The Negative EV screener has been available on our Quant Investing website since its inception, yet I have written almost nothing about it, nor shared my views on investing in Negative EV stocks.
Well, the time has finally come.
Negative EV stocks are the deepest kind of deep value stocks, and as such, they possess some substantial money-making potential. Yet investing in Negative EV stocks requires caution and awareness of their unique traits and drawbacks.
Through this spotlight article, I hope to explain both the theory and the practical aspects of investing in this unique type of stocks. As always, I will share my own original research as well as that of others. At the end of the article, I discuss how individual investors like us can take advantage of this unique phenomenon.
What are Negative EV stocks?
Let’s start by defining EV.
EV stands for Enterprise Value. It represents the total cost of a company to an acquirer, and calculated as follows:
EV = Market capitalization + Total Debt
– Cash & Cash Equivalents
When an acquirer acquires a company, he (or she) not only pays for its equity (represented by the market value of stocks). He assumes the debt of the company as well. Moreover, the acquirer also gets a hold on the company’s cash & equivalents and can do with it as he wills.
Therefore, while the market cap of equity represents the fair value of the company, the enterprise value represents the total costs incurred when acquiring a company.
An easy way to visualize it is by thinking on a real estate deal. Let’s assume you buy a house that has a mortgage on it, and you agree to enter in the seller’s shoes and assume the mortgage on the house yourself. A debt-free house would go for $1 Million, but since the mortgage is $400,000, you agree to buy it for $600,000. The deal’s value is $600,000 (market cap) – this is what you would pay out of your pocket. But the overall cost of the deal (enterprise value) is $1 million.
Now, let’s assume that the seller leaves you in the house a wine seller with valuable old wines that could be easily be sold and turned into cash. That would be our cash equivalents. When you calculate the cost of the deal, you would naturally account for that, and subtract the realizable value of the wines from the total cost of the deal.
It is highly unlikely that the wines would be worth more than the house itself. If that happens – it would be the deal of your life. You could cash those wines, and thus get the house for free and then some. Such a situation will happen only rarely. And if it does, you would rightly suspect that there’s something wrong with it. But if after all your checks, the deal is real – it is like finding money on the floor.
That situation is equivalent to finding Negative EV stocks. Negative EV stocks are those whose cash hoard is so large that it is larger than the total of their market cap of equity and their total debt. Buying Negative EV stocks is like buying a cash pile for less than it is worth.
The obvious question is, How Can It Be?
How Come Negative EV stocks exist?
Well, in some cases, The economic enterprise value of Negative EV stocks is not really negative. That often happens when the economic debt is not well-represented by the total accounting debt which appears in the SEC filings.
Such cases occur when companies have large operating leases, which are not accounted for in the balance sheet which are prepared according to GAAP accounting rules. In other cases, the company may have a large regulatory or legal commitment which is also not accounted for in the balance sheet. An investor in Negative EV stocks may thus want to read carefully the SEC filings to detect any commitments and contingencies that evaded the balance sheet. A good place to start searching is the “Commitment and Contingencies” section in the 10-K. The second place would be the “Risk Factors” section.
Or alternatively – diversify broadly to diffuse that risk. We will discuss diversification later in the article.
In other cases, the EV may appear negative due to a data error. Sometimes the data aggregators such as Morningstar, CapitalIQ, Factset, and Reuters, which are being used in various websites and screeners (including ours), have an error and fail to state correctly either a debt figure or the cash & equivalents figures, or the market capitalization.
An investor may want to double-check the EV of a stock by calculating it manually, based on the values which appear on SEC filings, rather than relying on the calculation of data providers. The screeners and websites are thus a good starting point for finding Negative EV stocks, yet a manual calculation is advised.
But what if the EV is calculated adequately and is indeed negative? How can one explain the occurrence of such situations?
Those situations occur in two cases. One, a major recession such as in 2002 and 2008. In times of crisis and fear, almost all stocks are underpriced, nonetheless Deep Value stocks. In such times there is an abundance in Negative EV stocks. See the following figures showing the number of liquid Negative EV stocks that were available in the U.S. stocks market. The rise in Negative EV opportunities during recessions is evident.
The second situation is company-specific problems and risks. When the business gets so messed up, investors dump the stock at any price, expecting it to completely fail. Sometimes, those companies do fail and go bankrupt. But more often than not, something positive happens. Either the company gets acquired and turned around, or that new management is brought in to fix the business, or the company is liquidated (at a higher price than the market cap).
