Negative Enterprise Value Stocks Crazy Outperformance


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Jae Jun

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In case you missed it, take a look at the 2013 half yearly results of the OSV value stock screens.

At the end of Q2, the leading screen is the Increasing Net Net Working Capital (NNWC) which searches for companies that are increasing in cash, accounts receivables and inventory at a much higher rate than debt.

All fundamentally positive signs for any company.

However, another screening strategy is getting all the attention. One that I’ve written about since 2009. That is negative enterprise value stocks.

Negative Enterprise Value Stocks

This is an article from the CFA Institute blog discussing the performance of negative enterprise value stocks between the period March 30, 1972 and September 28, 2012. Greenbackd also did a good follow-up.

Before getting into the performances and the stocks, what are negative enterprise value stocks?

There are two main characteristics with negative EV stocks.

  1. Hated
  2. Loaded with cash

And you have to like both. Not just one or the other.

If you try to analyze any negative EV stock, the numbers are horrible. 99% of the time, you will throw it into the CRAP (Can’t Realize a Profit) pile.

Enterprise Value Definition

The way I define EV is

Enterprise Value = Market Capitalization + Total Debt – Excess Cash

For a stock to have a negative enterprise value, the excess cash part must be bigger than both market cap and total debt.

Yes, excess cash.

Not total cash and equivalents. Only the cash that is not required to run day-to-day operations.

Compare that to the CFA’s article using the proper enterprise value definition.

EV =
Market cap
+ Preferred equity at market value
+ Minority interest at market value, if any
+ Debt at market value
+ Unfunded pension liabilities and other debt-deemed provisions
– Associate company at market value, if any
– Cash and cash-equivalents.

By selecting stocks based on the above definition, the performance results of the study is below.

Returns on Negative Enterprise Value Stocks | CFA Institute

The best performers come from the < $50m market cap companies but many companies are tiny micro caps that you can’t buy no matter how hard you try.

Negative Enterprise Value Stocks Returns by Country

Just as Japan is known for being the land of the rising Net Nets, Ireland and Israel should be known as the country of negative enterprise value stocks.

It is interesting to see how USA is only in the middle of the pack.

Is it Possible to Achieve Such Gains?

The majority of the returns are coming from micro caps < $50m. Those stocks will be extremely difficult to buy even if you know how to buy illiquid shares.

Plus, you don’t have a team of people going through every company in the universe and manually calculating negative EV the way the CFA institute describes it.

The biggest difficulty will be calculating debt at market value. The other pieces of information you will have to grind out from the 10-K.

It will take you about 20-30 minutes to do this for one stock and there is no way you can go through enough stocks to buy a basket of negative EV stocks.

You need a practical and quicker way, and that’s why I use the following formula.

Enterprise Value = Market Capitalization + Total Debt – Excess Cash

Excess Cash = Total Cash – MAX(0,Current Liabilities-Current Assets)

Real World Performance of Negative Enterprise Value Stocks

I constantly emphasize that real returns are important for any backtest and screen. The research by the CFA Institute shows that negative enterprise value stocks outperform, but the results are just theoretical.

To really gauge the performance, the stocks have to have enough volume, be listed on major exchanges, account for proper fees and be above a certain sticker price.

The negative enterprise value performance looks like this from 2000 to 2012.

Negative Enterprise Value Stocks

Negative Enterprise Value Performance

At the end of Q2 2013, the screen achieved 31.96%.

As of today, the performance has jumped to 43.13%.

Negative EV Performance Stats

Negative Enterprise Value Stocks Performance Stats

2013 Negative Enterprise Value Stocks

The year started off with 19 stocks on the list. Here are their respective performances so far.

2013 Negative EV stocks

2013 Negative EV stocks | click to enlarge

As of today, that number has dwindled down to six, but IGOI should be taken off the list as it is being bought out. That brings it down to five.

Latest Negative EV stocks

Latest Negative EV stocks | click to enlarge

QLT Inc (QLTI)

A biotechnology company that develops ocular products.

Recently distributed a dividend of about 50%. Even tiny companies flush with cash can be shareholder friendly but this also means that the negative EV calculated by the screen can be incorrect as it didn’t account for the dividend.

Does not rank highly on fundamentals or quality.

Some basic numbers I look through.

QLTI Fundamentals

Transcept Pharmaceuticals (TSPT)

A lot of biotech and pharma companies make this screen because these types of companies are heavily funded with cash and continue to raise and plow money. Horrible returns, but trading at cheap multiples.

TSPT Fundamentals

AVEO Pharma (AVEO)

AVEO quality scores are rock bottom.

Accruals are horrific, Piotroski scores are in the basement, and there is a huge spike in the warning flag for the Beneish earnings Manipulation score.

Shocking Accruals and Piotroski

 

Huge Warning Sign in the Beneish M Score

Maxygen (MAXY)

Another biotech company, but unlike the previous three, this one has positive earnings and is the best out of the bunch.

NEUROMetrix (NURO)

The last of the five is a medical device company but this company is still in the dumps. Lost money every year since 2007.

The Altman Z score is flashing signs that the business will go under.

Dire Altman Z Score

No wonder it is hated.

So How Do You Pick Negative EV Stocks?

You don’t.

There are only three ways to make this work.

  1. Buy a basket of 20 stock to diversify
  2. Don’t try to pick your own
  3. Trust the system

You need a lot of guts to buy and hold these stocks. There will be many that go to zero, but the few that shoot up 100+% will make all the difference. Look at the 2013 results so far as evidence.

Remember, no matter how hard you try, you won’ t be able to select negative enterprise value stocks at a winning percentage.

You are essentially trying to find gold in a pile of CRAP (Can’t Realize a Profit).

I provide this screen because once in a while I do find something that catches my eye, but overall I strictly recommend this as a mechanical investing strategy and for educational purposes only.

As a final note, the results from the negative enterprise value stocks backtest is slightly different to the the results presented on the site. Due to many requests, the filter for volume and price is turned off to give a wider range of ideas.

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4 responses to “Negative Enterprise Value Stocks Crazy Outperformance”

  1. matt says:

    Hi Jae, Thanks for the interesting and excellent post. Would you please add a column to your annual performance table (2000-2012) that shows the number of firms (and % of universe) that are negative EV at say the start of each year? I think that picking points in time where more firms meet this criterion would help to reduce the number of value traps. Of course, having a new bull market (like 03 or 09) provides the catalyst for these stocks to outperform….

  2. Not a reply to anyone. Just a note.

    One thing that I didn’t write well is that the 5 stocks are NOT recommendations. It is a look at what is being shown at the moment.

    The way this needs to work is to make sure that there is around 20 stocks in the list. If the screen shows 5 or 6, then it isn’t a good time to buy it. Market is getting pricey.

  3. G says:

    Hi Jae,
    Thanks for the article. You say to pick 20 out of the basket. However, when do you sell? Do you do this strictly per year, per quarter or what?
    Thanks!

  4. it’s just a one year rebalance. For the losers, sell 1 day before the year to take advantage of losses. For the winners, sell 1 day after a year to make it a long term gain. Then rebuy.

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