This is our sixth post in our series on “net nets” having previously published:
The focus of this post is the research paper “Emerging Markets: Evaluating Graham’s Stock Selection Criteria on Portfolio Return in Saudi Arabia Stock Market” by Nadisah Zakaria and Fariza Hashim. The objective of the paper was to examine the performance of securities that were trading at greater than 1.5 of Net Current Asset Value (NCAV)/Market Value (MV) (i.e. less than 2/3 of NCAV) during the 15 year period from 2000 to 2011 on Tadawul (i.e. the Saudi Arabian Stock Exchange).
Our objective was to analyze the study itself; determine its reliability, draw our own conclusions and glean, if any, actionable advice for the practitioner of the “net net” method of investing.
“In complying with the primary criteria of Graham’s approach, companies with per share NCAV greather than 1.5 times the current asset share price were identified. Investors should select NCAV/MV shares with a margin of safety: At a price no more than two thirds of the company’s NCAV.”
“In calculating the NCAV of the companies listed, all data regarding the companies’ current assets, current liabilities, long-term debt, and preferred stock were downloaded from balance sheet entries on Datastream (Xiao and Arnold, 2008).”
From the above we deduce that the authors calculated the NCAV per share as follows:
Net Current Asset Value per share = (Current Assets – (Current Liabilities + Long Term Debt + Preferred Shares))/Common Shares Outstanding
The number of firms meeting the “primary criteria” were identified in Table 1, replicated below:
What we observe is that the sample size is small and grows progressively smaller throughout the study period, despite the Global Financial Crisis (2007-2009).
However, the selection criteria does not end there.
“Those companies that fulfilled the primary criteria were further investigated to ensure they satisfy the secondary criteria, which are summarized in Table 2. It is important for the companies to comply with the two levels of criteria to enable them to be further analyzed.”
Now, the authors didn’t disclose how many firms qualified for investment based on the primary and secondary criteria but logically we know it can only be less than or equal to the number of firms that met the primary criteria as stipulated in Table 1.
With regard to “Satisfactory earnings” (refer Table 2) – to find a group of net nets with compounding earnings over such an extended time frame would be quite a feat. Companies don’t ordinarily trade below a conservative liquidation value while simultaneously compounding earnings. Indeed, one may wish to examine the financial statements forensically in such a case. Furthermore, the authors state that “The examining period for this study is from January 2000 until December 2014. This is due to the fact that prior to the year 2000, company data is not yet available in the Saudi Arabia stock exchange.” So, it isn’t clear to us how, or what source was used to retrieve historical data of such length to make the required assessment in accordance with this criterion.
It is stated that “Companies should have price to P/B ratio below 1”, however, this criterion is redundant because they would be subsumed by firms meeting the primary criteria.
It should be noted that applying just the primary criteria resulted in fewer than 10 firms being eligible for investment from investment from 2007 to 2011. Applying the secondary criteria could have only further reduced the numbers of firms examined as alluded to previously. Overall, the sample size appears to be particularly small in this study.
Weighting: Equal weight and Value weight
Formation date: “the study created an annual portfolio share in the month of July.”
Holding period: “The buy-and-hold portfolios are constructed for 1, 2 and 3 years, with the first formation in July 2000 and the last formation in July 2011.”
The stock universe:
“As of 31st December 2011, a total of 160 companies were listed on Tadawul with a market capitalization of USD385.3 million. Interestingly, the Saudi Arabian share market is the largest in the region, accounting for about 50% of the six AGCC markets: Bahrain, Kuwait, Oman, Qatar, and UAE. Indeed, more than 80% of all shares trading in terms of value take place in Saudi Arabia.”
By US standards the entire market capitalization of the Saudi Arabian share market was equivalent to a microcap or two! Furthermore, it should be noted that “In June 2015, Saudi Arabia’s stock exchange experienced a major change when it started to open to foreign participation” i.e. foreign investors faced a genuine limit to arbitrage during the test period.
While there are numerous biases/errors that can be made when conducting studies/back tests, below we have analysed those we deem most likely to impact a study of this nature:
1. Survivorship bias
No mention was made with regard to controlling for “survivorship bias”.
The data source may have suffered from survivorship bias. However, given the study parallels the commencement of the exchange itself, the impact of survivorship bias, if any, may have been smaller than would otherwise be expected.
2. Look Ahead bias
“Following Xiao and Arnold (2008), the study created an annual portfolio share in the month of July. Companies are required to have data for NCAV in December of t-1. This enabled the researcher to observe at least one return in the post-formation period.”
Based on that mentioned above the researchers appear to have avoided look ahead bias.
3. Time period bias
The study spans 15 years and we classify this as a “somewhat reliable” period.
· < 10 years; inadequate/unreliable
· 11 to 20 years; somewhat reliable
· > 20 years; more reliable
· > 40 years; most reliable
4. Data source and treatment
“In calculating the NCAV of the companies listed, all data regarding the companies’ current assets, current liabilities, long-term debt, and preferred stock were downloaded from balance sheet entries on Datastream (Xiao and Arnold, 2008). Companies that are listed as financial sectors are excluded from this analysis. Returns for each company including dividends were adjusted for changes in stock split, rights issues and share repurchases were obtained from Thompson Reuters Datastream, one of the major and authoritative financial information providers.”