Take for example Rubicon Technology (RBCN), which is highlighted in our Negative EV screener. Rubicon was a manufacturer of lab-grown Sapphire crystals. This was once a hot-hot-hot sector, as Apple integrated those crystals into their iPhone cams. But the hype is long gone, and the company couldn’t find enough customers for its manufacturing capacity. After burning almost all the company’s cash, the company admitted defeat and with its new activist CEO, decided to close down most of their Sapphire manufacturing facilities. The negative EV reflects investors’ expectations that the cash burn rate will eat up the value of the company in a few years, making the company worth more dead than alive. That is a real possibility and that is why the stock is trading so cheaply. But there are other possibilities that are more likely. The company could liquidate and distribute the cash to its shareholders. Buyers of the stock at current market prices will benefit. The company could be acquired. The company could invest its cash in a profitable line of business.
As with any deep value situation, we can not tell with sufficient confidence what will become of a specific company. But buying a diversified bucket of such situations is usually a profitable endeavor.
How Did Negative EV Stocks Perform Historically?
Let’s examine the performance of Negative EV stocks. For that, we will run a simulation which invests an equal amount of cash (equal-weighted) in all the liquid Negative EV stocks that appear on our Negative EV screener, every June 30th.
We chose June 30th as our rebalance date, to be consistent with our other simulations on the website, as well as with academic research.
Our Negative EV Screeners apply the following rules:
- Starts with a universe of all stocks trading in the U.S. market
- Liquidity rules – Eliminate stocks with market cap <$10M, and average monthly trading volume of <$20K, and stock price <90 cents
- Eliminate stocks domiciled in China – many Chinese companies are outright fraud
- Eliminate financial companies – our formulas for negative EV do not fit the accounting of financial companies
- Eliminate companies with less than 10 employees and zero revenues
- Eliminate companies with negative Common Equity – they mess up our calculations
- Select companies with Negative EV
In our simulation, we assume a slippage of 2%, as many of our picks are microcaps with a large bid-ask spread.
Here are the performance results year-over-year:
|Year (starting June 30th)||No. of stocks||Negative EV Returns||Russell 2000 returns|
|2018 (until 3/19)||11||-13.85%||-5.91%|
Wow, what a roller coaster.
On one hand, had you invested in the 13 Negative EV stocks available on June 30th, 2017 and held those stocks for a year, you what have doubled your money, while the R2K benchmark gained only 26.78%. But then, had you invested in the 12 Negative EV stocks available on June 30th, 2015, you would have lost a third of your capital, at the time when the R2K lost only 8.32%.
In some years, the gains on Negative EV stocks are spectacular, 40%, 50% even above 60%. In other years, they are miserable. Check out -38% in 2011 when the benchmark stayed almost flat.
I could not find any way to predict a-priori in which times Negative EV stocks will outperform and in which they will lag the benchmark. There seems to be some correlation to the overall valuation of the stock market, but it is not perfect. Thus, the best years for Negative EV were 2003 and 2009, when stocks were cheap following long recessions. But this correlation is not perfect and should be treated with care.
It is obvious that Negative EV portfolios are very volatile, and thus not suitable for everyone. Even those enterprising investors that would want to allocate a small portion of their funds to Negative EV – should do so carefully and gradually.
Let’s examine how a portfolio of Negative EV stocks performs over the years. Similar to the exercise above, The portfolio was initiated on June 30th, 1999 and rebalanced every 52 weeks. Upon every rebalance, we replace the holdings with all available Negative EV stocks that appear on our screener.
Overall, a consistent investment in Negative EV stocks over many years have proven to be profitable. But oh boy, how much patience and endurance does one need to stick with it.
How Can You Profit from Negative EV?
Let’s start with what Negative EV is NOT.
It is not a quantitative strategy that you can invest in it a large portion of your capital and sleep well at night.
It is not a get-rich-quick scheme. Maybe a get-poor-quick, rather (if you invest a large amount of money at the wrong time).
What Negative EV is – it is educated speculation that can make you some nice returns IF you have patience, and if you can control your emotions.
The key to investing in Negative EV stocks is – starting small.
Take a small amount of money that you are willing to risk. It should be an amount that if it drops 50% during the first year, you will still be able to sleep well, and not get overly concerned about it.
Then, start with the list of Negative EV stocks in our screener. Invest in at least 10 stocks (the more the better), to be somewhat diversified. If you have time and will, calculate the EV for yourself, to make sure no mistakes were made by data aggregators. Even better – read about the situations (Seeking Alpha is a great resource). Doing manual research is not necessary, as long as you diversify well.
And most importantly, expect the unexpected. Negative EV stocks will perform differently than the market. That is normal. Practice your patience.