Furthermore there are a few specific years when the returns of the NCAV portfolios are substantially higher than the market returns.45% 51.356963147 p-value 1.48% respectively.00% 74. The results are in line with Oppenheimer (1986).12% 54. 3 and 4 years post-formation. This is not a direct test. The formulas for the raw portfolio returns are described in the methodology section.724932 1. The returns for the equal weighted portfolio are higher than the market returns by 11.035632 ** 0. as the analyses are done separately.55% 5 year 60.21% 41.72% Table 3 B: Average market adjusted buy and hold for Discount NCAV portfolios 1 Year 3 year 5 year Discount NCAV value weighted.92% 113.89% 11. The share count includes all shares except for financial institutes.34% 5. index equal weighted 11. a portfolio of maximum of 1 MV/NCAV is selected.596001 2.172833 0.128193 0.040258029 Discount NCAV equal weighted. The equal weighted returns for 2003 are 111. geometric averages for the 26 years.123049 2.004484 *** 0.49% and 19.067601161 * p-value 3. The t-tests are based on excess returns above the market rate. To analyze this further. If there are not at least 5 stocks trading at 2/3 of NCAV value.61% -4.

A portfolio with an annual geometric compounded rate of interest of more than 23% would generate very generous returns over a period of 26 years. after the mid-1950's. The value weighted portfolio outperforms the market but this is not statistically significant according to the t-test. Strikingly the results shown for the combined 2/3 and 1 discount NCAV strategy are very close to the results claimed by Benjamin Graham (1976) as stated below: ―We used this approach extensively in managing investment funds. and over a 30-odd year period we must have earned an average of some 20 per cent per year from this source. For a while. The tests for the equal weighted indices show significance at the 1% level. The difference between the discount to NCAV and the market value can be a reason for this discrepancy. Although Dodd and Graham (2009) proposed a longer holding period of at least two years. The results in table 3 b) show that there is very strong significance for a 1 year holding period of equal weighted NCAV stocks. But it has returned in quantity since the 1973-74 decline. however. The high returns reported here are in line with Oppenheimer (1986) who reported annual returns of 28. In January 1976 we counted over 300 such issues in the Standard & Poor's Stock Guide--about 10 36 . Before drawing any conclusions a preliminary t-test is run to test the significance of these results.2% based on an equal weighted portfolio. This statement holds for the value-weighted portfolio but the equal weighted portfolio continues to show strong outperformance. This can be attributed to the original discrepancy between the market value of the stock and the balance sheet value. This does show that the one year holding period strongly outperforms that market indices over a period of 26 years. this analysis shows that the optimal holding period (of the three choices presented) is one year. Therefore when the market has increased the value to a point where it is no longer trading at a discount to NCAV it can no longer be expected to generate excess abnormal returns. this brand of buying opportunity became very scarce because of the pervasive bull market. The other two holding periods also show outperformance.exclude liquidity and trading costs. The longer the holding period becomes the lower the statistical significance is. If there were more discount NCAV stocks available during the beginning period the results might have been even higher. Our results analyze a longer sample period during a bull market. It might be the case that small capitalized stocks which are overweighed in the equal weighted portfolio contain a higher intrinsic value which is neglected by the market.

0155 0.78% NCAV Equal Weighted 9. These results are regressed against both equal and value weighted market portfolios of the NASDAQ/ NYSE/AMEX.29% Market Equal Weighted 5.9497 *** 6. R^2 18.11% This table shows the standard deviation for the portfolio during the 1984-2008 period. The NCAV portfolio is equal and value weighted.8154 1.0362 0. Higher standard deviations implies that there is higher volatility.1195 *** 3.0259 *** T(β) 8. all stocks trading below a MV/NCAV are taken Statistical signficance: *** Significant at 1% level ** Significant at 5% level * Significant at 10% level R it R ft ai b i ( R Mt R ft ) e it 37 . Beta: Value Weighted and Equal Weighted Portfolios NCAV Value Value Equal Equal Market Value Equal Value Equal α 0.0150 β 0. I consider it a foolproof method of systematic investment--once again.14% This analysis is based on the monthly returns of the NCAV portfolio.0905 *** 10.9110 *** Adj. As the NCAV mean monthly returns are significantly higher the chances of the portfolio returning less than the market (see table 4) are slight. The standard deviation does show that the dispersion among the mean is higher for the NCAV portfolios than for the market indices.0164 0. It is based on the monthly returns generated. not on the basis of individual results but in terms of the expectable group outcome. The risk free rate is the 30 day treasury bill.per cent of the total.24% 29.87% Market Value Weighted 4.0963 *** 3. This is the last descriptive statistics test and the next test will analyze the risk adjusted returns: Table 5: CAPM. Under these assumptions the following standard CAPM regression analysis was run The Portfolio consists of stocks trading at 2/3 of MV/ NCAV value whenever there are at least 5 stocks available at a discount to this value.‖ The next table describes the standard deviation of the portfolio: Table 4: Standard Deviation Standard Deviation (σ) NCAV Value Weighted 9.34% 29. If the average mean returns of the market and the NCAV are equal then this would imply extra risk to the investor.9852 1.4042 *** 10.1698 *** 3.0425 T(α) 3. The test period last from 06/1984 until 06/2008.0171 0. Whenever this is not the case.29% 12.

as is the case in NCAV stocks then this should yield abnormal returns. In order to gain further evidence more factors need to be included. It is also in line with the concept of intrinsic value which was discussed earlier. The next step is to increase the analysis to include the Fama and French three-factor model. This evidence runs counter to the efficient market hypothesis. This first risk analysis supports the alternative hypothesis that a widely diversified portfolio is able to produce abnormal riskadjusted returns. It is most likely due to irrational behavior and institutional constraints but the arguments for this are drawn in the conclusion.50%. for the value and equal weighted portfolios respectively. The riskadjusted returns on the basis of volatility risk is statistically significant for all comparable time periods. The portfolios are able to earn significantly higher returns while taking on less volatility risk than the market. The alphas that are produced by this analysis show that this portfolio is able to attain monthly risk-adjusted returns on a like-for-like basis of 1. yields outsized returns.The results of the CAPM analysis show that on the basis of monthly returns of the portfolios. The margin of safety takes into account the worst case scenario. all portfolio returns whether matched with equal or value weighted indices are significant. The large discrepancy between tangible and relatively liquid assets and the market price can be used as an explanation for the abnormal returns. 38 . If this gap is large.64% and 1. This confirms expectations that there is a difference between the intrinsic value of the firm and the price of a security. therefore any positive event. It can almost be described as a mechanical realignment of stock prices to intrinsic value. regardless of the underlying reasons for these returns.

