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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 Market allegory may seem out-of-date in today's investment world, in which most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'?"

2

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.

3

Table of contents

I. Introduction 5

IV. Data 21

V. Methodology 23

VI. Results 31

X. Limitations 56

XI. References 58

XII. Appendices 65

4

I. Introduction

This thesis discusses the persistency of a potential market anomaly; stocks trading at a discount

to their net current asset value (NCAV). Discount net current asset value stocks offer a margin of

safety to equity holders, which gives substantial protection from further operating losses and loss

of principal in case of bankruptcy (Dodd and Graham, 2009). NCAV stocks are stocks whose

market value is trading at a discount to the current asset value after subtracting all liabilities and

claims. 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, receivables and cash

which can be distributed to shareholders without losing significant value (Dodd and Graham,

2009), (Whitman and Shubik, 2006). It is this discount that offers significant safety against loss

of invested capital while still exposing the equity holder to upside potential. 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. 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, 1996). The strategy, first proposed by Dodd and Graham (2009), has shown

to produce risk-adjusted abnormal returns (Oppenheimer, 1986), (Bilsersee et al, 1993), (Arnold

and Xiao, 2008). It is proposed that the main reason for the risk-adjusted returns are due to

overreaction by investors and institutional constraints.

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 self-destructive, because public knowledge of the anomaly will increase

the funds allocated to the specific anomaly and reduce risk-adjusted abnormal returns (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. Evidence of persistency within

one market is not available for the anomaly and serves as the main reason why this strategy

should be revisited. Further arguments for this analysis are given next.

5

This thesis serves as an expansion and update of the article by Oppenheimer (1986).

Oppenheimer (1986) studied the period from 1970 to 1983. This thesis analyzes the period from

1984 to 2008. There are important 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 in the returns generated during a long-run bull market in

United States. The advent of behavioral finance during the last two decades has given the public

knowledge about psychological deviations from rational decision making. The knowledge

could have been used to exploit market anomalies and reduce overall returns to the NCAV

strategy. Finally Oppenheimer (1983) limited his risk-adjusted 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. 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. 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?

Persistent abnormal risk-adjusted returns will further support the evidence for this anomaly and

potentially provide a profitable strategy for investors.

6

To answer this question the following structure is setup: Chapter II discusses the prevalent

theory. Chapter III details the hypotheses that are set up. Chapter IV and V discusses the data

and the methodology used. After this section the results are presented in chapter VI . Section VII

provides a robustness test The thesis continues with a conclusion and implications section in

chapter VIII. Further research is discussed in chapter IX, limitations in X and finally references

are given in XI. The literature and theoretical foundation are discussed in the next section.

This thesis examines the persistency of a market anomaly; stocks trading at a discount to net

current asset value. A firm trading at such a discount can be purchased for a price less than the

book value of the sum of inventories, receivables and cash after subtracting all liabilities (Dodd

and Graham, 2009). This naturally implies that discount NCAV stocks also trade at a market

discount to book value. The book/market anomaly is a well documented anomaly and is

incorporated into the Fama and French three factor model (Daniel and Titman, 1992), (De Bondt

and Thaler, 1985), (Fama and French, 1996), (Lakonishok et al, 1992). 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 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. The first step is to analyze the origins of this anomaly

and this is done by first reviewing the basic CAPM model.

The CAPM model introduced by Sharpe (1964) and Treynor (1961), and extended by Lintner

(1965a;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. This risk, termed beta, measures the covariance of the asset

with respect to the market compared to the overall variance of the market. The higher the Beta

the higher the non-diversifiable risk of the stock. A higher beta is equal to higher volatility with

respect to the market. 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. The CAPM assumes that investors perceive volatility

as the main risk factor and then assumes that this is linked to expected returns. In the case of a

beta of two the CAPM predicts returns that are twice the market return after subtracting the risk

7

free rate. The early empirical results provided by Sharpe (1964) and Treynor (1961) were

promising but later research did not confirm the results. Fama and French (1992) stipulate that

the beta is insufficient in explaining expected returns between 1941 and 1990. To improve upon

the standard CAPM model Fama and French (1993) introduce their three-factor model.

The three-factor model proposed by Fama and French (1993) included the standard CAPM but

expanded to model to include two more factors. These two factors are the Small Minus Big

factor (SML) and the High Book to Market minus Low Book to Market factor (HML). 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. Fama and French (1993) offer a

rational explanation for the occurrence of these anomalies. 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, 1993). A distress explanation is given for the

second anomaly, the HML factor. Fama and French (1993) propose that distress is linked to

human capital, which they state to be important to most investors. 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. This means that employees of distressed firms have an incentive not

to own capital in their own firm. Although the strategy is logically appealing Daniel and Titman

(1997) found evidence that the covariance‘s did not change after the firm became distressed. 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 (1993) were able to explain a significant degree of cross-sectional returns by

using their three-factor model. Their argumentation is based on rational behavior which not

supported by the evidence (Daniel and Titman, 1997). Another argument made for explaining

the HML factor is behavioral. Behavioral finance assumes that humans do not under all

circumstance behave rationally and this leads to systematic deviations in stock market returns

Hirsleifer (2001). The first article relevant to the behavioral explanation of the HML factor is

the article by de Bondt and Thaler (1985). Their findings show that investors overreact to past

information and extrapolate into the future. This causes past losers to outperform past winners.

De Bondt and Thaler (1985) claim that individuals do not adhere to Bayes‘ rule but rather

8

overweight recent data and underweight prior data. This is in accordance to the representative

heuristic proposed by Kahneman and Tversky (1979). Where a heuristic is rule of thumb

individuals use to make decisions and representativeness is equated to using recently available

data. It is this phenomenon, that according to the De Bondt and Thaler (1985) causes the

outperformance of loser portfolios compared to winner portfolios. 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). As the De Bondt and Thaler (1985) article

was written before the Fama and French (1993) study, 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, among other anomalies, the HML factor on the basis irrational

behavior. 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.

Their results confirm this last statement and they conclude that investors consistently

overestimate future growth rate of glamour stocks relative to value stocks. Lakonishok et al

(1994) argue that while there might be a metaphysical risk attributed to value stocks, the

evidence suggests a more straightforward model. They do not mention the rational distress

argument. The gap between value and glamour stocks is 10 percent per year and can be

explained due to systematic behavioral deviations and institutional constraints. Individual

investors might extrapolate past growth rates which are highly unlikely to persist in the future.

This is again evidence of the representative heuristic of Kahneman and Tversky (1979). Investors

could also view well-run firms as being equal to good investments and buy glamour stocks they

believe they cannot lose money on. According to Lakonishok et al (1992) institutional investors

suffer from the same bias towards glamour stocks because they are deemed to be prudent

investments. 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 third and final factor is the short time horizon of most

investors. Investors often seek short term abnormal returns within months instead of 4 percentage

point over the course of 5 years. This is in line with the argument of practitioners, who claim that

time arbitrage will allow for abnormal returns (Pabrai, 2007). 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. The overall

9

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 overall conclusion of the market/book anomaly can now be drawn.

The market/book factor was introduced to help explain the lack of explanatory power of the

traditional CAPM model. 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. 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. The behavioral explanation is

rooted in experimental psychology Kahneman and Tversky (1979) whereas the institutional

constraints were investigated in Lakonishok et al (1992). The evidence for the irrational and

institutional constraints hypothesis is, according to the author, stronger than the rational

explanation. This thesis tests the persistency of these systematic deviations from an underlying

risk/return relationship. It does so specifically for the market/book value but on the basis of only

tangible current assets. To test the persistency of systematic deviation from underlying value, a

discussion is required of how to measure this value.

In order to compare the value of stock prices to the stated market price a definition is required.

The definition used in this thesis is intrinsic value. Lee et al (1997), 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. According to Lee et al (1997) there are only few studies

focusing on the problem of intrinsic value. They claim that academics view the securities price as

the best estimate of intrinsic value and view fundamental analysis as a futile exercise. This is in

line with the EMH, which states that if a market is semi-strong form efficient fundamental

analysis is useless (Malkiel, 2005), (Beechey et al, 2001). The issue with this is of course that

among others, Lakonishok et al (1992) have found widespread abnormal returns on the basis of

valuation criteria. Thus the securities price is not necessarily equal to intrinsic value otherwise

there would be a constant risk/return relationship, which evidence has proven not to be the case.

Therefore a model for measuring intrinsic value is required.

10

Frankel and Lee (1996) posit that the basis for measuring the intrinsic value of the firm is book

value as well as expected earnings. Campbell and Shiller (1988) base their calculation solely on

earnings to predict future dividends. Penman and Sougiannis (1997) do so on the basis of

residual income. These three models have in common that they rely on the facts provided by

accounting figures to provide a measurement of intrinsic value. 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. If this occurs then this implies an

inefficient market. The HML factor is linked to intrinsic value because book value is part of the

value of the firm . (Frank and Lee, 1996). 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. 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.

