A Negative Enterprise Value screen is a bargain investing strategy which looks for companies whose cash is worth more than the total value of their shares and long-term debt. The idea is that these stocks represent a theoretical arbitrage opportunity whereby a suitable motivated acquirer (e.g. a Private Equity fund) could buy all of the debt and equity in a firm and use the cash to cover costs and keep the difference. Most likely to be relevant at times of market stress, it is a variant of the Net-Net strategy espoused by Benjamin Graham, albeit it focuses on cash, rather than other receivables.
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 PRO). 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. It is probably sensible to exclude financial stocks, given the inherent difficulties in analysing net debt for these types of companies (due to off-balance sheet liabilities). To avoid value traps, it may make sense to introduce some size / momentum criteria, for example i) market capitalisation greater than £25 million and ii) positive relative strength over the last year.
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 PRO. 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".
We've implemented elements of this approach is our Trading Below Cash screen on PRO here.
Watch Out For
While, in theory, a negative EV screen may seem to throw up easy arbitrage opportunities, there are a number of reasons to be cautious. These stocks are likely to be trading for less than cash for a reason, namely the market thinks they may eventually declare bankruptcy. Some of the possible risks include a business model destined to fail, an inaccurate reflection of "cash on hand" in their books (due to say, leases - a related issue is likely to be off-balance sheet liabilities for financial firms), or there may be a management with no incentive to return value to shareholders. The firm may even have adopted a poison pill or other strategies that would make a hostile takeover prohibitively difficult, hence the market for "corporate control" won't work properly to allow the arbitrage. As Altucher comments:
"There is always the danger that management doesn't care about the shareholders but instead enjoys sitting on the assets of the company and using it for their personal benefit. Diversification is the tool that we can use to reduce the risk of corrupt, or at best, uncaring, management".
As Professor Damodaran points out, another possibility is that the cash balance is from the balance sheet date (rather than stated at the today's date used for the market cap). Given how quickly firms burn through cash, what you see on the balance sheet for, say, a biotechnology stock may not reflect what the firm has as of today in cash. Like any screen then, but perhaps even more so, this one merits further close investigation of the results to ensure that they are valid.
Does it Work?
In "Trade Like Warren Buffett", Altucher indicates that his basket of Cash Rich stocks was up over 100% over six months, "as the market not only jolted upwards in the aftermath of the Iraq War but also began to realize the value of the cash portfolios of these companies". The long-term performance of this screen - and its performance in more benign market conditions - is unknown. However, the Old School Value site has been running an interesting Negative Enterprise Value screen since 2009. His back-testing for the US market exhibited significant outperformance over a 10 year period, albeit with significant volatility. He found that companies tended to have a higher quality of assets than in a pure Graham Net Net screen (because it was more focused on cash, than inventory & receivables). Since then, OSV noted some implementation issues affecting performance in a 2011 update:
"Companies that have negative enterprise value are always flush with cash. This criteria became a problem in 2011 when Chinese reverse mergers began popping up everywhere. These Chinese companies were just loaded with cash and filled the screen. Since reverse mergers are not listed as ADR’s, I couldn’t find a way to weed it out. If this continues to happen, I am thinking of just deleting the screen entirely".
We're not aware of any back-testing for the UK market, so we will be watching the screen performance on PRO with interest.
How can I run this Screen?
- Altucher's excellent book, "Trade Like Warren Buffett" is available on Amazon (the relevant Cash Index chapter is also available online).
- The SmartMoney Negative-Enterprise-Value Screen
- Magic Diligence: Why use Enterprise Value?
- Negative Enterprise Value - Is that possible?
- Cheap Stocks or Value Traps?