The SMB and HML factors were retrieved from: http://mba.2091 T(α) 3.Table 6: Fama French 3 factor model: Value Weighted and Equal Weighted NCAV Value Equal Market Value Equal α 0. If the Fama and French model is a good predictor then these factors should have a strong predictive power.1283 h -0.3244 *** 2.5339 *** T(s) 4.tuck. This is not the case.02% This analysis is based on the monthly returns of the NCAV portfolio.0172 0.9779 *** 0. NCAV strategy are often small firms with very high book-marketvalues.0142 β 0. One would expect a high correlation between these factors and the NCAV strategy. R^2 24. If the B/M value is not able to explain the NCAV returns. This runs counter to expectations. The two factors compensate investors for taking on firms with a relative high probability of financial distress. This is however not the case. The small-minus big factor is statistically significant and the predictive power of the model also increased (on the basis of the adjusted rsquared).0743 1. The risk free rate is the 30 day treasury bill.4423 *** 8.dartmouth.html.8404 1.french/data_library. These results further strengthen the evidence for the alternative main hypothesis that the discount NCAV portfolio produces abnormal risk-adjusted returns.edu/pages/faculty/ken.53% 29. The next risk-adjusted test also includes the momentum factor. The calculations for these factors are based on the NASDAQ/NYSE/AMEX data and is therefore compatible with our dataset This leads to the following Fama and French 3 Factor model: Statistical signficance: *** Significant at 1% level ** Significant at 5% level * Significant at 10% level R it R ft ai b i ( R Mt R ft ) s i SMB h i HML e it The Fama and French three factor model incorporates two factors that compensate investors for taking on specific risks. the question arises what the validity is of this model.8199 *** T(β) 6. The NCAV portfolio is equal and value weighted These results are regressed against both equal and value weighted market portfolios of the NASDAQ/NYSE/AMEX The test period last from 06/1983 until 12/2008.0505 ѕ 0.6838 T(h) -0.0146 0. This High minus Low factor is an extreme test of the book to market and should correlate strongly with our test.1406 Adj. This last table is listed below: 39 .8314 0.

Table 7: Momentum + Fama French 3 factor model : Value Weighted and Equal Weighted NCAV Value Equal Market Value Equal α 0.5581 -0.3224 *** T(β) 6.95% This analysis is based on the monthly returns of the NCAV portfolio.edu/pages/faculty/ken.23% 29.4317 0. The NCAV portfolio is equal and value weighted These results are regressed against both equal and value weighted market portfolios of the NASDAQ/NYSE/AMEX The test period last from 06/1983 until 12/2008.3011 *** T(s) 5.0821 0.html.5669 *** 1. This appears to be the case and is statistically significant. A momentum or ‗hot-hands‘ effect is shown to further add to the abnormal riskadjusted returns for the equal weighted portfolios and therefore a statistically significant negative correlation increases the monthly risk-adjusted returns that are generated. Therefore one would expect a negative correlation between the momentum factor and the NCAV portfolio.4326 *** 3.1820 ** Adj.0226 0. The SMB and HML factors were retrieved from: http://mba. R^2 30. The adjusted R^2 increases.dartmouth. As they are trading at depressed levels they have often experienced negative stock returns to be trading at a discount to NCAV.8970 0.9519 ѕ 0. NCAV stocks are often stocks that trade at depressed levels.french/data_library.0173 β 0.2140 T(h) -0. This table is shown below: 40 . The first table is listed below: The next step is to analyze the results of the Chen and Zhang three factor model. The conclusion and the implications for theory and practice will be given in the next chapter but first the robustness checks for two alternative models are run.8617 T(i) -4.0462 *** 7.2338 h -0.1582 i -0. The momentum factor describes the ‗hot-hands‘ phenomena where firms that have done well over the past year will continue to do so.tuck.7642 0. The risk free rate is the 30 day treasury bill. This last test further strengthens the case for the alternative hypothesis.2647 T(α) 4. The calculations for these factors are based on the NASDAQ/NYSE/AMEX data and is therefore compatible with our dataset This leads to the following Fama and French 3 Factor model: Statistical signficance: *** Significant at 1% level ** Significant at 5% level * Significant at 10% level Rit R ft ai bi ( R Mt R ft ) s i SMB hi HML i MOM eit Thos risk-adjusted model also includes the momentum factor.9191 *** -2.

9659 rINV -0.6468 *** T(rROA) -5.8486 2.7713 *** -2. As this study is a test of the book/market anomaly it is not expected to reduce the abnormal returns. The adjusted R^2 is higher showing that it is better at predicting the returns than the standard CAPM model.Table 8: Chen and Zhang 3 factor model: Value Weighted and Equal Weighted NCAV Value Equal Market Value Equal α 0.0033 T(α) 5.0174 rMKT 0. The alpha increases for all two comparisons.html The calculations for these factors are based on the NASDAQ/NYSE/AMEX data and is therefore compatible with the dataset This leads to the following Chen and Zhang 3 Factor model: Statistical signficance: *** Significant at 1% level ** Significant at 5% level * Significant at 10% level Rj Rf aqj bj MKT rMKT bj INV rINV it bj ROA rROA e j The Cheng and Zhang three factor model incorporates two factors that attempt to predict expected stock returns.0275 0. These results further strengthen the evidence for the alternative main hypothesis that the discount NCAV portfolio produces abnormal returns.0073 rROA -0.0067 -0.2413 *** T(rMKT) 5. Chen and Zhang (2009) already state that this model is not able to predict the book/market anomaly more successfully than the Fama and French three factor model (Fama and French. The IA and ROA factors were retrieved from: http://apps. The NCAV portfolio is equal and value weighted These results are regressed against both equal and value weighted market portfolios of the NASDAQ/NYSE/AMEX The test period last from 06/1984 until 5/2008. Although the model is both intuitively as well as mathematically complex (the derivation of the factor loadings. This model has not shown to be a better predictor of the book/market anomaly. The risk free rate is the 30 day treasury bill. R^2 26.edu/faculty/chenl/linkfiles/data_equity.5452 ** Adj. 1996).wustl.6661 0.0962 *** 3.0020 *** 8.0021 *** T(rINV) -0.0024 0. Thus this study is in line with their own analysis.93% This analysis is based on the monthly returns of the NCAV portfolio. This last table is listed below: 41 . The two factors are expected return on assets (ROA) and expected returns based on investment to assets (I/A). not the regression).70% 31.olin. it actually does worse than the standard CAPM model with respect to reducing alpha.