The models of intrinsic value provided by mainstream academics is in line with Dodd and

Graham (2009), the originators of the NCAV strategy and more importantly the concept of

intrinsic value. They state that the intrinsic value of a security is determined by facts. Among

these facts are the assets, earnings, dividends, definite prospects and others. In line with the

belief that there is an independent intrinsic value to firms, they argue intrinsic value is

independent from the current market price. It is said that the calculation should not include the

price quotation because it can fluctuate on the basis of psychological excess, which is in line

with the arguments provided by Lakonishok et al (1992). 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. 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. 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. Therefore a calculation of intrinsic value entails a

range of estimates of the discounted cash flows that can be received from the firm. It is claimed

by Dodd and Graham (2009) that it is not necessary to achieve a precise figure in order to

11

purchase a security. 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. Note that this last statement requires the market to inefficient otherwise no such safety

criteria would exist. In line with Frankel and Lee (1996), Campbell and Shiller (1988) and

Perman and Sougiannis (1997), 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. 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.

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. Thus in most cases the larger the market to book

value the larger the discrepancy between intrinsic and market value. 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. 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. To analyze why net current asset value is closely

linked to intrinsic value a discussion is given next.

First proposed by Dodd and Graham (2009), the Net Current Asset Value approximates the

liquidation value of the firm. Net Current Asset Value is calculated by taking current assets and

subtracting all short and long term liabilities. Long term assets are not included. This total net

current asset value is divided by the shares outstanding which gives the net current asset value

per share. If the current market value per share is lower than the NCAV per share then this

security is trading at a discount to NCAV. According to Graham, stocks that trade at a sizeable

discount to their NCAV should be profitable if sold to another firm or liquidated. 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

business owner would sell their assets at such a low price to another investor. 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, but we found it almost

unfailingly dependable and satisfactory in 30-odd years of managing moderate-sized investment

funds..

I consider <the NCAV strategy> a foolproof method of systematic investment--once again, not

on the basis of individual results but in terms of the expectable group outcome.‖

The EMH predicts that stocks that trade at distressed prices incorporate extra risk (Fama and

French, 1996). If a firm trades at a discount to NCAV, the EMH predicts that the firm will

continue to diminish the capital base of the corporation. A gradual reduction in firm value due to

poor business economics or mismanagement causes investors to price the share at a discount to

NCAV.

Dodd and Graham (2009) argue that there are several developments that can take place to

prevent this gradual reduction. A gradual reduction may occur but is unlikely to do so because;

1. The earnings power of the firm can increase. When earnings go up the return on assets will

increase thereby often increasing the share price. A business or industry with a record of low

profitability can improve because competition is reduced or the economics of the business

improve. A mean reversion to normal levels of returns often occurs according to Dodd and

Graham (2009). Another reason for an increase in earnings is due to a change in operating

policy. Unprofitable businesses can be closed down or (new) management can change the

strategy of the business. This can either be done voluntarily or they can be forced to change their

policy by the shareholders.

2. The firm might be sold to a competitor who is able to utilize the assets more efficiently than

the current operators. The competitor will at least pay the liquidation value of the assets.

13

3. The discontinuation of the business. The firm is already trading at a discount to NCAV and

therefore liquidation would be profitable. This liquidation would release the value of the tangible

current assets.

If a diversified group of discount NCAV stocks is purchased there is a high probability that the

value of the discount will be unlocked. 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. Although some discount NCAV firms will continue to diminish the assets of the

stockholder, 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. 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 liquidating value is equal to a discount to net current asset value of at

least 1/3. While the continued diminishing of assets might occur occasionally, the author

considers this discrepancy to be due to behavioral and institutional constraints (De Bondt and

Thaler 1985), Lakonishok et al (1994).

The unique aspect of this test is that it is very straightforward to observe that the pricing of the

stock is irrational. 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. It could be the case that long term assets have far higher book values than

true economic value. The NCAV strategy only takes into account current assets and does not

include assets that are difficult to value. This implies that it is a direct test of these phenomena

and a test of deviations from intrinsic value. The arguments advocating why a NCAV should pay

off have now been given. The next section will discuss the previous tests of the strategy.

Graham, the first known advocate of the strategy, 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,

1976). This is well in excess of the market returns over this period. Since Graham has not

14

released his results, I will rely on the scarce academic tests that are available. The research that

is available shows positive abnormal risk adjusted returns if there are enough discount NCAV

stocks available to form a representative portfolio. This section will summarize the three papers

that, to the authors‘ knowledge, have been written about the topic. This thesis serves as an update

and expansion of the paper written by Oppenheimer (1986). Therefore this paper will be

discussed first.

Oppenheimer (1986) undertook this analysis during the 1970-1983 period in the United States.

He undertook this study because of the lack of academic analysis on this topic. The research was

limited to the United States, as is this thesis. The results show that the 13-year risk adjusted

returns were significantly greater than the market portfolio returns. The mean monthly returns for

this period were 2,45% for the NCAV portfolio whereas the NYSE-AMEX and the Small Firm

indices produced 0,96% and 1,75% respectively. Over this period a discount NCAV portfolio

worth 10,000 dollars would have grown to 254,973 dollars whereas the NYSE-AMEX index

grew to 37,296 dollars and the small-firm indices to $101,992 dollars. Taking into account risk-

adjusted returns the NCAV portfolio outperformed the NYSE-AMEX by 19% on a yearly basis

and the small firm index by 8%. These results were achieved by buying a portfolio of securities

that is at most two thirds of NCAV. 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.

Graham (2009) stated that in order to achieve adequate risk adjusted returns the firms should be

relatively profitable and have consistent dividends. Oppenheimer (1986) claims that this

argument does not hold for this specific sample. Firms without positive earnings and profitable

firms omitting dividend payments show higher returns. 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. Although not discussed by Oppenheimer (1986) one can argue that

the greater the undervaluation the greater the effect of the representative heuristic, regret

aversion and hindsight bias. 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 risk-

adjusted returns. Although the US market will be investigated, other markets have been tested as

well.

15

Bildersee et al (1993) examined the performance of Japanese common stocks in relation to their

NCAV. They wanted to research whether the discount NCAV strategy held in a country which is

different from the United States. Their sample ranged from 1975 until 1988. This sample

coincides with one of the largest bull markets of the past century. 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 1,5 NCAV. This allowed a representative portfolio to be formed. 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. A less stringent test implies that

the underlying value is not as a liquid and the value of the balance sheet is less certain. Even

though the authors had to stretch the parameters the results still showed that the NCAV strategy

produced abnormal risk adjusted returns. The results are not as robust as the Oppenheimer study.

The results are dependent on the holding period of the sample. 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 last paper discusses a more recent test

of the NCAV strategy in London.

The working paper by Arnold and Xiao (2008) analyzes the NCAV strategy in London from

1981 until 2005. This paper is interesting because it analyzes a liquid stock market during a

period of high stock 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 results show that

stocks trading at a discount to NCAV value produce significantly positive market-adjusted

returns. The results are up to 19,7% percent per year. 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. They conclude that the premiums that these stocks provide can be due

to irrational pricing by investors.

The three articles that have analyzed the NCAV strategy show that this strategy is able to

produce abnormal risk adjusted returns. Each article analyzes a different market and a different

time period. The NCAV strategy produces positive abnormal returns regardless of the location of

the market or the pricing of the stock market. 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.

16

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 authors stretched the original

criteria to select stocks that were trading at relatively low premiums to NCAV. 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). Overall one can conclude that the

results of these three articles provide evidence that the NCAV strategy produces abnormal risk-

adjusted returns.

The literature review has shown that traditional volatility is insufficient in explaining the

expected returns of stock market returns. By expanding the model to include other factors the

predictability is improved, but evidence by Daniel and Titman (1997) has shown that the

rational risk argument posited by Fama and French (1993) is insufficient. 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. These arguments give credence to the outperformance

of high book/market stocks. It is proposed that these stocks have an intrinsic value that is higher

than the market price. Academics, 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, 2009), (Dodd and Graham, 2009), (Frankel and Lee, 1996). 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. The HML

factor also takes into account tangible and intangible long term assets which may or may not

have a definite value. Thus the NCAV test is a more thorough test of the systematic deviations

based on behavioral biases and institutional constraints. 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. The next chapter will explain the need for this study

and why there should be a persistency test of this anomaly.

17

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 self-

destructive, 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 long-

run 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.

18

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 risk-

adjusted 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 risk-

adjusted 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

Using the arguments given, It is expected that the strategy will yield abnormal risk-adjusted

returns. Various tests will be run to detect whether or not stocks trading at a discount the their

Net Current Asset Value conform to expectations.

This main purpose is to test the performance of the discount NCAV portfolio. One of the reasons

why the topic requires an update is the long bull market during the sample period. It is expected

that higher relative stocks prices will lead to a lower amount of discount NCAV stocks. 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 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. Data

1. Financial Statement and Monthly Stock Return data

2. The gathering of comparable index returns and factor loadings to run the required analysis

3. Data with respect to the relative price of the stock market required to answer the ancillary

hypothesis.

