How Stock Values Can Change

2dRWtoRBenjamin Graham was a well-known mentor of billionaire investor Warren Buffett who ran his own hedge-fund with stunning results. Every US$1,000 invested with Graham in 1936 would have become US$38,000 twenty years later when he retired.

He utilised a technique he termed as ‘Net-Net’, where he would invest in shares that were selling at a price that was below its liquidation value. In other words, Graham was looking for shares that are literally worth more dead than alive. Net-Nets, given in a simple formula, looks like this:

Net-Net = Current Assets – Total Liabilities

He reasoned that if these companies’ shares are traded at a price below its Net-net value, statistically speaking, a portfolio comprised of a huge basket of such shares would do well.

That’s because these companies might be acquisition targets at prices far above their quoted market price as competitors with more resources might gobble them up. Or, the market will eventually reflect these companies’ underlying asset values or earnings power through an increase in their quoted share price – at least, that’s what the theory says.

But, when we first shared how the Net-Net worked with three locally listed companies, AEM Holdings (SGX: A10), DMX Technologies (SGX: 5CH) and Pan Hong Property Group (SGX: P36), an important risk about the technique was mentioned too – often, these companies are facing business-difficulties of one sort or another. Because of that, the thesis for investment for each individual company, if it were based on its Net-Net value, can change fairly quickly.

The semiconductor equipment manufacturer, AEM Holdings, had a Net-Net value of S$49.6m and a market capitalisation of S$40.4m when we first wrote about it on 29 March 2013. Now, barely 2 months later, after the release of its first quarter results on 10 May 2013, the company’s Net-Net value has deteriorated, as shown in the table below:

AEM Holdings S$m
Current Assets 60.0
Total Liabilities 18.1
Net-Net 41.9

 The company’s first quarter result for 2013 saw it make it a quarterly loss of S$1.06m as it burned through S$6.03m in cash. AEM saw its quarterly revenue drop by 44% as it sold lesser equipment. This was not a new development – the company’s sales had dipped by more than half for the fourth quarter of 2012 as compared to 2011.

This difficulty in even maintaining its sales is probably one reason why the company’s being available at such a low price with its current market cap of only S$40.9m, a smidge lower than its Net-net value of S$41.9m.

But, if an investor’s main thesis for investing was that the company’s market cap was at a nice discount to its Net-Net value back in March this year, he would have seen that discount shrink quite a fair bit as AEM’s Net-Net had decreased by more than 15% to S$41.9m. That’s what we meant about a ‘fairly quick change’ in the investment thesis.

Of course, not every company that passes the Net-Net criteria is in the same situation. For example, the information technology provider DMX Technologies’ Net-Net value had increased to S$324.4m from S$322.2m in its latest first quarter results for 2013.

In Pan Hong’s case, there has been no new earnings result from the property developer. But, the gap between its Net-net of RMB 1,520m (or around S$320m) and its market cap has shrunk as the company’s share price has appreciated by 18% from S$0.22 on 29 March 2013 to S$0.26 today.

Either way, the gap between those three companies’ Net-Net value and market cap has changed for different reasons, thus altering the Net-net investment thesis for them. As it is with any investment technique, nothing is perfect and investors who are interested in Graham’s Net-Net approach will have to be cognizant of the risks involved.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.