The NCAV portfolio is equal and value weighted These results are regressed against both equal and value weighted market portfolios of the NASDAQ/NYSE/AMEX The test period last from 06/1983 until 12/2008.html The calculations for these factors are based on the NASDAQ/NYSE/AMEX data and is therefore compatible with our dataset This leads to the following Factor model: Rit R ft ai bi ( RMt liUMD R ft ) eit si RMS 5 hi R2RM ii S 5 VS5g ji RMVRMG Statistical signficance: *** Significant at 1% level ** Significant at 5% level * Significant at 10% level K i R2 VR2G The last factor model is the model by Cremers et al (2008).2285 ** T(i) 0. Cremers et al (2008) states that one of the goals of the model is to improve the benchmarking of strategies.0260 ѕRMS5 0.3902 *** -1.4213 T(h) 3.88% 30. This model improves upon the Fama and French three-factor model by attempting to remove benchmark alphas.4926 *** T(β) 5.9657 *** 2. This is in line with the higher equal weighted returns.5456 -0.net/data. then it is clear that the strategy produces significant alpha.0844 kR2VR2G 0.9701 -1.1645 0. If this model achieves its goal. showing a positive relationship between the size of the firms and the returns generated.4322 0.8183 0.3607 -0. The conclusion and the implications for theory and practice will be given in the next chapter but the results for the ancillary hypothesis still need to be discussed.2204 T(α) 4.7870 1.41% This analysis is based on the monthly returns of the NCAV portfolio.0675 -0. Petajisto and Zitzewits index-based 7 factor model NCAV Value Equal Market Value Equal α 0. This last test further strengthens the case for the alternative hypothesis. because small cap firms generate higher returns than large cap returns for the NCAV portfolio.1678 0.6139 *** 7.petajisto. The first table is listed below: 42 .1066 jRMVRMG -0.6843 iS2VS5g 0. The risk free rate is the 30 day treasury bill.2476 T(k) 0. The seven factors were retrieved from: http://www.Table 9: Cremers.3985 *** T(s) 0.3520 T(j) -0.2782 0.0187 β 0.5381 hR2RM 1.4740 T(l) -4.6793 *** Adj.1778 lUMD -0.6302 *** 3.0241 0. R^2 29. The adjusted R^2 increases in the four analyses. The small versus large cap factor is significant.0203 -0.

When market participants bid up the overall price level in expectancy of higher returns. Furthermore in the succeeding years when the price/earnings 43 .64 24 1990 17.38413 This table lists the average price earnings ratio on the basis of the Shiller data.77 22 1989 16. This is however not the case.32 45 1993 20.78 the amount of NCAV stocks increased.82 38 1991 18. As the rolling 10 year price/earnings ratio increased to over 42.74 19 2007 27.18 68 2000 42.83 85 2004 26.78 75 2001 33.39 162 2003 24.06 22 2006 24. As the average price/level trended up during the sample period the amount of discount NCAV stocks available increased. The results show that during the first 3 of the first 4 years the amount of discount NCAV stocks available was lower than 7.Table 10: Average 10 year price earnings ratio vs amount of stocks available Year Price Earnings Ratio Firms Trading at a Discount to NCAV 1984 9.40 16 2005 26.yale.89 6 1987 16.97 28 1997 31. Discount NCAV stocks are stocks that trade at a depressed price level.xls).econ.61 40 1994 20.81 13 1986 13.72 38 1996 25. The dichotomy between a large amount of stocks trading at a discount to NCAV and a high overall price/earnings ratio is most apparent during the internet bubble of 1999-2002.07 163 2002 26.41 89 Correlation -0. one could assume that there is a reduction in the availability of these stocks. even though the price earnings ratio for a representative market as the S&P 500 was at the lowest level during the entire sample period.80 46 1999 42.83 6 1988 14. The Shiller data was retrieved from http://www.01 6 1985 10.41 18 2008 22.26 42 1998 36. The original hypothesis assumed that lower relative price/earnings levels would lead to more stocks trading at a discount to their NCAV value.02 43 1992 19.29 50 1995 22.edu/~shiller/data/ie_data.

05% The following regression is run on the basis on yearly Log returns R a i b i e it Statistical signficance: *** Significant at 1% level ** Significant at 5% level * Significant at 10% level The results show that there is a negative correlation between these two factors but the explanatory variable is only capable of explaining 11. but the analysis is too weak to draw any strong conclusions..ratio remained at historically high levels the amount of discount NCAV stocks increased to over 100. Therefore the null hypothesis cannot be strongly rejected that there is a decrease of discount NCAV stocks when the overall price level of the market is higher.9953 * Adj. The correlation between the Price/earnings ratio and the amount of discount NCAV stocks is negative implying that there is some relationship between lower overall price/earnings ratios and more firms trading at a discount to NCAV but this does not include any test of statistical significance.7954 T(α) 1.1731 β -1.. R^2 11. Although it was expected that there would a strong negative relationship between the rolling P/E ratio and the amount of discount NCAV stocks the results show that is a weak relationship but not substantial evidence. The occurrence of these two phenomena during the same time period might provide evidence against the efficient market hypothesis. This evidence is also only based on 26 annual data points and should be not considered the definitive answers. This is not fully in line with 44 . The last table gives the results of the regression analysis run to analyze the relationship between the price/earnings ratio and firms trading at a discount to NCAV in order the analyze the statistical significance of the relationship: Table 11: Regression Analysis: Price/Earnings Ratio versus availability of stocks α 0.05% of the total returns.3911 T(β) -1. The results show that there is statistical significance at the 10% level.