The sample period of this thesis lasts from June 1984 until December 2008. The data selected

covers three markets in the United States, the NYSE, AMEX and NASDAQ. The United States

was chosen as it is the world‘s most liquid market with strong financial regulation to prevent

21

erroneous reporting. This is in line with the study by Arnold and Xiao (2008). Stock market

returns were retrieved from the CRSP (Center for Research in Security Prices). Financial

accounting data was retrieved from COMPUSTAT. The data was merged using the CUSIP

identifier. There are some differences between COMPUSTAT and CRSP with respect to the

CUSIP identifier but after a random sample analysis of the data, the impact was concluded to be

negligible. See limitations for a further explanation. The dataset includes only domestic

companies as international regulating standards might differ and this thesis attempts to analyze

only the United States stock market. I have excluded financial firms from the analysis due to the

high leverage ratios that are inherent to this industry, also in line with Arnold and Xiao (2008).

High leverage reduces the margin of safety concept proposed by Benjamin Graham. 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.

The COMPUSTAT data contains identifying information as well as the required balance sheet

information. The required balance sheet data are: All Current Assets (ACT), All Liabilities (LT)

and Preferred Stock/Preferred Capital stocks (PSTK). 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. Extensive definitions can be found in appendix 1. The exact

selection criteria for both COMPUSTAT and CRSP can be found in appendix 2.

Factor data

The risk free rate were downloaded from the Kenneth French site

(http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html). The risk free rate is

the 30 day treasury bill rate. 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.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html). The data for the

Chen and Zhang (2009) model is retrieved from the personal site of Lu Zhang

(http://apps.olin.wustl.edu/faculty/chenl/linkfiles/data_equity.html). The Cremer et al (2008) is

retrieved from the personal site of Antti Petajisto (http://www.petajisto.net/data.html).

22

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 10 year price to earnings ratio was retrieved from the website of Robert Shiller.

(http://www.econ.yale.edu/~shiller/data/ie_data.xls). Although this dataset measures the

price/earnings ratio of the S&P 500 instead of the NYSE/AMEX/NASDAQ, 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.

V. Methodology

This section will explain the methodology that is used to analyze the retrieved data. The

calculations and procedures required to achieve the results will be discussed in sequence. The

methodology is for a large part in line with the procedure adopted by Arnold and Xiao (2008).

The merged data from CRSP and COMPUSTAT allowed for the calculation of the total stock

sample from which the NCAV portfolios were formed. This excluded all financial firms and only

took into account domestic firms. Domestic firms are firms which are incorporated in the United

States and operate from the United States. ADRs and firms with only a stock listing in the United

States are therefore excluded. The total stock count is equal to all stocks remaining in the sample

which was repeated for every year.

To count the amount of NCAV stocks in a given year, the NCAV portfolios needed to be

formed. 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). The 1/3

discount is taken because this was prescribed by Benjamin Graham as his original strategy (Dodd

23

and Graham, 2009) In order to calculate this value, the following data from the merged dataset is

required; Stock Price (PRC), number of shares outstanding (SHROUT), all current assets

(ACT), all liabilities (LT) and preferred/preference stock (PSTK). 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. This procedure is then repeated for the length of each holding period (one

year, 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).

These three calculations lead to a ratio which gives the market value relative to its Net Current

Asset Value. This leads to a total overview of discount stocks as well the total selected sample of

stocks trading on the AMEX/NYSE/NASDAQ. The next step is to calculate the raw returns for

each year.

To give an overview of the returns generated by the NCAV portfolios, the yearly holding period

returns are calculated. The NCAV portfolio are formed at the beginning of June and held until

the end of May. The main test is run using stocks that trade for at least a 1/3 discount to NCAV.

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. 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. The robustness check analyzes this total sample. The weighing is done on an

equal and value weighted basis. The holding period returns are calculated using monthly returns.

To achieve holding period returns the following calculation is applied:

24

This is done for each stock that meets the requirements of the NCAV portfolio. By performing

these calculations the holding periods returns for a specific year are arrived at. 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. 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. This value is then

divided by the total market value of the NCAV portfolio. By adding up all the market weighted

returns for the individual stocks, the returns for the portfolio are arrived at. 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. This data gives an overview of the raw returns, 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. The setup of this analysis is discussed

next.

25

The next analysis is used to get an overview of the overall mean return of the NCAV strategy.

There are three main holding periods: A 1 year, 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., The mean return for the specific holding period is calculated. Thus in the in the case of

the 1 year holding period, all 24 years are used in the calculation of the mean returns (where year

1 is p1, year 2 is p2). For the other holding periods the same procedure is used, but with fewer

different holding periods. 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. This is done by applying the following t-

test formula. 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. It does not however give any indication of the risk profile of such a stock. Before

continuing with a risk analysis, the standard deviation is analyzed.

A calculation of the standard deviation will show the relative dispersion among the mean. It

implies risk but only in so far as the mean of the portfolio is similar to the market. If this mean is

significantly higher then any downward risk will still yield higher returns than the portfolio.

Thus caution needs to be taken when comparing the results. The next step is to calculate the

CAPM.

5. CAPM

26

The first analysis that incorporates risk adjusted returns, utilizes the standard asset pricing model;

the capital asset pricing model. The risk-adjusted returns are calculated on the basis of monthly

returns. The following CAPM model is set up analyze both value weighted and equal weighted

returns. Once the results have been calculated the following regression is run:

On the left hand side of the equation R ft is the monthly risk free rate, Rit is the monthly return

generated by the portfolio. On the right hand side of the equation, ai is the alpha. bi is the

sensitivity of the asset returns to market returns. eit is the error term.

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 next step is to

include the Fama and French Three-factor model.

The three factor model takes into account the premia for small and high book-to-market stocks.

Fama and French stipulate that these factors compensate for inherent risk. Whether or not this is

true it does take into account, the Book-to-Market and Small Minus Big factors which are

predictive of value premia. These are often stocks who have underperformed the market. 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. The factors loadings are retrieved from the

Kenneth R. French online database

(http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html) and the calculations

for these factors are in line with Fama and French (1996). By including these factors and keeping

to the same procedure as the CAPM, we arrive at the following regression:

27

On the left hand side of the equation R f is the monthly risk free rate, R j is the monthly return

generated by the portfolio. On the right hand side of the equation, a i is the alpha of the model.

RMt is the monthly return of the market. R ft is the monthly return of the 30 day risk free rate.

si SMB is the small minus big factor. hi HML is the high minus low factor. eit is the error term.

8 Momentum

To momentum factor introduced by Chan et al (1996) is the last asset pricing model to be

introduced. The momentum factor is also retrieved from the Kenneth R. French online Database

(http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html) and follows the

calculation prescribed by Chan et al (1996). The momentum factor measures the premium of

stocks that have performed well in the past and because of this performance continues to do so.

The inclusion of this factors leads to the following regression analysis:

On the left hand side of the equation R f is the monthly risk free rate, R j is the monthly return

generated by the portfolio. On the right hand side of the equation, a i is the alpha of the model.

RMt is the monthly return of the market. R ft is the monthly return of the 30 day risk free rate.

si SMB is the small minus big factor. hi HML is the high minus low factor. i MOM is the

This three factor model takes a different approach from the traditional asset pricing models.

There are two factors that attempt to explain the returns. The first is the investment factor. The

expected return decreases with an increase in investment to assets. Thus firms with lower

28

investments have higher expected returns. The second factor is the return on assets factor, which

stipulates that firms with higher expected ROA should generate higher expected returns (Chen

and Zhang, 2009). This leads to the following asset pricing model:

MKT INV ROA

On the left hand side of the equation R f is the monthly risk free rate, R j is the monthly return

generated by the portfolio. On the right hand side of the equation, a q is the alpha of the model.

b is the sensitivity of the asset returns to market returns. RMt is the monthly return of the

MKT

market. R ft is the monthly return of the 30 day risk free rate. b is the investment to assets

INV

ROA

The alternative factor model by Cremers et al (2008) is the last model that is discussed. The

model strives to eliminate benchmarks from generating alpha. The authors claim that the Fama

and French three-factor model (Fama and French, 1996) makes it difficult for small-cap value

investors to earn alphas and easy for large cap growth stocks to outperform. Therefore the

models is expanded to included 7 factors. The model is listed below:

k i r 2vr 2 g liUMD eit

On the left hand side of the equation R f is the monthly risk free rate, R j is the monthly return

generated by the portfolio. On the right hand side of the equation, a q is the alpha of the model.

bi is the sensitivity of the asset returns to market returns. RMt is the monthly return of the

market. R ft is the monthly return of the 30 day risk free rate. si RMS 5 is the mid minus large

29

cap factor. hi R 2 RM is the small versus large cap factor. ii S 2VS 5 g is the large cap value minus

growth factor. ji RMVRMG is the midcap value minus midcap growth factor. ki r 2vr 2 g is the

mid versus large cap factor. liUMD is the momentum factor. eit is the error term.

The last analysis is used to answer the ancillary hypothesis, which tests the relationship between

the amount of NCAV stocks available and the rolling ten year P/E ratio for the S&P 500.

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. As the P.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. It can be compared

directly. To calculate the relative change the natural logarithm is taken of both the S&P and

NCAV, 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. The formula for the correlation between these two factors

is:

30

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. The following regression is run.

