(By David Brickell) An investment strategy proposed by US investor and commentator James Altucher that screens the market for potential bargain stocks. In particular, the strategy seeks out companies that are being valued by the market at less than net cash but still have reasonable quantitative and qualitative hallmarks.
James Altucher is an investor, prolific author and entrepreneur who made and lost a fortune during the dot com bubble. Altucher's interest in investment has resulted in several books, Trade Like a Hedge Fund and Trade Like Warren Buffett, in which he deconstructs and analyses successful trading techniques. He presents his views on life and business in a candid and highly recommended blog.
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In the 2005 book Trade Like Warren Buffett, Altucher set out to examine how Buffett had applied the concept of ‘margin of safety', advocated by his one-time tutor and value investing legend, Benjamin Graham. In it he examines how Graham (together with David Dodd in their book Security Analysis) had sought very conservative protection from failure by buying stocks at prices below their liquidation values. Graham's strategy became known as Net Net Working Capital and falls under a broader umbrella of seeking out stocks whose market capitalisation is lower than their cash value.
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Altucher picked up this concept and proposed his own "Cash Index" screen, which blends quantitative and qualitative measures. It is similar to the Negative Enterprise Value screen, which looks for companies whose cash is worth more than the total value of their shares and long-term debt.
Altucher 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). 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 (which we've implemented), he suggested looking out for more qualitative factors, which would require a qualitative review:
- 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 favourable 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".
Watch out for
As with all screening strategies, care should be taken and further research is essential, particularly in the case of ‘potential bargain' screens.
Like the Negative Enterprise Value screen, there are potential problems with Cash Index stocks. Not least, companies trading below cash have already have been written off by the market. That's part of the reason why they are so cheap. They may also suffer from flawed business models and management teams with no incentive to deliver shareholder value.
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".
Does it work?
Altucher indicates that within the six months following publication of the Cash Index screen in December 2002, the basket of stocks recommended was up over 100% "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".
More recently, Stockopedia's interpretation of the Cash Index screen – Trading Below Cash has faired less well, with a year-to-date return of just 3%. That's under the FTSE All Share which makes it one of our worst performing screens - 83% of our quant screens are beating the market - but it's very early day (under one year of data) and perhaps its time is yet to come!
Interestingly, it's doing much less well than its Negative Entreprise cousin. Part of the reason may be that the Cash Index includes financial stocks, which present their own challenges in determining true cash levels (as opposed to customer balances) and leverage (on a debt to asset basis). Another factor may of course be the lack of qualitative filtering.
From the source
Altucher's excellent book, Trade Like Warren Buffett is available on Amazon (the relevant Cash Index chapter is also available online).