The conclusion of this thesis is drawn next. This strategy selected severely undervalued stocks with a high margin of safety. A combination of portfolios trading at value of at the most 2/3 MV/NCAV and if not available a selection from the entire sample of discount MV/NCAV stocks is expected to produce risk-adjusted abnormal returns. by including all of 2008 (the last test only incorporated the first 6 months) the returns do not severely deteriorate. The results have shown strong evidence for the alternative main hypothesis and weak evidence for the alternative ancillary hypothesis. These stocks still trade a discount to NCAV and should therefore provide adequate protection against capital loss. Instead of selecting a combination of stocks and setting the most stringent benchmark the entire universe of stocks trading at a discount to NCAV is selected. This lowers the margin of safety but does not mean the stocks are not undervalued. They were not included in the full analysis because the holding period only lasted for six months. As a robustness check one further modification is made. This last analysis ends the results section. To further analyze the results a robustness check will now be run. The first test analyzes the raw returns generated by this portfolio and are depicted on the next page. It is also interesting to see if. 45 . This robustness check will check the impact that a reduction in the margin of safety has on the returns that are generated by the portfolio. VII. they are included. Instead of excluding 2008 for the risk-adjusted return analyses. According to the arguments brought forth by Graham and Dodd (2009). Robustness Check The robustness check is run to analyze the strength of the strategy.the Bildersee et al (1993) analysis of Japan which found few discount NCAV stocks available during the bull market in the 1980‘s. This will consist of the entire universe of stocks trading at a discount to MV/NCAV. the lower the margin of safety the lower the returns should be.

72% Equal weighted 40.76% Equal weighted 19.62% Equal weighted 25.81% and 2001 29.02% 12.25% 1995 2008 Value weighted 25.7090 1.05% Equal weighted 104.43% 4.Table 12 Yearly Discount NCAV returns and Total market Sample Returns Discount NCAV Market Discount NCAV 1984 1997 Value weighted 26.32% Value weighted 26.52% 24. while the market generated 45.00% 1992 2005 Value weighted 20.02% 11.06% 1.04% Equal weighted 24.62% 15.49% 10.57% Value weighted 10.92% Equal weighted 0.70% 1994 2007 Value weighted 1.27% Value weighted 2.90% 9.36% 6.58% 34.81% 1991 2004 Value weighted 11.36% Equal weighted 30.13% Equal weighted 32.35% Value weighted 70.3725 Maximum 0. This procedure is repeated for each year up to and including 2007.3116 -0.08% Value weighted -9.83% Equal weighted -49.34% 1986 1999 Value weighted 51.41% 11.08% 18.0481 Sum 3.3365 5.10% 1990 2003 Value weighted 12.64% 10.98% 19. AMEX and NASDAQ stocks. Excludes financial firms.95% 1987 2000 Value weighted 0.2015 0.46% respectively.17% Value weighted 30.58% 20.50% Value weighted 17.74% -13.59% 17.80% 1989 2002 Value weighted 4.36% 30. The equal weighted returns for 2003 are 104.3619 Count 24 24 Table 2: 1 year holding period returns.92% Equal weighted 18.49% and -5.90% Equal weighted 17.53% Equal weighted -37.2234 Standard Error 0. investment trusts and non US based firms.23% 13.48% Equal weighted 28.59% 24.56% Equal weighted 38.78% 17.52% 11.85% Equal weighted 27.89% Equal weighted 32.65% -12.11% Value weighted -31.26% This first observation is that the performance of both the value weighted and equal weighted discount NCAV portfolios is in the majority of cases much higher than the comparable market indices.66% -0.13% 5.84% Equal weighted 33.85% -6.91% -4.88% 1988 2001 Value weighted 17.16% Equal weighted 14.05% 12.58% 25.60% Equal weighted 11.1197 0.58% Equal weighted -10. Furthermore there are a few specific years when the returns of the NCAV portfolios are substantially higher than the market returns.53% 31.1390 0.56% 22.50% 10.68% Value weighted -43.29% Equal weighted -7. Based on equal weighted and value weighted returns. The whole sample of discount NCAV stocks is taken Market 29.63% 1993 2006 Value weighted 7.92% 1996 Value weighted 2.46% -6.68% Value weighted 18.63% -1.92% Statistics Value NCAV Equal NCAV Aritmethic Average 0.82% Equal weighted -10.16% -44.85% 1985 1998 Value weighted 13.2686 Minimum -0.90% -11.86% 22.08% Equal weighted 57.40% 41.85% 16.2501 Standard Deviation 0.0548 Median 0.50% -38.90% Equal weighted 10.12% 21. The portfolios includes US based NYSE.84% 29.17% 23.72% 16.80%.48% -10.79% 10.16% Value weighted 8. The portfolios are formed at the beginning of June in 1984 and held for 12 months.05% 45.0411 0.36% Equal weighted 29. The results are 46 .94% Value weighted -8.33% 8.00% 5.

It will be more likely that the returns revert to the mean. The share count includes all shares except for financial institutes. Statistical signficance: *** Significant at 1% level ** Significant at 5% level * Significant at 10% level The returns show that only the equal weighted discount NCAV stocks outperform the market significantly for a one year holding period.78% 74.147899902 p-value 0.02% 42.34% 51.76% 32. geometric averages for the 26 years.21% 41.lower during most years than the more stricter main test but still appear to be higher than the overall market returns.486306 ** 2. This period has been excessively poor for discount NCAV stocks and it is unlikely that this degree of underperformance will continue. This outperformance is still statistically significant especially as this test includes all of 2008 (only a 6 month holding period). These results are in line with expectations.18% 9. To analyze this the holding period returns are given next: Table 13: Raw Returns and Market-Adjusted Returns for Discount NCAV portfolios Table 13 A: Average raw buy and hold returns Value weighted discount NCAV stocks Value weigthed market returns 1 Year 9. The difference between these two weightings could be ascribed to the premium given to small companies which are weighted more heavily in the equal weighted portfolio. The results do show that the results are robust for equal weighted portfolios but that the returns are also much lower than for the stricter benchmark.070999859 p-value 2. The returns listed are geometric averages for the 26 years. index value weighted -0.019946 0.787167 1. The longer holding periods for equal weighted portfolios all show significant outperformance.55% 5 year 106.596001 ** 2.47% 60.035632 0.92% 112.128193 0.33% Equal Weighted market returns 9.45% 51.126848343 * NYSE/AMEX/NASDAQ stocks are selected for the discount NCAV portfolio of their MV/NCAV is lower than 1 at the beginning of june 1983 and for each portfolio formation until end of may 2008. The t-tests are based on excess returns above the market rate.07% -4.25% 3 year 37. deviation is discussed next: The standard 47 .724932 ** 1.61% t-test 0. Average raw and market adjusted are calculated for portfolios that are held for 1. index equal weighted 5.72% Table 13 B: Average buy and hold for Discount NCAV portfolios 1 Year 3 year 5 year Discount NCAV value weighted.790294475 Discount NCAV equal weighted.40% 54. 3 and 4 years post-formation.438583 0.52% t-test 0. non-US firms and investment trusts.88% Equal weighted discount NCAV Stocks 14.