R ai bi eit

On the left hand side of the equation R is dependent variable. On the right hand side of the

equation, ai is the alpha or negative/positive returns generated beyond the predictive capacity of

VI. Results

This section will discuss the results of this thesis. It will discuss all the analyses that were

described in the methodology section. These results will serve as a basis to answer the main and

ancillary hypothesis. The first results are the total stock and NCAV count. The results are posted

below

31

Table 1: Total Sample and Discount NCAV Portfolio Count

Year Listed Companies MV/NCAV < 1 MV/NCAV < 0.67

1984 5486 6 1

1985 5494 13 0

1986 5537 6 0

1987 5566 6 1

1988 5601 22 4

1989 5690 24 5

1990 5750 38 18

1991 5836 43 14

1992 5898 45 15

1993 5985 40 11

1994 6053 50 12

1995 6140 38 14

1996 6172 28 9

1997 6216 42 14

1998 6262 46 20

1999 6272 68 22

2000 6276 75 25

2001 6292 163 91

2002 6307 162 72

2003 6284 85 28

2004 6267 16 5

2005 6256 22 7

2006 6267 19 3

2007 6252 18 3

2008 6264 89 31

Table 1: Total numbers of listed companies in the sample. Includes US based NYSE, AMEX

and NASDAQ stocks. Excludes financial firms, 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 0.67) of MV/NCAV value.

No strong conclusions can be drawn from this table but observations can be made. During the

first years of the sample the amount of discount NCAV stocks was limited even though the

market traded at relatively low multiples. This is especially the case for firms trading below a 2/3

(or 0.67) MV/NCAV value. 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. This is why for the years 1984 to 1988 all firms traded at a discount

of MV/NCAV were used to form the portfolio. 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. The minimum amount of stocks was 6, which according to Greenblatt (1998) Professor

32

of value investing at Columbia, should offer enough diversification. This is also in line with

Ross et al (2007). For our main test the number of firms trading at MV/NCAV < 0.67 increased

significantly after 1989. 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.

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. This decrease could be due to the publication of the Oppenheimer study in

1986, and the publication of this strategy. 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, 2007). This situation did not

continue and the amount of stocks increased after 1988. Another observation is that the amount

of available NCAV stocks increased significantly during the latter part of the stock market

internet bubble. The bubble caused an overall increase in the prices of stocks and severe

overvaluation among most sectors (Shiller, 2005). 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. It seems that during a time of stock market irrationality, stocks

can both trade are exuberantly high as well as exceptionally low prices. Pastor and Veronesi

(2009) claim that this is due to the high uncertainty inherent in the future profits of the firm. A

large downward revision coupled with high uncertainty leads to a large fall in stock prices.

Although the argument is logical, it does not hold for NCAV stocks. The lower the price of

NCAV stocks, the higher the certainty of the underlying assets. This is not compatible with the

logic of the Pastor and Veronesi (2009) model. Although more difficult to quantify, the ―Mr.

Market‖ parable based on behavioral arguments offers a better explanation. It is also interesting

to note that the evidence is not in line with Arnold and Xiao (2008) nor Bildersee et al (1993).

They showed a decrease in the amount of stocks trading at a discount of NCAV when the market

traded at relatively high multiples, the inverse of the results shown here. The relationship

between the price level of the market and the amount of NCAV stocks is discussed at end of this

chapter. 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 0.67) of

33

MV/NCAV value (with the exception of years with fewer than 5 stocks where the whole sample

of NCAV stocks is selected). The first is a list of yearly raw returns based on a 12-month holding

period.

Table 2: Yearly Discount MV/NCAV < 2/3 returns and Total market Sample Returns

Discount NCAV Market Discount NCAV Market

1984 1996

Value weighted 26.53% 31.17% Value weighted 8.33% 22.29%

Equal weighted 17.78% 17.36% Equal weighted 1.92% 1.92%

1985 1997

Value weighted 13.58% 34.68% Value weighted 36.49% 29.59%

Equal weighted 27.84% 29.48% Equal weighted 48.04% 24.85%

1986 1998

Value weighted 51.72% 16.16% Value weighted 5.39% 16.66%

Equal weighted 40.33% 8.08% Equal weighted 42.58% -0.50%

1987 1999

Value weighted 0.85% -6.94% Value weighted 35.51% 10.98%

Equal weighted 11.90% -11.82% Equal weighted 67.51% 19.48%

1988 2000

Value weighted 17.58% 25.50% Value weighted -5.74% -10.13%

Equal weighted 24.62% 15.36% Equal weighted -18.03% 5.65%

1989 2001

Value weighted -5.93% 12.57% Value weighted 24.26% -12.00%

Equal weighted -4.03% -1.76% Equal weighted 31.20% 5.46%

1990 2002

Value weighted 5.94% 11.35% Value weighted 40.22% -6.36%

Equal weighted 16.11% 10.05% Equal weighted 35.60% 6.12%

1991 2003

Value weighted -1.24% 11.08% Value weighted 72.12% 21.05%

Equal weighted 19.33% 24.58% Equal weighted 111.84% 45.49%

1992 2004

Value weighted 32.16% 13.32% Value weighted 1.12% 10.02%

Equal weighted 46.86% 22.84% Equal weighted -9.95% 11.05%

1993 2005

Value weighted 43.38% 4.27% Value weighted 23.15% 12.58%

Equal weighted 57.18% 10.56% Equal weighted 30.54% 20.17%

1994 2006

Value weighted 1.08% 17.11% Value weighted 2.92% 23.08%

Equal weighted 81.12% 9.53% Equal weighted 38.70% 18.91%

1995 2007

Value weighted 25.23% 30.68% Value weighted -31.16% -4.74%

Equal weighted 16.50% 41.83% Equal weighted -37.25% -13.50%

Aritmethic Average 0.1765 0.2909

Standard Error 0.0460 0.0657

Median 0.1558 0.2919

Standard Deviation 0.2253 0.3216

Minimum -31.16% -37.25%

Maximum 72.12% 111.84%

Sum 4.2350 6.9823

Count 24 24

Table 2: 1 year holding period returns. Based on equal weighted and value weighted returns. The portfolios

are formed at the beginning of June in 1984 and held for 12 months. This procedure is repeated for each year

up to and including 2007. The portfolios includes US based NYSE, AMEX and NASDAQ stocks. Excludes

financial firms, investment trusts and non US based firms. 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).

No statistical conclusion as yet can be drawn from this table, but observations can be made. The

average raw returns generated are the subject of the next table and thus the discussion is based on

generalized finding. 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

market indices. Furthermore there are a few specific years when the returns of the NCAV

portfolios are substantially higher than the market returns. The equal weighted returns for 2003

are 111,84% and for 1999 they are 67.51% while the market generated 45,49% and 19.48%

respectively. This is not a direct test, as the analyses are done separately. The results are in line

with Oppenheimer (1986), who also showed that equal weighted returns also generated returns in

excess of 100%. To analyze this further, the average raw returns as well as excess raw returns are

shown below in the next table.

Table 3: Raw Returns and Market-Adjusted Returns for Discount at combination of 2/3 and 1 Discount NCAV portfolios

1 Year 3 year 5 year

Value weighted discount NCAV stocks 14.89% 37.21% 60.12%

Value weigthed market returns 11.28% 41.55% 54.88%

Equal Weighted market returns 11.50% 42.45% 51.72%

Table 3 B: Average market adjusted buy and hold for Discount NCAV portfolios

1 Year 3 year 5 year

Discount NCAV value weighted, index value weighted 3.61% -4.34% 5.24%

t-test 0.172833 0.128193 0.356963147

p-value 1.403279 1.724932 1.040258029

Discount NCAV equal weighted, index equal weighted 11.49% 32.47% 61.54%

t-test 0.004484 *** 0.035632 ** 0.067601161 *

p-value 3.123049 2.596001 2.160067874

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. If there are not at least 5 stocks trading at 2/3 of NCAV value,

a portfolio of maximum of 1 MV/NCAV is selected. For the yearly returns 2008 is excluded because only 6 months of data is

available, for 3 and 5 year holding periods 2008 is included. Average raw and market adjusted are calculated for

portfolios that are held for 1, 3 and 4 years post-formation. The share count includes all shares except for

financial institutes, non-US firms and investment trusts. The returns listed are geometric averages for the 26 years.

geometric averages for the 26 years. The t-tests are based on excess returns above the market rate.

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. The formulas for the raw portfolio

returns are described in the methodology section. The returns are split into 1 year, 3 year and 5

year holding periods. The results for table 3 a) will be discussed first. The 1 year results for the

NCAV portfolio is higher for both the value weighted NCAV stocks and the equal weighted

NCAV stocks. The returns for the equal weighted portfolio are higher than the market returns by

11,50% while the value weighted returns are also strong but weaker than the equal weighted

returns. This could be due to the small size premium. 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

exclude liquidity and trading costs. 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. The

other two holding periods also show outperformance. Before drawing any conclusions a

preliminary t-test is run to test the significance of these results. The results in table 3 b) show that

there is very strong significance for a 1 year holding period of equal weighted NCAV stocks.

