Two Incredibly Cheap Shares?

As investors, we’d all love to buy shares at prices that are lower than what they are really worth. In other words, we’d all like to pick up a dollar for 50 cents. One particularly effective way of doing so would be to search for companies that are selling below their net-net value: That is, companies whose market capitalisations are below what’s left-over from their current assets after deducting all liabilities.

By way of analogy, this is what a net-net share looks like. You have Peter, who owns a property (long-term asset) worth S$1 million that’s fully-paid up for. He has S$500,000 in the bank (current asset) and has total liabilities, made up of various types of personal loans, of around S$100,000. In this way, his current assets sans all liabilities, would be S$400,000. One day, he just walks up to you and says, “Would you pay me $200,000 for all the cash, property, and loans I have?” That’s a net-net share for you – and we’re not even looking at whether Peter’s drawing a salary, which could add to his bank account periodically.

I hope you can see why a net-net share could be a great bargain from that analogical exercise I did. In fact, Benjamin Graham, the intellectual father of value investing, had pioneered such an approach for his own investing activities. And with a career as a hedge fund manager that had seen him generate 20% annualised returns on average for over two decades (from 1936 to 1956), such a method would be worth taking a closer look.

Mathematically, we’re looking at a relationship like this:

Market Capitalisation < (Current Assets minus Total liabilities)

But as attractive as a net-net may be, here’s an incredibly important caveat. Graham used such an approach as a filter, picking up practically all shares that passed through them. In other words, the net-net method was a portfolio-level operation – Graham wasn’t looking to pick individual shares using such an approach, he just wanted to buy them all and be safe in the knowledge that, statistically speaking, all those cheap shares would end up doing well even if there would be duds ever so often.

This is an important distinction from using the net-net method as a way to pick individual shares. To illustrate the risks of picking net-net shares individually, let’s take a look at two such shares in particular, Qingmei Group Holdings (SGX: KT9) and China Sports International (SGX: FQ8).

Qingmei Group Holdings

China Sports International

Current market capitalisation

S$16 million

S$25 million

Current assets

S$105 million

S$247 million

Total liabilities

S$19 million

S$75 million

Net-net value

S$86 million

S$172 million

Source: S&P Capital IQ

From the table above, it’s easy to tell how Qingmei Group and China Sports look really good from a net-net perspective at their current prices of S$0.024 and S$0.026 respectively. And just to drive home how cheap they seem to be, the median price to book ratio (a ratio that compares the market cap of a share against the value of all its assets sans total liabilities) for the 30 blue chips within the Straits Times Index (SGX: ^STI) is currently around 1.3.

I can’t say for sure, but if the balance sheet figures presented by both companies are legitimate – there’s always a risk of fraud with any share – they might even have interested Graham from a portfolio-level perspective. From a stock-pickers’ vantage point however, there are significant risks involved with each.

Chief amongst them is how those two companies have been burning up cash. In the 21 months ended 31 March 2014, Qingmei Group has used up S$28 million in cash from its daily operations – i.e. its business isn’t generating cash at all. It’s pretty much the same scenario for China Sports, which has burned through S$33 million in cash from operations in the 15 months ended 31 March 2014.

In the modern era, shares that are selling for valuations as low as what Qingmei Group and China Sports are going for generally have significant problems. In fact, many net-net shares in Graham’s era in the 1930s to 1950s also had big issues. Some of those shares would eventually turn things around and post some spectacular returns. Problem is, it’s tough to tell which are the ones that can do so a priori. That’s why Graham had cast a wide net without fretting over which were the ones that might turnaround.

For investors who are interested in studying Qingmei Group and China Sports for a possible investment from a stock-picking perspective, they’d have to be confident in their appraisal of the companies’ businesses and the timing of any potential turnaround. If the two businesses don’t improve their operational performance, their bargain status – represented by the huge gaps between their current market caps and their net-net value – might just disappear.

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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 writer Chong Ser Jing doesn’t own shares in any companies mentioned.