One can attain higher returns by lowering the volatility risk. Under these assumptions the following standard CAPM regression analysis was run R it R ft a i bi ( R Mt R ft ) e it Statistical signficance: *** Significant at 1% level ** Significant at 5% level * Significant at 10% level These results.48% Market Equal Weighted 5.1045 ** T(β) 10. These results are regressed against both equal and value weighted market portfolios of the NASDAQ/ NYSE/AMEX. are all statistically significant. The value weighted portfolios also contain less volatility risk than the equal weighted portfolios and the market and gives it superior volatility risk adjusted returns. This robustness check increases the validity of the main test.15% Market Value Weighted 4. although weaker in absolute terms.0067 β 0.94% 55.0123 0. Beta: Value Weighted and Equal Weighted Portfolios NCAV Value Equal Market Value Equal α 0. R^2 27. The risk free rate is the 30 day treasury bill. The NCAV portfolio is equal and value weighted. The most interesting conclusion that be drawn from the analysis is that the Beta for the equal weighted portfolio is significantly higher than for the main test. It is in line with expectations. This is simply done by setting up a more stringent benchmark which increases margin of safety Table 15: CAPM. This definitely confirms the margin of safety argument by Graham and Dodd (2009).1734 *** 2. It is based on the monthly returns The equal weighted portfolio once again shows that the risk/return relationship is not always positive.7241 *** 19.0930 *** Adj. The efficient market hypothesis assumes there is a linear positive 48 .80% NCAV Equal Weighted 8.Table 14: Standard Deviation Standard Deviation (σ) NCAV Value Weighted 7.1487 T(α) 3. Thus the stricter benchmark runs far less volatility risk while generating 8. The results are weaker but because it also includes 2008 and has less of a margin of safety. The test period last from 06/1983 until 12/2008.29% This analysis is based on the monthly returns of the NCAV portfolio.11% more on annual holding period basis.28% This table shows the standard deviation for the portfolios and the market returns.9227 1.

One can wonder how these results could ever be included in the framework of the efficient market hypothesis.5252 1.edu/pages/faculty/ken.french/data_library. The NCAV portfolio is equal and value weighted These results are regressed against both equal and value weighted market portfolios of the NASDAQ/NYSE/AMEX The test period last from 06/1983 until 12/2008. The risk free rate is the 30 day treasury bill. The SMB and HML factors were retrieved from: http://mba.67% This analysis is based on the monthly returns of the NCAV portfolio.1739 *** -3.risk/return relationship and the relationship between the main and robustness check is actually strongly negative.4336 *** 11.9749 ѕ 0.2753 T(α) 4. The calculations for these factors are based on the NASDAQ/NYSE/AMEX data and is therefore compatible with our dataset This leads to the following Fama and French 3 Factor model: Statistical signficance: *** Significant at 1% level ** Significant at 5% level * Significant at 10% level R it R ft ai b i ( R Mt R ft ) s i SMB h i HML e it Table 17: Momentum + Fama French 3 factor model : Value Weighted and Equal Weighted NCAV Value Equal Market Value Equal α 0.edu/pages/faculty/ken.html.4210 ** T(h) -0. The NCAV portfolio is equal and value weighted These results are regressed against both equal and value weighted market portfolios of the NASDAQ/NYSE/AMEX The test period last from 06/1983 until 12/2008.70% This analysis is based on the monthly returns of the NCAV portfolio.8397 0.3514 -0.1947 h -0.1283 *** 5. Table 16: Fama French 3 factor model: Value Weighted and Equal Weighted NCAV Value Equal Market Value Equal α 0.0228 T(i) -4.1044 *** T(β) 7.6971 0.0162 0.4540 *** T(s) 6.0433 *** T(β) 7.tuck.3043 h -0.0074 β 0.html.0774 ѕ 0.dartmouth.1184 0. The next tables are the four remaining risk-adjusted models.6271 *** 2.0105 β 0.7924 0.0027 i -0.49% 54. R^2 33.dartmouth.3188 *** T(h) -0.87% 19.0128 0. The risk free rate is the 30 day treasury bill.tuck. R^2 37.7510 0. The SMB and HML factors were retrieved from: http://mba.6042 *** T(s) 6. The calculations for these factors are based on the NASDAQ/NYSE/AMEX data and is therefore compatible with our dataset This leads to the following Fama and French 3 Factor model: Statistical signficance: *** Significant at 1% level ** Significant at 5% level * Significant at 10% level Rit R ft ai bi ( R Mt R ft ) s i SMB hi HML i MOM eit 49 .2772 *** 3.7842 *** 5.7451 1.0556 T(α) 3.0760 0.french/data_library.3662 *** 3.4753 *** Adj.1718 Adj.