The tests for the equal weighted indices show significance at the 1% level. The value weighted

portfolio outperforms the market but this is not statistically significant according to the t-test.

This does show that the one year holding period strongly outperforms that market indices over a

period of 26 years. The longer the holding period becomes the lower the statistical significance

is. This can be attributed to the original discrepancy between the market value of the stock and

the balance sheet value. The difference between the discount to NCAV and the market value can

be a reason for this discrepancy. 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 statement holds for the value-weighted portfolio but the equal

weighted portfolio continues to show strong outperformance. 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. Although Dodd and Graham (2009) proposed a

longer holding period of at least two years, this analysis shows that the optimal holding period

(of the three choices presented) is one year. The high returns reported here are in line with

Oppenheimer (1986) who reported annual returns of 28,2% based on an equal weighted

portfolio. Our results analyze a longer sample period during a bull market. If there were more

discount NCAV stocks available during the beginning period the results might have been even

higher. 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, however, after the mid-1950's, this brand of buying opportunity became very scarce

because of the pervasive bull market. But it has returned in quantity since the 1973-74 decline. In

January 1976 we counted over 300 such issues in the Standard & Poor's Stock Guide--about 10

36

per cent of the total. I consider it a foolproof method of systematic investment--once again, not

on the basis of individual results but in terms of the expectable group outcome.‖

NCAV Value Weighted 9.78%

NCAV Equal Weighted 9.87%

Market Value Weighted 4.29%

Market Equal Weighted 5.11%

This table shows the standard deviation for the portfolio

during the 1984-2008 period. It is based on the monthly returns

generated.

The standard deviation does show that the dispersion among the mean is higher for the NCAV

portfolios than for the market indices. Higher standard deviations implies that there is higher

volatility. If the average mean returns of the market and the NCAV are equal then this would

imply extra risk to the investor. As the NCAV mean monthly returns are significantly higher the

chances of the portfolio returning less than the market (see table 4) are slight. This is the last

descriptive statistics test and the next test will analyze the risk adjusted returns:

NCAV Value Value Equal Equal

Market Value Equal Value Equal

α 0.0164 0.0155 0.0171 0.0150

β 0.9852 1.0362 0.8154 1.0425

T(α) 3.1195 *** 3.1698 *** 3.0963 *** 3.0259 ***

T(β) 8.0905 *** 10.9497 *** 6.4042 *** 10.9110 ***

Adj. R^2 18.34% 29.29% 12.24% 29.14%

This analysis is based on the monthly returns of the NCAV portfolio. 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 06/2008. The risk free rate is the 30 day treasury bill.

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. Whenever this is not the case, all stocks trading below a MV/NCAV are taken

R it R ft ai b i ( R Mt R ft ) e it

Statistical signficance:

*** Significant at 1% level

** Significant at 5% level

* Significant at 10% level

37

The results of the CAPM analysis show that on the basis of monthly returns of the portfolios, all

portfolio returns whether matched with equal or value weighted indices are significant. The risk-

adjusted returns on the basis of volatility risk is statistically significant for all comparable time

periods. 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 1,64% and 1,50%, for the value and

equal weighted portfolios respectively. The portfolios are able to earn significantly higher returns

while taking on less volatility risk than the market. This first risk analysis supports the

alternative hypothesis that a widely diversified portfolio is able to produce abnormal risk-

adjusted returns. This evidence runs counter to the efficient market hypothesis. The large

discrepancy between tangible and relatively liquid assets and the market price can be used as an

explanation for the abnormal returns. The margin of safety takes into account the worst case

scenario, therefore any positive event, yields outsized returns. It is also in line with the concept

of intrinsic value which was discussed earlier. This confirms expectations that there is a

difference between the intrinsic value of the firm and the price of a security. If this gap is large,

as is the case in NCAV stocks then this should yield abnormal returns, regardless of the

underlying reasons for these returns. It can almost be described as a mechanical realignment of

stock prices to intrinsic value. It is most likely due to irrational behavior and institutional

constraints but the arguments for this are drawn in the conclusion. In order to gain further

evidence more factors need to be included. The next step is to increase the analysis to include the

Fama and French three-factor model.

38

Table 6: Fama French 3 factor model: Value Weighted and Equal Weighted

NCAV Value Equal

Market Value Equal

α 0.0172 0.0142

β 0.8404 1.0505

ѕ 0.8314 0.1283

h -0.0146 0.2091

T(α) 3.3244 *** 2.8199 ***

T(β) 6.4423 *** 8.5339 ***

T(s) 4.9779 *** 0.6838

T(h) -0.0743 1.1406

Adj. R^2 24.53% 29.02%

This analysis is based on the monthly returns of the NCAV portfolio. 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.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.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 Fama and French 3 Factor model:

R it R ft ai b i ( R Mt R ft ) s i SMB h i HML e it

Statistical signficance:

*** Significant at 1% level

** Significant at 5% level

* Significant at 10% level

The Fama and French three factor model incorporates two factors that compensate investors for

taking on specific risks. The two factors compensate investors for taking on firms with a relative

high probability of financial distress. One would expect a high correlation between these factors

and the NCAV strategy. NCAV strategy are often small firms with very high book-market-

values. If the Fama and French model is a good predictor then these factors should have a strong

predictive power. 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 r-

squared). This High minus Low factor is an extreme test of the book to market and should

correlate strongly with our test. This is not the case. This runs counter to expectations. If the B/M

value is not able to explain the NCAV returns, the question arises what the validity is of this

model.

These results further strengthen the evidence for the alternative main hypothesis that the discount

NCAV portfolio produces abnormal risk-adjusted returns. The next risk-adjusted test also

includes the momentum factor. This last table is listed below:

39

Table 7: Momentum + Fama French 3 factor model : Value Weighted and Equal Weighted

NCAV Value Equal

Market Value Equal

α 0.0226 0.0173

β 0.7642 0.9519

ѕ 0.8970 0.2338

h -0.0821 0.1582

i -0.5581 -0.2647

T(α) 4.4326 *** 3.3224 ***

T(β) 6.0462 *** 7.3011 ***

T(s) 5.5669 *** 1.2140

T(h) -0.4317 0.8617

T(i) -4.9191 *** -2.1820 **

Adj. R^2 30.23% 29.95%

This analysis is based on the monthly returns of the NCAV portfolio. 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.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.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 Fama and French 3 Factor model:

Rit R ft ai bi ( R Mt R ft ) s i SMB hi HML i MOM eit

Statistical signficance:

*** Significant at 1% level

** Significant at 5% level

* Significant at 10% level

Thos risk-adjusted model also includes the momentum factor. The momentum factor describes

the ‗hot-hands‘ phenomena where firms that have done well over the past year will continue to

do so. NCAV stocks are often stocks that trade at depressed levels. As they are trading at

depressed levels they have often experienced negative stock returns to be trading at a discount to

NCAV. Therefore one would expect a negative correlation between the momentum factor and

the NCAV portfolio. This appears to be the case and is statistically significant. The adjusted R^2

increases. A momentum or ‗hot-hands‘ effect is shown to further add to the abnormal risk-

adjusted returns for the equal weighted portfolios and therefore a statistically significant negative

correlation increases the monthly risk-adjusted returns that are generated. This last test further

strengthens the case for the alternative hypothesis. 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. The first table is listed below:

The next step is to analyze the results of the Chen and Zhang three factor model. This table is

shown below:

40

Table 8: Chen and Zhang 3 factor model: Value Weighted and Equal Weighted

NCAV Value Equal

Market Value Equal

α 0.0275 0.0174

rMKT 0.6661 0.9659

rINV -0.0024 0.0073

rROA -0.0067 -0.0033

T(α) 5.0962 *** 3.2413 ***

T(rMKT) 5.0020 *** 8.0021 ***

T(rINV) -0.8486 2.6468 ***

T(rROA) -5.7713 *** -2.5452 **

Adj. R^2 26.70% 31.93%

This analysis is based on the monthly returns of the NCAV portfolio. 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. The risk free rate is the 30 day treasury bill. The IA and ROA factors

were retrieved from: http://apps.olin.wustl.edu/faculty/chenl/linkfiles/data_equity.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:

MKT INV ROA

*** Significant at 1% level

** Significant at 5% level

* Significant at 10% level

The Cheng and Zhang three factor model incorporates two factors that attempt to predict

expected stock returns. The two factors are expected return on assets (ROA) and expected

returns based on investment to assets (I/A). This model has not shown to be a better predictor of

the book/market anomaly. As this study is a test of the book/market anomaly it is not expected to

reduce the abnormal returns. Although the model is both intuitively as well as mathematically

complex (the derivation of the factor loadings, not the regression), it actually does worse than the

standard CAPM model with respect to reducing alpha. The adjusted R^2 is higher showing that it

is better at predicting the returns than the standard CAPM model. 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, 1996). Thus this study is in line

with their own analysis. The alpha increases for all two comparisons.

