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Scary beats safe in realm of cheap stocks

Cheap and safe are two attributes I look for when picking stocks. But seeking safety doesn't always pay. History suggests that a cheap-and-scary approach may be the better way to go - if you have the stomach for it.

Tobias Carlisle, a U.S. money manager, is putting this theory to the test by conducting a friendly race among different portfolios of value stocks. The race focuses on deep-value stocks in a segment of the market where many investors fear to tread.

The competition started with some screens from Tyler Durden (anon) at the Zero Hedge blog, which focus on stocks in the Russell 2000 index with market capitalizations (the total market value of their shares) that are lower than the net cash on their balance sheets.

As you might expect, it's rare to see companies selling for less than the cash they have in the bank. The few that can be found today are usually very tiny stocks and typically come with a mountain of problems. For instance, some are seeing their cash going out the door much faster than it's coming in. Others might sell obsolete products that customers no longer desire. In short, these stocks tend to be ugly, which is why investors value them at less than the cash they have on hand.

To set up the race Mr. Carlisle used four slightly different portfolios generated by Mr. Durden. The first portfolio simply follows the 10 stocks found by the basic screen on Dec. 4, 2012. The second cuts out six of the 10 stocks with negative free-cash flows. Think of this portfolio as a safer take on the main strategy because it focuses on firms that generate money rather than those that lose it.

The next two portfolios expand the universe by redefining net cash as the sum of cash plus short-term investments minus debt, rather than just cash less debt. The first of the variants follows the expanded list of stocks while the other tracks only those with positive free-cash flows.

Mr. Carlisle makes several predictions about how the race will turn out. He thinks all of the portfolios will beat the market over the long term but the best performer will likely be the worst looking of the bunch. The portfolios with only positive-free-cash-flow stocks are likely to do worse than those with the money burners. Similarly, the portfolios based on the more lenient net cash calculation are expected to trail those found via the original formula.

In other words, Mr. Carlisle is betting against cheap and safe and going for cheap and scary. To explain why requires a quick visit to the dark times of the 1930s, when Benjamin Graham, the father of value investing, was perfecting his bargain-hunting philosophy.

In the depths of the Great Depression, Mr. Graham advocated buying 'net-net' stocks, which were plentiful at the time. Net-net stocks have market capitalizations below two thirds of the value of their current assets minus all liabilities, which makes them closely related to the stocks in Mr. Carlisle's race. Mr. Graham's net-net stocks went on to do quite well but, as the markets rose, such bargains largely disappeared and only a few can be spotted today.

Despite their rarity, Mr. Carlisle and his colleagues tested how net-net stocks fared in the U.S. between 1983 and 2008. It turns out they did very well indeed. They posted average monthly returns of 2.55 per cent, which easily beat the market's gains of 0.85 per cent a month.

But he also looked at how net-net stocks with positive earnings fared. It turns out they gained only 1.96 per cent a month whereas those with negative earnings grew by an astounding 3.38 per cent a month on average.

The results heavily favour unprofitable net-net stocks, and it's a finding I didn't expect. While Mr. Carlisle says it's not clear why the unprofitable net-nets win, he hypothesizes that the gushing red ink prompts management to take corrective action, which boosts the stock price. At the profitable firms, the need for change may not be as pressing.

He is also quick to point out that the phenomenal results posted by the net-nets should be taken with a grain of salt. After all, they tend to be few in number, have very small market capitalizations, and suffer from liquidity problems. As a result, the big spreads between bid and ask prices can easily turn a method that works well in theory into a disappointment in practice.

While it's still too early to say which portfolio will win the race, you can follow them via links at Greenbackd.com. Just remember: The stocks listed in these portfolios should only be considered by a very small fraction of highly knowledgeable and experienced investors. Nonetheless, deep value investors seeking to acquire insomnia might want to investigate them further.

First published in the Globe and Mail, December 30 2012.

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