0606 rINV -0. R^2 37. Petajisto and Zitzewits index-based 7 factor model NCAV Value Equal Market Value Equal α 0.6291 *** -3.7205 *** 2.7196 1.92% This analysis is based on the monthly returns of the NCAV portfolio.4592 0. R^2 33.1268 *** Adj.2472 Adj. The risk free rate is the 30 day treasury bill.0183 0.6693 0.html The calculations for these factors are based on the NASDAQ/NYSE/AMEX data and is therefore compatible with the dataset This leads to the following Chen and Zhang 3 Factor model: Statistical signficance: *** Significant at 1% level ** Significant at 5% level * Significant at 10% level Rj Rf j aq bj MKT rMKT bj INV rINV it bj ROA rROA ej Table 19: Cremers. The NCAV portfolio is equal and value weighted These results are regressed against both equal and value weighted market portfolios of the NASDAQ/NYSE/AMEX The test period last from 06/1983 until 12/2008.2609 *** 13. The NCAV portfolio is equal and value weighted These results are regressed against both equal and value weighted market portfolios of the NASDAQ/NYSE/AMEX The test period last from 06/1984 until 5/2008.4405 *** 10.7476 *** 3.1601 0.2005 rROA 0.0399 -0.7905 * T(i) 0.63% This analysis is based on the monthly returns of the NCAV portfolio. The risk free rate is the 30 day treasury bill.5295 -0.3379 T(rROA) 0.5512 0.1186 *** T(rINV) -6.0092 lUMD -0.html The calculations for these factors are based on the NASDAQ/NYSE/AMEX data and is therefore compatible with our dataset This leads to the following Factor model: Rit R ft ai bi ( RMt l iUMD R ft ) eit s i RMS5 hi R2 RM ii S 5 VS5 g j i RMVRMG Statistical signficance: *** Significant at 1% level ** Significant at 5% level * Significant at 10% level K i R2VR2G 50 .0497 kR2VR2G -0.8268 0.1546 *** T(β) 6.0112 β 0.7897 *** 1.0372 T(l) -3.3341 -0.0301 T(h) 3.2291 T(α) 4.wustl.0075 hR2RM 0.4374 0.2709 T(α) 4.93% 53.0190 0.net/data.Table 18: Chen and Zhang 3 factor model: Value Weighted and Equal Weighted NCAV Value Equal Market Value Equal α 0.edu/faculty/chenl/linkfiles/data_equity.3631 iS2VS5g 0.9953 ѕRMS5 0.1791 -0.1610 -0. The IA and ROA factors were retrieved from: http://apps.0335 jRMVRMG 0.4018 0. The seven factors were retrieved from: http://www.8689 *** T(s) 1.6393 -0.7509 1.1675 T(j) 0.6286 *** T(rMKT) 7.0095 rMKT 0.petajisto.olin.40% 53.2207 T(k) -1.1174 *** -2.

This is very strong evidence for the persistency of this anomaly. The ancillary hypothesis tests whether there is a negative relationship between the relative price level of the market and the availability of NCAV stocks. but a similar study in Japan by Bildersee et al (1993) showed less significant results. Malkiel (2003) and Schwert (2002) argue that anomalies which generate systematic abnormal risk-adjusted returns will be exploited by investors and then disappear. VIII. The strongest results are found for a one year holding period.11% more on an annual basis. Conclusion and Implications The main purpose of this thesis is to analyze the performance of discount NCAV stocks versus the broad based United States indices between 1984 and 2008. The model by Chen and Zhang (2009) is also not able to predict the returns of the NCAV strategy. Achieving higher returns requires the investor to take on more risk. The abnormal risk-adjusted returns decrease for the longer holding periods of three and five years.73% for equal weighted returns. Proponents of the efficient market hypothesis assume that the market price fully reflects all available information and risks. No further comments need to be made. This concludes the robustness check. This robustness check has further strengthened the evidence for the alternative hypothesis. The conclusion of this thesis is drawn next. Most interestingly the HML factor is not statistically significant even though this is a study of liquid current book value. The results are in line with Oppenheimer (1986) and Arnold and Xiao (2007). Based on the Carhart four factor (1997 ) model the results show that the abnormal risk-adjusted monthly returns are 2. Furthermore it has shown that the original test runs less volatility risk while earning 8. The results are clear and show that the strategy has produced significant abnormal-risk adjusted returns during the sample period. Although the 51 . Only weak evidence is found. They state that anomalies such as the January-effect have disappeared after publication. All other tests and robustness checks run confirm these results.These results further confirm the previous analyses and add to the robustness of the findings. This analysis serves as a test for the persistency of the anomaly.27% for value weighted and 1.

it appears limited in applicability. He also claims that there might be periods when asset prices are irrationally high but that these periods are the exception instead of the rule. It seems very unlikely that there is any other potential risk factor to explain the abnormal returns. 2003). The discount NCAV strategy is an inherently safe strategy due to the margin of safety given by the large amount of net current assets in proportion to the total market value. One would have expected the market/book factor to capture at least part of a net current asset value strategy. the factor is not even significant. The strategy produced abnormal risk-adjusted returns during the combined sample period of this and Oppenheimer‘s (1986) study. I can merely come to the conclusion that the returns are not generated due to inherent risk but is due to other (irrational) market factors. The discount NCAV strategy is an extreme test of the book-to-market anomaly. The last argument discusses the overall price of the market. The disappearance of anomalies argument does not hold in this case. What this thesis adds is 52 . 1976). If I include his career then this anomaly has persisted for well over 70 years and is clearly not self-destructive. A different argument asserts that the current asset pricing models do not capture all the risk factors and are therefore incomplete (Malkiel.argumentation behind this statement may be sound. Malkiel (2003) claims that periods of high relative market prices are due to uncertainty of future forecasts of growth rates. This publicity and especially the study by Oppenheimer (1986) has not reduced the abnormal risk-adjusted returns of the NCAV strategy. The internet bubble during the end of the last and the beginning of this century showed historically high relative market prices. The NCAV strategy has received much attention and is a widely publicized strategy which was promoted by Benjamin Graham during his career. Indeed it appears to be a very persistent anomaly . but the Fama and French 3 factor model (1996) is not able to explain the abnormal returns. Although the 3 factor model is relatively successful in other empirical tests. The Cremer et al (2008) model improves the Fama and French three factor model and should capture most of the risk-adjusted abnormal returns. This argument is in line with Pastor and Veronesi (2009). Not only is Fama and French (1996) model not able to explain the abnormal returns. it does not apply to the discount NCAV strategy. Furthermore according to Benjamin Graham the strategy has always produced satisfactory returns during his career (Graham.