While we do not have any specific knowledge as to the reliability of the data sets used, from the above extract it is clear the researchers took specific measures to ensure their data was reliable and that the companies, markets and sectors examined were also appropriate.
5. Minimum market capitalization
No minimum market capitalization cut off for the securities examined in this study was mandated. Consequently, the inclusion of the smallest firms could have unduly influenced results as even when investing relatively modest sums the securities of the very smallest firms are virtually untradeable.
6. Human error
There is nothing specified in the research methodology that would make us believe this study is at greater risk of suffering from human error.
7. Journal rating/credibility[i]
This study was not, to our knowledge, published in a top tier academic journal and therefore cannot be granted the “additional credibility” that may come with such publication.
Reliability Assessment: Due to the relatively short time period (15 years), sample size concerns and the absence of a minimum market capitalization requirement for the securities examined the study does not appear to be reliable from a practitioner’s viewpoint.
Results and Analysis
Table 3 summarizing the relevant returns is reproduced below:
“Panel A shows the results of average market-adjusted BHAR on the Saudi Arabia stock exchange (Tadawul) in a period of 12, 24 and 36 months. The stock portfolios analyzed are those that comply with Graham’s primary and secondary stock selection criteria. The results were analyzed separately based on the two indices; EWI and VWI, The results of the t-test for the stock portfolios from the EWI index against BHAR was 2.9 (P = 0.01) and BHAR was 20.17% for the 1-year period; 4.87 (P = 0.01) and BHAR was 46.7% for the 2-year period; and 6.1 (P = 0.01) and BHAR was 83.47% for the 3-year period. These results indicate that the longer the investors hold the portfolios, the higher the abnormal return. Nevertheless, the results of stock portfolios from VWI demonstrated a slightly different scenario. The t-test result for the stock portfolios from the VWI against BHAR was 1.34 (not significant at P = 0.1) and BHAR was 8.62% for the 1-year period; 3.28 (P = 0.01) and BHAR was 27.69% for the 2-year period; and 3.31 (P = 0.01) and BHAR was 49.02% for the 3-year period. These results indicated that investors gained abnormal returns only after a year of investment, which signifies that the abnormal return was secured but requires a longer period of holding the portfolios.”
“The findings above illustrate that the NCAV/MV portfolios that were measured against the market benchmark of SAS-EWI significantly performed exceeding the expectation on average by +83.47% in the 3-year holding period. Correspondingly, when the NCAV/MV portfolios were measured against the market benchmark of SAS-VWI, they also demonstrated a positive and significant market-adjusted BHAR of +49.02% over the 3-year period, though the percentage of return was marginally lower. This situation indicated that smaller companies outperformed the larger companies on the Saudi Arabia Stock Market during the period of study.”
As we have done throughout this series on net nets we will examine how the returns were calculated and what they actually represent. In this study the authors explained the methodology they used to calculate returns:
“In analyzing the return, we focused on abnormal return, which is defined in this context as the difference between the actual return and the expected return of individual stocks in the portfolios. Despite Lyon et al. (1999. p. 198) reminding us regarding the use of buy-and-hold abnormal returns (BHAR), extensive literature supports the use of the BHAR method as it copes better with the effect of compounding than does cumulative abnormal return (CAR) (Ritter, 1991; Barber and Lyon, 1997), Fama (1998) also argued that compounding short-term returns to obtain long-term BHAR better captures long-term investor experience. In fact, using merely the average abnormal returns used in the CAR approach does not accurately measure returns to investors over the long-run period. In modern event studies, the most commonly accepted methodology is the BHAR approach. Therefore, this research adopts this method to evaluate the share return performance of NCAV portfolios over the long-run period. Ritter (1991) asserts that in minimizing the problem related to measuring portfolios, benchmarking those portfolios is vital. Therefore, we employ two market indices: Equal-weight index (EWI) and value weight index (VWI).”
Right, that is an extensive explanation, but what are “buy-and-hold abnormal returns (BHAR)”? In essence, in this instance, the BHAR represents the geometric mean return less the market return.
So, while equally weighting and holding 12 months produced a 20.17% BHAR the next question that comes to mind is, “what was the equally weighted market return that was outperformed by 20.17%”? Unfortunately, this was not reported.
It is worth reinforcing that value weighting (“VWI”) resulted in a materially lower BHAR implying that the smaller companies were driving the “abnormal returns”.
“Emerging Markets: Evaluating Graham’s Stock Selection Criteria on Portfolio Return in Saudi Arabia Stock Market” suffered from time period bias (15 years) and the sample size examined was particularly small. Significantly, no minimum market capitalization was specified for the securities examined. Consequently, the inclusion of all firms may have unduly influenced the results as even when investing relatively modest sums the securities of the very smallest firms are virtually untradeable. Furthermore, the market addressed possessed a capitalization of less than USD 400m raising further concerns with regard to liquidity. Also noteworthy is that regulatory restrictions during the study period would have prevented foreign investors from being able to access the potential opportunities.