Negative Enterprise Value strategy

Negative Enterprise Value strategy

Negative Enterprise Value is a deep value bargain strategy inspired by the writings of investment writer, Jae Jun. It looks for companies that are priced so cheaply by the market that their cash balance is worth more than their enterprise value (the sum of the company's market cap and total long term debts). On paper, these stocks present an arbitrage opportunity: you could buy all of the debt and equity using the company's cash to cover the cost and simply pocket the difference. Jae Jun says: "If done correctly, it looks like this strategy is hugely profitable, but it does come with a lot of volatility." Jae Jun's back-testing for the US market exhibited significant outperformance over a 10 year period. A word of warning: company cash balances change all the time, so it's essential to know precisely how much cash a company has got. Likewise, make sure all debts are taken into account when it comes to calculating enterprise value.

Criteria
What is Enterprise Value?
Many investors focus on market cap - i.e. share price * number of shares - as a measure of the market valuation of a company (this is the figure that is used in P/E calculations for example). This figure is widely available but, in reality, it is not the best measure of a firm's valuation, as it ignores the impact of the capital structure of the company. It would treat a highly leveraged company in the same way as a debt-free company, despite the fact that the equity holders in the first scenario sit behind the (potentially substantial) claims of the debt-holders in the event of a liquidation.
A better measure is Enterprise Value (available for all stocks as part of Stockopedia Premium). This is defined by summing a company's market cap AND its long-term debt / preferred shares minus its cash (together known as "net debt" or "net cash" if cash exceeds debt). To illustrate the calculation, if a company has a market cap of ?100 million, ?50 million in outstanding debt, and ?25 million in cash, its enterprise value would be ?125 million (?100 million + ?50 million - ?25 million). The reason this is a more complete valuation is that is that, if somebody bought all of that company's outstanding shares at the market price, that person would also take on all its obligations and cash.
In our negative Enterprise Value screen, we look for those (rare & unusual) companies that have a market cap less their net cash balance. In effect, this means that a shareholder is buying into the cash at a discount and receiving a claim to the rest of the company for free. The idea is that, in an efficient market, this situation should not persist for long - catalysts for a revaluation could include a management buy-out or takeover, a business turnaround, or a dividend to shareholders (given that the board has a responsibility to create shareholder value, and not just hoard cash).
Negative Enterprise Value Screening Parameters
The most obvious parameter is that Enterprise Value should be less than 0. To avoid value traps, it may make sense to introduce some size / momentum criteria, for example i) market capitalisation greater than ?15-25 million and possibly ii) positive relative strength over the last year (since momentum blends well with value).
Note: As of June 21st 2013, we modified this screen to exclude financial stocks, given the inherent difficulties in analysing net debt for these types of companies (due to off-balance sheet liabilities). We've also swapped in the market capitalsation criterion and removed the relative strength criterion to make the screen more purist (this could be re-inserted via a screen "duplicate").
Trading Below Cash Variant
A more complicated variant of this screen was espoused as the "Cash Index" approach outlined by James Altucher in his book, "Trade Like Warren Buffett". He suggests a multi-pronged approach to analysing potential bargain/arbitrage stocks trading below cash in times of market distress (in his case, post the 2001 bubble / Iraq War). We have modelled the Cash Index approach separately on Stockopedia Premium. In his version, Altucher looks for eight factors, four of which are easily quantified:

Market cap below cash (i.e. effectively negative EV, assuming cash is net of all liabilities).
Very low leverage (less than 20%)
Enough cash headroom to cover the current annual burn-rate, and
Some stability in revenues and earnings.
In addition to these easily-screenable criteria, he suggested looking out for more qualitative factors:
A reasonable belief that the sell-off in the stock was partly irrational - "Hundreds of Internet companies went bankrupt, but not every company whose shares sold off will go bankrupt".
Favorable arbitrage analysis - "Where the company has already accepted a takeover offer, we want to make sure that owning the shares right now still has a high likelihood of having a favorable annualized return".
Insider buying. "While not a requirement, it is nice to know that senior officers and directors in the company feel as we do".
Institutional ownership. "We like to see mutual funds with above-average track records that focus on value opportunities swooping down onto these opportunities".
This strategy uses the following checklist:
EV ?m < 0
Mkt Cap ?m > 15