The agency problems are largely caused by the need for money managers to please the treasury department. Setting up a discount NCAV portfolio can be expensive. Aside from the institutional constraints. and the possible explanations for this risk-adjusted performance are drawn next. individuals also encounter barriers to form a portfolio. Lakonishok et al (1992) proposed that the industry suffers from various agency problems which causes chronic underperformance. By dedicating to a discount NCAV portfolio the institutions overall performance would not be greatly affected. This has shown that there are institutional barriers but has not discussed the potential for individual investors. One possible reason why this strategy has not been exploited can be ascribed to institutional constraints. This evidences counters the uncertainty of future growth rates argument of Malkiel (2003). If the market perceives the economy and firms to experience high growth rates then firms should not trade below their net current asset value. The efficient market hypothesis and the Fama and French (1996) three factor model are not able to explain the results and for that reason other explanations need to be introduced. The money manager might not want to take this risk in fear of losing his customer and/or job. There is only a limited amount of discount NCAV stocks available at a given time. such as the discount NCAV strategy would be difficult to sell and would appear to have high risks because the stocks selected have often done poorly in the past and can be in distress. This causes money managers to pursue popular strategies and to adopt risk averse strategies. The results show that the strategy is persistent even after the publication of the Oppenheimer study and that the asset pricing models have not been able to explain the abnormal returns. A relatively unknown strategy. If one assumes that a single trade costs 53 . The size of institutions is also believed to play a role. Overvaluation might be present in the overall stock market as well as potential undervaluation in the abundance of discount NCAV stocks available during this time. Therefore there is no great incentive to launch a specific discount NCAV fund.that undervaluation as well as overvaluation might occur during the same sample period. The conclusion can be drawn that the discount NCAV strategy produces abnormal risk-adjusted returns. This small increase in performance would often not be noticeable on the total size of the portfolio.

if this ‗value‘ strategy has provided positive returns it can be expected that other similar strategies also perform better than the market. The three different arguments for the persistency of this anomaly have now been giving.$10. The cost aspect is one possible barrier which prevents the individual and the institutions from investing in a discount NCAV strategy but the most salient argument is behavioral. while underweighting the potential of firms to recover. The excludes any other potential costs (with the assumption of relatively low trading costs) and the opportunity costs for setting up. that the individual has a portfolio of 30 equal weighted NCAV stocks and that the holding period is 12 months. the total costs would amount to at least 600 dollars a year. Overconfidence in one‘s own judgment capabilities adds to the perceived expected performance and the actual financial risks run. The implication of this is that the models based on the EMH hypothesis might be less valid than 54 . The implications of the anomaly for theory and practice is the final part of this conclusion. In the case of the discount NCAV strategy investors overreact to poor past performance and extrapolate this into the future.000 dollars to drop the annual costs below 1%. the market overreacts to past performance. Emotional based anomalies are likely to be persistent because each individual suffers from the same limitations to rational decision making. This overweighting of past performance causes the firms to trade below liquidating (NCA) value. If it were not due to inherent limitations in the human psyche this anomaly should have disappeared after the initial publication by Benjamin Graham and especially after the Oppenheimer (1986) study. The discount NCAV has shown strong persistency in delivering risk-adjusted returns. An investor would need to hold a portfolio of at least 60. In line with De Bondt and Thaler (1985). Consequently this expected poor performance does not materialize and the stock is able to generate abnormal risk-adjusted returns. The main behavioral concept that is applicable to the discount NCAV anomaly is the representative heuristic. searching and analyzing the stocks. could be the main reason for the occurrence and persistence of this anomaly. Deviations from rational decision making. knowledge and is willing to invest at least this amount in a diversified portfolio. It is doubtful whether there is a large group of individuals who has the available capital. Although further research is beyond the scope of this thesis. with the last explanation being behavioral.

The results of this thesis underline and support this last statement. Furthermore if these models have poor explanatory power. This thesis has documented the persistency of the discount to net current asset value strategy. The results show that the strategy was able to produce risk-adjusted returns during the 1984-2008 period that are in line with the results produced by (Oppenheimer. Advocates of the EMH prescribe that holding a passive index tracking portfolio yields the best results but this thesis confirms that valuing a publicly traded firm on the basis as if it were a private business can yield very satisfactory returns. It is proposed that the abnormal risk-adjusted returns are due to institutional constraints. The overall conclusion will now be drawn. Therefore one should question the applicability of asset pricing models that are based on the EMH assumption and the deriving advice to invest in index tracking funds. The implications include a possible invalidity of the aspects of semi-strong EMH model. Perhaps the future of asset pricing models should not be in trying to incorporate all risk factors into the current model but to review the basic foundations that underlie these models. why should so much be invested in trying to teach these models to future financial academics and business professionals. As is this case in economics.assumed. a high individual cost basis and is strongly influenced by behavioral biases. the consequences that has on academic research as well as investment advice and on the amount of time that is invested in attempting to teach students these models. Would it not be wiser to invest more time in the analysis and valuation of specific firms. The implication of these results is that one should not underestimate the capacity of an individual who has a sound background in financial analysis to outperform the market. 1986). perhaps a micro level approach to teaching investing yields more explanatory power than a macro approach. The final implication is that this strategy should continue to deliver satisfactory results for investors able to overcome the cost and behavioral constraints. The individual is able to do so on the basis of buying firms at a value higher than the current market price of the security. It is my strong opinion that the emotional vagaries of the market will continue to offer investors profitable opportunities if they have the financial knowledge and emotional stability to counter conventional wisdom. 55 .

Further Research: There are several avenues of research which can expand the results of this thesis. it was noted that discount NCAV firms often experience goodwill write downs in the previous 12 to 24 months. X. Finally during the analysis of specific firms. (Buffet. Therefore the data had to be merged manually. Miles and Rosenfeld (1983) showed that corporate spinoffs produced significant abnormal returns. It was merged using the CUSIP identifier. the study of high Return on Invested Capital stocks (Graham. The database of the University of Maastricht does not have access to the merged CRSP and COMPUSTAT files. The first concerns a technical aspect of merging CRSP and COMPUSTAT databases. 2003).IX. Another interesting field would be the study of corporate spinoffs. Furthermore other analyses of value investment strategies could be run. 2009). To examine the degree of mismatches. An examination of the persistency of corporate spinoff returns would increase the evidence against the semi-strong form of market efficiency. This causes some stocks to be mismatched when merged. I recognize that such a model is difficult to set up considering the complexities of quantitatively measuring emotions. Research would nonetheless help clarify the persistency of this and other anomalies. During the last decade of the sample period almost no mismatches were found. CRSP and COMPUSTAT use different means of determining the CUSIP. Further research with respect to asset pricing models which contain behavioral proxies could potentially allow for a model which is able to explain the returns generated. Limitations: This analysis has several limitations. This could include other strategies identified by Benjamin Graham or a strategy proposed by Warren Buffet. The effect is therefore 56 . It could be interesting to analyze whether the market overreacts to goodwill write downs and whether firms who have written down goodwill outperform the market. An international meta analysis of the NCAV strategy would allow a direct comparison between markets. There were a small number of mismatches but as the years progressed the mismatched amount of stocks grew smaller. If the results are persistent across countries using the same sample period this would strengthen the evidence for the anomaly. several years of data was analyzed.