These results further strengthen the evidence for the alternative main hypothesis that the discount

NCAV portfolio produces abnormal returns. This last table is listed below:

41

Table 9: Cremers, Petajisto and Zitzewits index-based 7 factor model

NCAV Value Equal

Market Value Equal

α 0.0241 0.0187

β 0.7870 1.0260

ѕRMS5 0.3607 -0.5381

hR2RM 1.1678 0.6843

iS2VS5g 0.0203 -0.1066

jRMVRMG -0.2782 0.0844

kR2VR2G 0.1645 0.1778

lUMD -0.5456 -0.2204

T(α) 4.6302 *** 3.4926 ***

T(β) 5.6139 *** 7.3985 ***

T(s) 0.9701 -1.4213

T(h) 3.9657 *** 2.2285 **

T(i) 0.0675 -0.3520

T(j) -0.8183 0.2476

T(k) 0.4322 0.4740

T(l) -4.3902 *** -1.6793 ***

Adj. R^2 29.88% 30.41%

This analysis is based on the monthly returns of the NCAV portfolio. 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 seven factors

were retrieved from: http://www.petajisto.net/data.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 R ft ) si RMS5 hi R2RM ii S 5VS5g ji RMVRMG

Statistical signficance: K i R2VR2G liUMD eit

*** Significant at 1% level

** Significant at 5% level

* Significant at 10% level

The last factor model is the model by Cremers et al (2008). This model improves upon the Fama

and French three-factor model by attempting to remove benchmark alphas. The small versus

large cap factor is significant, showing a positive relationship between the size of the firms and

the returns generated. This is in line with the higher equal weighted returns, because small cap

firms generate higher returns than large cap returns for the NCAV portfolio. The adjusted R^2

increases in the four analyses. Cremers et al (2008) states that one of the goals of the model is to

improve the benchmarking of strategies. If this model achieves its goal, then it is clear that the

strategy produces significant alpha. This last test further strengthens the case for the alternative

hypothesis. 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. The first table is

listed below:

42

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 9.01 6

1985 10.81 13

1986 13.89 6

1987 16.83 6

1988 14.77 22

1989 16.64 24

1990 17.82 38

1991 18.02 43

1992 19.32 45

1993 20.61 40

1994 20.29 50

1995 22.72 38

1996 25.97 28

1997 31.26 42

1998 36.80 46

1999 42.18 68

2000 42.78 75

2001 33.07 163

2002 26.39 162

2003 24.83 85

2004 26.40 16

2005 26.06 22

2006 24.74 19

2007 27.41 18

2008 22.41 89

Correlation -0.38413

This table lists the average price earnings ratio on the basis of the Shiller data. The Shiller data was

retrieved from http://www.econ.yale.edu/~shiller/data/ie_data.xls).

The results show that during the first 3 of the first 4 years the amount of discount NCAV stocks

available was lower than 7, 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. The original hypothesis

assumed that lower relative price/earnings levels would lead to more stocks trading at a discount

to their NCAV value. This is however not the case. As the average price/level trended up during

the sample period the amount of discount NCAV stocks available increased. Discount NCAV

stocks are stocks that trade at a depressed price level. When market participants bid up the

overall price level in expectancy of higher returns, one could assume that there is a reduction in

the availability of these stocks. 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. As the rolling 10 year price/earnings ratio increased to over 42,78 the

amount of NCAV stocks increased. Furthermore in the succeeding years when the price/earnings

43

ratio remained at historically high levels the amount of discount NCAV stocks increased to over

100. 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... The occurrence of these two phenomena during the same time period might

provide evidence against the efficient market hypothesis, but the analysis is too weak to draw

any strong conclusions. 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:

versus availability of stocks

α 0.1731

β -1.7954

T(α) 1.3911

T(β) -1.9953 *

Adj. R^2 11.05%

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 11,05% of the total returns. The results show

that there is statistical significance at the 10% level. 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. This evidence is

also only based on 26 annual data points and should be not considered the definitive answers.

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. This is not fully in line with

44

the Bildersee et al (1993) analysis of Japan which found few discount NCAV stocks available

during the bull market in the 1980‘s.

This last analysis ends the results section. The results have shown strong evidence for the

alternative main hypothesis and weak evidence for the alternative ancillary hypothesis. To

further analyze the results a robustness check will now be run. This will consist of the entire

universe of stocks trading at a discount to MV/NCAV. The conclusion of this thesis is drawn

next.

The robustness check is run to analyze the strength of the strategy. 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.

This strategy selected severely undervalued stocks with a high margin of safety. 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. According to the arguments brought forth by Graham and Dodd

(2009), the lower the margin of safety the lower the returns should be.

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. These stocks still trade a discount to NCAV

and should therefore provide adequate protection against capital loss. As a robustness check one

further modification is made. Instead of excluding 2008 for the risk-adjusted return analyses,

they are included. They were not included in the full analysis because the holding period only

lasted for six months. It is also interesting to see if, by including all of 2008 (the last test only

incorporated the first 6 months) the returns do not severely deteriorate. The first test analyzes the

raw returns generated by this portfolio and are depicted on the next page.

45

Table 12 Yearly Discount NCAV returns and Total market Sample Returns

Discount NCAV Market Discount NCAV Market

1984 1997

Value weighted 26.53% 31.17% Value weighted 30.90% 29.59%

Equal weighted 17.78% 17.36% Equal weighted 30.85% 24.85%

1985 1998

Value weighted 13.58% 34.68% Value weighted 18.85% 16.66%

Equal weighted 27.84% 29.48% Equal weighted 28.34% -0.50%

1986 1999

Value weighted 51.72% 16.16% Value weighted 8.72% 10.98%

Equal weighted 40.33% 8.08% Equal weighted 57.95% 19.48%

1987 2000

Value weighted 0.85% -6.94% Value weighted -8.60% -10.13%

Equal weighted 11.90% -11.82% Equal weighted -10.88% 5.65%

1988 2001

Value weighted 17.58% 25.50% Value weighted 17.04% -12.00%

Equal weighted 24.62% 15.36% Equal weighted 29.80% 5.46%

1989 2002

Value weighted 4.02% 12.57% Value weighted 10.92% -6.36%

Equal weighted 0.63% -1.76% Equal weighted 19.10% 6.12%

1990 2003

Value weighted 12.52% 11.35% Value weighted 70.90% 21.05%

Equal weighted 10.79% 10.05% Equal weighted 104.81% 45.49%

1991 2004

Value weighted 11.41% 11.08% Value weighted -9.13% 10.02%

Equal weighted 32.52% 24.58% Equal weighted -10.00% 11.05%

1992 2005

Value weighted 20.23% 13.32% Value weighted 26.89% 12.58%

Equal weighted 32.86% 22.84% Equal weighted 33.63% 20.17%

1993 2006

Value weighted 7.43% 4.27% Value weighted 2.92% 23.08%

Equal weighted 18.64% 10.56% Equal weighted 38.70% 18.91%

1994 2007

Value weighted 1.59% 17.11% Value weighted -31.16% -4.74%

Equal weighted 14.90% 9.53% Equal weighted -37.25% -13.50%

1995 2008

Value weighted 25.36% 30.68% Value weighted -43.62% -38.16%

Equal weighted 25.40% 41.83% Equal weighted -49.92% -44.26%

1996

Value weighted 2.56% 22.29%

Equal weighted -7.06% 1.92%

Aritmethic Average 0.1390 0.2234

Standard Error 0.0411 0.0548

Median 0.1197 0.2501

Standard Deviation 0.2015 0.2686

Minimum -0.3116 -0.3725

Maximum 0.7090 1.0481

Sum 3.3365 5.3619

Count 24 24

Table 2: 1 year holding period returns. Based on equal weighted and value weighted returns. The portfolios

are formed at the beginning of June in 1984 and held for 12 months. This procedure is repeated for each year

up to and including 2007. The portfolios includes US based NYSE, AMEX and NASDAQ stocks. Excludes

financial firms, investment trusts and non US based firms. The whole sample of discount NCAV stocks is taken

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. Furthermore there are a few specific years when the returns of the NCAV portfolios are

substantially higher than the market returns. The equal weighted returns for 2003 are 104,81%

and 2001 29,80%, while the market generated 45,49% and -5,46% respectively. The results are

46

lower during most years than the more stricter main test but still appear to be higher than the

overall market returns. To analyze this the holding period returns are given next:

Table 13: Raw Returns and Market-Adjusted Returns for Discount NCAV portfolios

1 Year 3 year 5 year

Value weighted discount NCAV stocks 9.18% 37.21% 106.40%

Value weigthed market returns 9.25% 41.55% 54.88%

Equal Weighted market returns 9.02% 42.45% 51.72%

Table 13 B: Average buy and hold for Discount NCAV portfolios

1 Year 3 year 5 year

Discount NCAV value weighted, index value weighted -0.07% -4.34% 51.52%

t-test 0.438583 0.128193 0.147899902

p-value 0.787167 1.724932 ** 1.790294475

Discount NCAV equal weighted, index equal weighted 5.76% 32.47% 60.61%

t-test 0.019946 0.035632 0.070999859

p-value 2.486306 ** 2.596001 ** 2.126848343 *

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. Average raw and market adjusted are calculated for

portfolios that are held for 1, 3 and 4 years post-formation. The share count includes all shares except for

financial institutes, non-US firms and investment trusts. The returns listed are geometric averages for the 26 years.

geometric averages for the 26 years. The t-tests are based on excess returns above the market rate.

