03 May The Genesis of the Conservative Net Asset Value (CNAV) Approach
Like most people, my first understanding of value investing was to read about Warren Buffett in books. Mainly because it is the most available and he was the richest investor in the world. If he is so rich, he must be right? As I know more about the things he could do, such as getting huge investment capital through the insurance companies he bought over, negotiating a good price through private placement of shares, negotiating a block deal with public companies, access to management, and even selling naked options for 15-20 years, I find it almost impossible for retail investors to follow.
Probably due to Warren Buffett’s success, the financial industry focuses on earnings forecast. I would use an example to illustrate the problem. A group of analysts visited Yangzijiang in Nov 13, and four reports were published by separate financial institutions over the next two days. The target prices ranged from $1.05 to $1.50, or a 40% difference!
These were highly qualified analysts who visited the same company at the same time but their analysis was world’s apart. The science of their calculations is sound and one cannot argue over the formulas. The main issue is the assumptions of the analysts, which are highly subjected to biases and completeness of information or understanding.
The degree of subjectivity in forecasting earnings was too large for my comfort. Ten analysts will provide ten different answers. And I do not think I am smart enough to consider all the factors that could affect future earnings and include them in my calculation. In fact, Warren Buffett has a trump card and he is Charlie Munger. Charlie is known to read widely, beyond investment and financial books.
He adopts and applies the big principles from various fields such as Physics, Genetics, Psychology, Philosophy, and a hundred more, into his analysis of companies. It may sound weird but the amount of work that the two chiefs at Berkshire Hathaway do is way too complex and voluminous for retail investors who have jobs. Knowing that I am not Warren Buffett was the first step towards turning my investment fortunes.
If value investing is not Warren Buffett, then what is?
I attended a value investing course conducted by the late Dennis Ng. One of the most favourite strategies used by the graduates was to invest in REITs and financial companies trading below 70% of the Net Asset Value (NAV). It was an objective measure of valuation and very easy to apply.
Dr Michael Leong stated in his book Your First $1,000,000 Making it in Stocks, that he likes to invest in ‘free’ businesses. Free businesses come by when the company’s cash and properties are worth more than the total liabilities. An investor won’t be paying a single cent for future earnings. The way he frames the perspective is brilliant! In other words, pay a fraction for the good assets that the company owns, instead of paying a premium for future earnings.
Our interview with Aggregate Asset Management was an enlightening one. It was inspiring to see a fund who does not follow the footpath of most funds. If all the big funds are buying similar blue chip stocks, isn’t their returns going to be average? Instead of investing in mostly familiar big caps or mid caps, Aggregate went for small caps which were much more discounted due to a less competed space. Aggregate could also afford to diversify into many discounted small cap stocks without the worry they would buy out these companies or compromise their returns. A true contrarian indeed.
Aggregate pointed out several research papers which were summarised by Tweedy Browne in this free ebook. They also suggested we study the investment philosophy of Walter Schloss, a less well known value investor who is a friend of Warren Buffett.
Of course, not forgetting the teachings from the Father of Value Investing, Benjamin Graham. One of his famous strategies was the Net Working Capital which an investor can find bargains in stocks which are trading below two-thirds of net current assets (defined as Current Assets minus Total Liabilities).
However, Ben’s most precious teaching was the Margin of Safety principle, which is the cornerstone of all value investing strategies. No one can be right all the time and the Margin of Safety cushions our mistakes. Just like building a bridge with a safety factor. It is a protection against the uncertainty of the future and our overconfidence.
Schloss was a disciple of Benjamin Graham. He loved to invest in low price-to-book stocks and he said
“Try to buy assets at a discount than to buy earnings. Earnings can change dramatically in a short time. Usually assets change slowly. One has to know how much more about a company if one buys earnings.”
We also know that it cannot be simply buying low price-to-book stocks because most of them deserve to be there for all the problems they have. It relates to a scene in a fashion shop. The latest models get the most attention and are sold at a premium (think hot stocks or familiar blue chips). In a corner there is a load of clothes which belong to the previous season and are trading at big discounts (cold and illiquid stocks).
But not all the clothes are nice as they are ugly in the first place and no one buys them so they are in this dump (cheap stocks with poor fundamentals). However, you can find nice ones sometimes (value stocks). You will need to be patient enough to wait for the discount to happen and grab the opportunity when it comes. It applies to the stock market too. The best deals are usually in the dump.
To find the fundamentally strong low price-to-book stocks, we turn to Dr Joseph Piotroski’s F-score. He used a 9-point system to evaluate the financial stability of the lowest 20% price-to-book stocks and found that the returns are boosted by 7.5% per year. You can read his full research paper.
Combining the wisdom of these people, we created the CNAV strategy – investing in stocks below current valuation and not future valuation. We prefer a quantitative approach because we cannot trust ourselves. We are bias – we see what we want to see and a qualitative method allows our biases to work their full effect on us.