Disclaimer: This article is written for the purpose of discussing my thought on a buy or sell process basing on a fundamental approach. It is not a recommendation to buy or sell any particular stock. Like other posts I wrote recently, I have put this up in my private learning blogs first prior to publishing here.

“Whether socks or stocks, I like buying quality merchandise when it is marked down.” Warren Buffet

In MyThirdPortfolio, I have three stocks not meeting the principle of the Magic Formula investing strategy as shown in the appended link below. They did not performed well too especially for Plenitude (-25.4%) and Perak Corp (-36.3%).

http://klse.i3investor.com/blogs/kcchongnz/68248.jsp

However as mentioned in the article, I have decided to keep them in my portfolio going forward in 2015. Why didn’t I cut loss? What is so great about these losing stocks? Nothing actually, but just to share some thoughts about deep value investing.

Value investors do not just cut loss because the stock price has gone down, unless they have determined that the value of the company, and hence its stock has lost its value. What value are we talking about since they do not meet the requirements of the Magic Formula?

All these stocks, including another one of Daiman Development in MySecondPortfolio as summarized in Table 1 in the Appendix, were purchased based on the proven balance sheet investing strategy, in particular, the Graham net net working capital value, or NNWCV.

NNWCV = Cash and short-term investments + (0.75 * accounts receivable) + (0.5 * inventory) – total liabilities

It's the lowest form of valuation you could possibly do because it ignores everything about the business and just focuses on tangible assets, and even discount them. The formula states that;

• cash and short term investments are worth 100% of its value
• accounts receivables should be taken at 75% of its stated value because some might not be collectible
• take 50% off inventories, due to discounting if close outs occur

For more information of this investment strategy, please refer to the appended link below:

http://klse.i3investor.com/blogs/kcchongnz/45296.jsp

Here we will take Plenitude as an example to compute its NNWCV

Graham Net Net Working Capital Valuation for Plenitude

Plenitude is an established property development and investment company in Malaysia. Its latest balance sheet as at 30 September 2014 was used to compute its net tangible asset and NNWCV. Besides cash, the net net values of land, development costs and investment properties owned are also taken as 100% of the book value. This is a fair assessment as it is believed that these assets are likely to worth more than their book value than otherwise. Note that tax assets, property, plant and equipment, Goodwill and “other assets” are taken as worth nothing.

Table 2 in the appendix shows the detail computation of NNWCV of Plentitude. At the close of RM2.29 for Plenitude as the end of year 2014, it is trading at a discount of 38% and 31% to its net tangible asset backing per share of RM3.71 and NNWCV of RM3.31 per share respectively. These discounts are wide.

The other three stocks are also trading at a wide margin of safety to their NNWCV as shown in Table 1 in the Appendix; Daiman at 25%, Perak Corporation at 30%, and Kuchai at a whopping 61%. In fact Kuchai is one of the very rare negative enterprise value stocks in Bursa.

What is negative enterprise value stock?

Kuchai, negative enterprise value, and arbitrage opportunity

One way to look at it is considering the enterprise value (EV) of a stock is as below:

[Think of enterprise value as the theoretical takeover price. In the event of a buyout, an acquirer would have to take on the company's debt, but would pocket its cash. EV differs significantly from simple market capitalization in several ways, and many consider it to be a more accurate representation of a firm's value. The value of a firm's debt, for example, would need to be paid by the buyer when taking over a company, thus EV provides a much more accurate takeover valuation because it includes debt in its value calculation.] Investopedia

EV = Market Capitalization + Debt + Minority Interest - Cash – associates –  equity investment

http://klse.i3investor.com/blogs/kcchongnz/49016.jsp

Base on the latest balance sheet of Kuchai at 30^th September 2014, the enterprise value of Kuchai is:

EV = 1.26 * 123.8 + 0 + 0 – 38.4 – 134.9 – 201.2 = -218.5 m.

This negative enterprise value of 219m provides us with an arbitrage opportunity as below:

We can withdraw and pocket the balance cash of 75 million Ringgit after paying all my personal loans and liabilities of the company. Besides I still own an shop house in Singapore worth 23m which I can collect a rental income of RM780,000 a year. I will also own 26% stake in Sg Bagan worth RM48 million at the market price of RM3.03 now.

However, things are not that simple as the shareholding of these three companies, Kuchai, Sg Bagan and Kluang Rubber are intertwined. And 60% of Kuchai’s outstanding shares are held by related parties. Nobody would be able to make a hostile takeover without the consent of the Lee brothers. Otherwise, Kuchai would have long been taken over by some rich value investor/arbitrageurs.

Does NNWCV works in Bursa?

It would be great if someone can provide a research on this in Bursa. I have about a couple of years of experience on a portfolio of 10 NNWCV stocks as shown in the link below:

http://klse.i3investor.com/blogs/kcchongnz/56472.jsp

Table 3 in the Appendix shows the latest return of the stocks Vs the broad market. The portfolio of 10 NNWCV stocks returned an average of 32.6% , or for a two and a half times more compared to the return of 13.3% of the KLCI in about a two-year period. Seven out of the ten stocks out-performed the broad index with KSL gaining 110%, and PMCorp 97%. There are only two losers. FACB and Perak Corp with an average loss of just 4.3%. Outsized gains and minor losses seems to be the characteristics of all value investing. This also shows Graham NNWCV strategy also worked in Bursa for short term too.

Conclusions

The balance sheet investing strategy of Graham net net working capital value has shown extra-ordinary return for a long period of time in the US market. This strategy also worked for me for a shorter period of two years in Bursa. As the NNWCV of the four stocks mentioned in this article are still way above their stock prices, and hence a wide margin of safety, that is the reason why I still keep them in my portfolio, patiently waiting for the unlocking of their values, like what happened to KSL and PMCorp. Most of all, this is a safe investing strategy meeting the Dhandho Principle:

“Heads I win; Tail I don’t lose much”        Mohnish Pabrai

What about the two company warrants in MyThirdPortfolio, BIMB Wa and MRCB Wa? They are down by huge 36.4% already? Cut loss? No. They were purchased with financial risk management in mind. Just what is this financial risk management? We will talk about it next.

Are you keen to learn this proven safe investment strategy for building your long term wealth for a small fee? Please contact me as the next course will start soon.

Ckc13invest@gmail.com

K C Chong ( 16/01/2015)

Appendix

Table 1: Graham net net working capital value stock

Table 2: NNWCV computation for Plenitude

Table 3: Return of NNWCV stocks

*A course participant has rightly pointed out that KESM is not a NNWCV stocks.