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. This outperformance is still statistically significant

especially as this test includes all of 2008 (only a 6 month holding period). This period has been

excessively poor for discount NCAV stocks and it is unlikely that this degree of

underperformance will continue. It will be more likely that the returns revert to the mean. The

longer holding periods for equal weighted portfolios all show significant outperformance. 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. These results are in line with expectations. The standard

deviation is discussed next:

47

Table 14: Standard Deviation Standard Deviation (σ)

NCAV Value Weighted 7.80%

NCAV Equal Weighted 8.15%

Market Value Weighted 4.48%

Market Equal Weighted 5.28%

This table shows the standard deviation for the

portfolios and the market returns. It is based on

the monthly returns

The equal weighted portfolio once again shows that the risk/return relationship is not always

positive. One can attain higher returns by lowering the volatility risk. This is simply done by

setting up a more stringent benchmark which increases margin of safety

Table 15: CAPM, Beta: Value Weighted and Equal Weighted Portfolios

NCAV Value Equal

Market Value Equal

α 0.0123 0.0067

β 0.9227 1.1487

T(α) 3.1734 *** 2.1045 **

T(β) 10.7241 *** 19.0930 ***

Adj. R^2 27.94% 55.29%

This analysis is based on the monthly returns of the NCAV portfolio. 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.

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, although weaker in absolute terms, are all statistically significant. This robustness

check increases the validity of the main test. The results are weaker but because it also includes

2008 and has less of a margin of safety. It is in line with expectations. 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. 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. Thus the stricter benchmark runs far less volatility risk while generating 8,11%

more on annual holding period basis. This definitely confirms the margin of safety argument by

Graham and Dodd (2009). The efficient market hypothesis assumes there is a linear positive

48

risk/return relationship and the relationship between the main and robustness check is actually

strongly negative. One can wonder how these results could ever be included in the framework of

the efficient market hypothesis. The next tables are the four remaining risk-adjusted models.

Table 16: Fama French 3 factor model: Value Weighted and Equal Weighted

NCAV Value Equal

Market Value Equal

α 0.0128 0.0074

β 0.7451 1.0774

ѕ 0.7510 0.1947

h -0.0760 0.0556

T(α) 3.3662 *** 3.0433 ***

T(β) 7.7842 *** 5.6042 ***

T(s) 6.1283 *** 5.3188 ***

T(h) -0.5252 1.1718

Adj. R^2 33.87% 19.70%

This analysis is based on the monthly returns of the NCAV portfolio. 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.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.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 Fama and French 3 Factor model:

R it R ft ai b i ( R Mt R ft ) s i SMB h i HML e it

Statistical signficance:

*** Significant at 1% level

** Significant at 5% level

* Significant at 10% level

Table 17: Momentum + Fama French 3 factor model : Value Weighted and Equal Weighted

NCAV Value Equal

Market Value Equal

α 0.0162 0.0105

β 0.6971 0.9749

ѕ 0.7924 0.3043

h -0.1184 0.0027

i -0.3514 -0.2753

T(α) 4.2772 *** 3.1044 ***

T(β) 7.4336 *** 11.4540 ***

T(s) 6.6271 *** 2.4210 **

T(h) -0.8397 0.0228

T(i) -4.1739 *** -3.4753 ***

Adj. R^2 37.49% 54.67%

This analysis is based on the monthly returns of the NCAV portfolio. 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.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.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 Fama and French 3 Factor model:

Rit R ft ai bi ( R Mt R ft ) s i SMB hi HML i MOM eit

Statistical signficance:

*** Significant at 1% level

** Significant at 5% level

* Significant at 10% level

49

Table 18: Chen and Zhang 3 factor model: Value Weighted and Equal Weighted

NCAV Value Equal

Market Value Equal

α 0.0190 0.0095

rMKT 0.7196 1.0606

rINV -0.5295 -0.2005

rROA 0.1601 0.2291

T(α) 4.7205 *** 2.6286 ***

T(rMKT) 7.2609 *** 13.1186 ***

T(rINV) -6.1174 *** -2.3379

T(rROA) 0.7509 1.2472

Adj. R^2 33.93% 53.63%

This analysis is based on the monthly returns of the NCAV portfolio. 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. The risk free rate is the 30 day treasury bill. The IA and ROA factors

were retrieved from: http://apps.olin.wustl.edu/faculty/chenl/linkfiles/data_equity.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:

Rj Rf aqj bj rMKT bj rINVit bj rROA ej

Statistical signficance: MKT INV ROA

** Significant at 5% level

* Significant at 10% level

NCAV Value Equal

Market Value Equal

α 0.0183 0.0112

β 0.6693 0.9953

ѕRMS5 0.4018 0.0075

hR2RM 0.8268 0.3631

iS2VS5g 0.0399 -0.0335

jRMVRMG 0.1610 -0.0497

kR2VR2G -0.4374 0.0092

lUMD -0.3341 -0.2709

T(α) 4.7476 *** 3.1546 ***

T(β) 6.4405 *** 10.8689 ***

T(s) 1.4592 0.0301

T(h) 3.7897 *** 1.7905 *

T(i) 0.1791 -0.1675

T(j) 0.6393 -0.2207

T(k) -1.5512 0.0372

T(l) -3.6291 *** -3.1268 ***

Adj. R^2 37.40% 53.92%

This analysis is based on the monthly returns of the NCAV portfolio. 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 seven factors

were retrieved from: http://www.petajisto.net/data.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 R ft ) s i RMS5 hi R2 RM ii S 5VS5 g j i RMVRMG

Statistical signficance: K i R2VR2G l iUMD eit

*** Significant at 1% level

** Significant at 5% level

* Significant at 10% level

50

These results further confirm the previous analyses and add to the robustness of the findings. No

further comments need to be made.

This concludes the robustness check. This robustness check has further strengthened the

evidence for the alternative hypothesis. Furthermore it has shown that the original test runs less

volatility risk while earning 8,11% more on an annual basis. This is very strong evidence for the

persistency of this anomaly. The conclusion of this thesis is drawn next.

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. This analysis serves as a test for

the persistency of the anomaly. The results are clear and show that the strategy has produced

significant abnormal-risk adjusted returns during the sample period. Based on the Carhart four

factor (1997 ) model the results show that the abnormal risk-adjusted monthly returns are 2,27%

for value weighted and 1,73% for equal weighted returns. Most interestingly the HML factor is

not statistically significant even though this is a study of liquid current book value. All other

tests and robustness checks run confirm these results. The strongest results are found for a one

year holding period. The abnormal risk-adjusted returns decrease for the longer holding periods

of three and five years. The model by Chen and Zhang (2009) is also not able to predict the

returns of the NCAV strategy. The ancillary hypothesis tests whether there is a negative

relationship between the relative price level of the market and the availability of NCAV stocks.

Only weak evidence is found. The results are in line with Oppenheimer (1986) and Arnold and

Xiao (2007), but a similar study in Japan by Bildersee et al (1993) showed less significant

results.

Proponents of the efficient market hypothesis assume that the market price fully reflects all

available information and risks. Achieving higher returns requires the investor to take on more

risk. Malkiel (2003) and Schwert (2002) argue that anomalies which generate systematic

abnormal risk-adjusted returns will be exploited by investors and then disappear. They state that

anomalies such as the January-effect have disappeared after publication. Although the

51

argumentation behind this statement may be sound, it does not apply to the discount NCAV

strategy. The NCAV strategy has received much attention and is a widely publicized strategy

which was promoted by Benjamin Graham during his career. This publicity and especially the

study by Oppenheimer (1986) has not reduced the abnormal risk-adjusted returns of the NCAV

strategy. Indeed it appears to be a very persistent anomaly . The strategy produced abnormal

risk-adjusted returns during the combined sample period of this and Oppenheimer‘s (1986)

study. Furthermore according to Benjamin Graham the strategy has always produced satisfactory

returns during his career (Graham, 1976). If I include his career then this anomaly has persisted

for well over 70 years and is clearly not self-destructive. The disappearance of anomalies

argument does not hold in this case.

A different argument asserts that the current asset pricing models do not capture all the risk

factors and are therefore incomplete (Malkiel, 2003). The Cremer et al (2008) model improves

the Fama and French three factor model and should capture most of the risk-adjusted abnormal

returns. The discount NCAV strategy is an extreme test of the book-to-market anomaly, but the

Fama and French 3 factor model (1996) is not able to explain the abnormal returns. Not only is

Fama and French (1996) model not able to explain the abnormal returns, the factor is not even

significant. One would have expected the market/book factor to capture at least part of a net

current asset value strategy. Although the 3 factor model is relatively successful in other

empirical tests, it appears limited in applicability. 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. It seems very unlikely that there is any other potential risk

factor to explain the abnormal returns. 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 last

argument discusses the overall price of the market.