The last limitation is due to the inexperience of the author as a researcher. the impact should be minimal because the firms are all publicly traded firms who have to meet SEC regulatory standards. Although the author has sufficient statistical knowledge. The second limitation is possible differences between accounting standards. 57 . While there might be differences. this is his first analysis of primary data. Not only is the amount of mismatches very small compared to the total discount NCAV portfolio but mismatches would occur randomly and weaken the results of the tests and not strengthen them. Thus small errors might exist but it is believed that these errors should not influence the conclusions drawn in this thesis. I believe that these few errors do not have a sizeable impact on the overall results.minimal. As the results are significant.

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Current Liabilities – Total 2. Cash and Short-Term Investments 2. The liabilities total consists of the following items and is in accordance to US GAAP: 1. Receivables This item represents cash and other assets that are expected to be realized in cash or used in the production of revenue within the next 12 months.Total The Liabilities item number is LT. Liabilities – Other 4. Long-Term Debt – Total This item excludes: 1. included in Minority Interest (Balance Sheet 65 . Deferred Taxes and Investment Tax Credit 3. Inventories 4. Minority interest. The currents assets consist of the following items and is in accordance to US GAAP: 1.XII. Liabilities . Contingent liabilities reported supplementary to the Balance Sheet 2. Current Assets 3. Appendices Appendix 1: Balance Sheet and Stock Return Definitions: Compustat and CRSP Used for the screening process Current Assets – Total The current asset item number is ACT.

Utilities subsidiary preferred stock 3. Cost of redeemable preferred treasury stock which is netted against Preferred Stock – Redeemable This item is the sum of: 1.Appendix definitions: Preferred/Preference Stock (Capital) . Receivables on preferred stock 6. Subsidiary preferred stock This item is reduced by the effects of: 1.Total The preferred stock item is PSTK The currents assets consist of the following items and is in accordance to US GAAP: 1. Preferred stock subscriptions 2. Adjustment for redeemable preferred treasury stock. Redeemable preferred stock 4. Preference stock 5. respectively 2. Preferred Stock – Nonredeemable (PSTKN) 2. Preferred stock sinking funds reported in current liabilities 2. 7. Par or carrying value of nonredeemable preferred treasury stock which was netted against this item prior to annual and quarterly fiscal periods of 1982 and 1986. first quarter. Excess over par value of preferred stock when a separate breakout is not available This item excludes: 1. Preferred Stock – Redeemable (PSTKR) 66 . Secondary classes of Common/Ordinary Stock (Capital) 3.

Shares Outstanding (SHROUT) The number of publicly held shares on NYSE. recorded in 1000s and adjusted for all price factors Price (PRC) Monthly — The closing price of a security for the last trading day of the month. NASDAQ. and NYSE Arca exchanges. the number in the price field is replaced with a bid/ask average (marked by a leading dash). If unavailable. 67 . adjusted for distributions. Amex.

NASDAQ . Only industrial firms are included. international firms might have different accounting standards and practices. Compustat Stock Exchange Code: 1. It is also a test within the united states and nowhere else.Complete database is taken. Only domestic stocks are taken into account. NASDAQ: 14 CRSP Stock Exchange Code: 1. NYSE: 11 2. leverage of financial institutions makes it difficult to compare.The years that are selected will be from 1983-2008 . NYSE 2. 2.Appendix 2: Selection Criteria Compustat and CRSP Use the following dataset 1. AMEX: 2 3. 68 . NYSE: 1 2. AMEX 3. NASDAQ: 3 Selection criteria: 1. AMEX: 12 3.

Preferred Stock = PSTK 9. Add to output -> Select only consolidated. Save. Ticker Symbol. Conditional Statement 2 -> None 7. exchange code 8.SIC codes: financial services = 6xxx 1. Identifying information -> Cusip. Select Fundamental data required -> . Conditional Statement 1 -> Exchange code = 11 NYSE. Select Output format -> Stata 11. Select CRSP Database -> Monthly Stock File 69 . Select Date Format -> Default YYMMDDn8 10. Select Companies to be selected -> Entire Database 3. Steps to be undertaken in Compustat: 1. domestic. financial. sort cusip fyear . replace 2. both active and inactive 5. drop fyear 13. 12 AMEX. Select Compustat Database -> North America 2. uniqusing 15. Steps to be undertaken in CRSP: 1. generate(fyear1) 12. currency = usd. Select Date Range -> Jan 1983 until Dec 2008 4. tostring fyear .All Current Assets = ACT .Liabilities Total = LT . 14 NASDAQ 11 OR 12 OR 14 6. rename fyear 1 fyear 14.

adjusted Holding period return. Identifying information: CUSIP TICKER EXCHANGE CODE 7. including dividends Holding period return. excluding distributions 8. Time Series Information: Price - Price Number of Shares of Outstanding. Search -> Entire Database 4. excluding dividends Value Weighted return. excluding distributions Equal Weighted return. including distributions Equal Weighted return. Conditional Statement 1: Share Code = 11 First Digit: Ordinary Common Stocks Second Digit: Firms which need not be defined further Fill in CRSP = 11 5. Select Date Format -> Default YYMMDDn8 70 . Select Date Range -> Jan 1983 until Dec 2008 3. Stata File 9. Conditional Statement 2: Exchange Code Exchange codes: 1 = NYSE 2 = AMEX 3 = NASDAQ Fill in CRSP <= 3 6.2. including distributions Value Weighted return.

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