Malkiel (2003) claims that periods of high relative market prices are due to uncertainty of future

forecasts of growth rates. This argument is in line with Pastor and Veronesi (2009). 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. The internet bubble during the end of the last and the

beginning of this century showed historically high relative market prices. What this thesis adds is

52

that undervaluation as well as overvaluation might occur during the same sample period.

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. 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 conclusion can be drawn that the discount NCAV strategy produces

abnormal risk-adjusted returns, and the possible explanations for this risk-adjusted performance

are drawn next.

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. 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.

One possible reason why this strategy has not been exploited can be ascribed to institutional

constraints. Lakonishok et al (1992) proposed that the industry suffers from various agency

problems which causes chronic underperformance. The agency problems are largely caused by

the need for money managers to please the treasury department. This causes money managers to

pursue popular strategies and to adopt risk averse strategies. A relatively unknown strategy, 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. The money

manager might not want to take this risk in fear of losing his customer and/or job. The size of

institutions is also believed to play a role. There is only a limited amount of discount NCAV

stocks available at a given time. By dedicating to a discount NCAV portfolio the institutions

overall performance would not be greatly affected. This small increase in performance would

often not be noticeable on the total size of the portfolio. Therefore there is no great incentive to

launch a specific discount NCAV fund. This has shown that there are institutional barriers but

has not discussed the potential for individual investors.

Aside from the institutional constraints, individuals also encounter barriers to form a portfolio.

Setting up a discount NCAV portfolio can be expensive. If one assumes that a single trade costs

53

$10, 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. An investor

would need to hold a portfolio of at least 60,000 dollars to drop the annual costs below 1%. The

excludes any other potential costs (with the assumption of relatively low trading costs) and the

opportunity costs for setting up, searching and analyzing the stocks. It is doubtful whether there

is a large group of individuals who has the available capital, knowledge and is willing to invest at

least this amount in a diversified portfolio. 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.

Deviations from rational decision making, could be the main reason for the occurrence and

persistence of this anomaly. The main behavioral concept that is applicable to the discount

NCAV anomaly is the representative heuristic. In line with De Bondt and Thaler (1985), the

market overreacts to past performance. In the case of the discount NCAV strategy investors

overreact to poor past performance and extrapolate this into the future, while underweighting the

potential of firms to recover. This overweighting of past performance causes the firms to trade

below liquidating (NCA) value. Consequently this expected poor performance does not

materialize and the stock is able to generate abnormal risk-adjusted returns. Overconfidence in

one‘s own judgment capabilities adds to the perceived expected performance and the actual

financial risks run. 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. Emotional based anomalies are likely to be persistent because

each individual suffers from the same limitations to rational decision making. The three

different arguments for the persistency of this anomaly have now been giving, with the last

explanation being behavioral. The implications of the anomaly for theory and practice is the final

part of this conclusion.

The discount NCAV has shown strong persistency in delivering risk-adjusted returns. Although

further research is beyond the scope of this thesis, if this ‗value‘ strategy has provided positive

returns it can be expected that other similar strategies also perform better than the market. The

implication of this is that the models based on the EMH hypothesis might be less valid than

54

assumed. 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. 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. 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. Furthermore if these models have poor explanatory power, why

should so much be invested in trying to teach these models to future financial academics and

business professionals. Would it not be wiser to invest more time in the analysis and valuation of

specific firms. As is this case in economics, perhaps a micro level approach to teaching

investing yields more explanatory power than a macro approach. The implications include a

possible invalidity of the aspects of semi-strong EMH model, 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. The final implication is that this strategy should

continue to deliver satisfactory results for investors able to overcome the cost and behavioral

constraints. The overall conclusion will now be drawn.

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, 1986). 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. 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. 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. The

results of this thesis underline and support this last statement.

55

IX. Further Research:

There are several avenues of research which can expand the results of this thesis. An

international meta analysis of the NCAV strategy would allow a direct comparison between

markets. If the results are persistent across countries using the same sample period this would

strengthen the evidence for the anomaly. Furthermore other analyses of value investment

strategies could be run. This could include other strategies identified by Benjamin Graham or a

strategy proposed by Warren Buffet; the study of high Return on Invested Capital stocks

(Graham, 2003), (Buffet, 2009). Another interesting field would be the study of corporate spin-

offs. Miles and Rosenfeld (1983) showed that corporate spinoffs produced significant abnormal

returns. An examination of the persistency of corporate spinoff returns would increase the

evidence against the semi-strong form of market efficiency. Finally during the analysis of

specific firms, it was noted that discount NCAV firms often experience goodwill write downs in

the previous 12 to 24 months. 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. 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. 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.

X. Limitations:

This analysis has several limitations. The first concerns a technical aspect of merging CRSP and

COMPUSTAT databases. The database of the University of Maastricht does not have access to

the merged CRSP and COMPUSTAT files. Therefore the data had to be merged manually. It

was merged using the CUSIP identifier. CRSP and COMPUSTAT use different means of

determining the CUSIP. This causes some stocks to be mismatched when merged. To examine

the degree of mismatches, several years of data was analyzed. There were a small number of

mismatches but as the years progressed the mismatched amount of stocks grew smaller. During

the last decade of the sample period almost no mismatches were found. The effect is therefore

56

minimal. 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. As the results are significant, I believe that these few errors do not have a

sizeable impact on the overall results. The second limitation is possible differences between

accounting standards. While there might be differences, the impact should be minimal because

the firms are all publicly traded firms who have to meet SEC regulatory standards. The last

limitation is due to the inexperience of the author as a researcher. Although the author has

sufficient statistical knowledge, this is his first analysis of primary data. Thus small errors might

exist but it is believed that these errors should not influence the conclusions drawn in this thesis.

57

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64

XII. Appendices

Appendix 1: Balance Sheet and Stock Return Definitions: Compustat and CRSP

The currents assets consist of the following items and is in accordance to US GAAP:

2. Current Assets

3. Inventories

4. 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.

Liabilities - Total

The liabilities total consists of the following items and is in accordance to US GAAP:

2. Deferred Taxes and Investment Tax Credit

3. Liabilities – Other

4. Long-Term Debt – Total

2. Minority interest, included in Minority Interest (Balance Sheet

65

Appendix definitions:

The currents assets consist of the following items and is in accordance to US GAAP:

2. Utilities subsidiary preferred stock

3. Redeemable preferred stock

4. Preference stock

5. Receivables on preferred stock

6. Adjustment for redeemable preferred treasury stock.

7. Excess over par value of preferred stock when a separate breakout is not available

2. Secondary classes of Common/Ordinary Stock (Capital)

3. Subsidiary preferred stock

1. 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,

respectively

2. Cost of redeemable preferred treasury stock which is netted against Preferred Stock –

Redeemable

2. Preferred Stock – Redeemable (PSTKR)

66

Shares Outstanding (SHROUT)

The number of publicly held shares on NYSE, Amex, NASDAQ, and NYSE Arca exchanges,

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, adjusted for

distributions. If unavailable, the number in the price field is replaced with a bid/ask average

(marked by a leading dash).

67

Appendix 2: Selection Criteria Compustat and CRSP

1. NYSE

2. AMEX

3. NASDAQ

1. NYSE: 11

2. AMEX: 12

3. NASDAQ: 14

1. NYSE: 1

2. AMEX: 2

3. NASDAQ: 3

Selection criteria:

1. Only industrial firms are included, leverage of financial institutions makes it difficult to

compare.

2. Only domestic stocks are taken into account, international firms might have different

accounting standards and practices. It is also a test within the united states and nowhere

else.

68

SIC codes: financial services = 6xxx

2. Select Companies to be selected -> Entire Database

3. Select Date Range -> Jan 1983 until Dec 2008

4. Add to output -> Select only consolidated, financial, domestic, currency = usd, both

active and inactive

5. Conditional Statement 1 -> Exchange code = 11 NYSE, 12 AMEX, 14 NASDAQ

11 OR 12 OR 14

6. Conditional Statement 2 -> None

7. Identifying information -> Cusip, Ticker Symbol, exchange code

8. Select Fundamental data required ->

- Liabilities Total = LT

- Preferred Stock = PSTK

10. Select Output format -> Stata

11. tostring fyear , generate(fyear1)

12. drop fyear

13. rename fyear 1 fyear

14. sort cusip fyear , uniqusing

15. Save, replace

69

2. Select Date Range -> Jan 1983 until Dec 2008

3. Search -> Entire Database

4. 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. Conditional Statement 2: Exchange Code

Exchange codes: 1 = NYSE 2 = AMEX 3 = NASDAQ

Fill in CRSP <= 3

6. Identifying information: CUSIP TICKER EXCHANGE CODE

7. Time Series Information: Price

- Price

- Number of Shares of Outstanding, adjusted

- Holding period return, including dividends

- Holding period return, excluding dividends

- Value Weighted return, including distributions

- Value Weighted return, excluding distributions

- Equal Weighted return, including distributions

- Equal Weighted return, excluding distributions

8. Stata File

9. Select Date Format -> Default YYMMDDn8

70

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