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On the Persistence of a Market Anomaly:

The Performance of the Net Current Asset Value Strategy in the United States
1984-2008

University of Maastricht
Faculty of Economics and Business Administration
Maastricht, August, 2009
Oliemans, F.
i278408
International Business: Finance
Master Thesis
Mrs. Nadja Guenster
―Investing is most sensible when it is most businesslike‖
Benjamin Graham (N.D.)

"Ben's Mr. Market allegory may seem out-of-date in today's investment world, in which most
professionals and academicians talk of efficient markets, dynamic hedging and betas. Their
interest in such matters is understandable, since techniques shrouded in mystery clearly have
value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame
and fortune by simply advising 'Take two aspirins'?"

Warren E. Buffett (1987)

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Abstract

This thesis analyzes the performance and persistence of a net current asset value strategy. This
strategy analyzes a portfolio of firms that trade at a market discount to liquidating or net current
asset value The results show that the strategy was able to produce risk-adjusted returns over the
1984-2008 period that are in line with the study by Oppenheimer (1986). Based on the Carhart
(1997) four factor model the results show that the abnormal risk-adjusted monthly returns are
2,27% for value weighted and 1,73% for equal weighted returns. It is proposed that the abnormal
risk-adjusted returns are due to institutional constraints, a high individual cost basis and is
strongly influenced by behavioral biases.

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Table of contents

I. Introduction 5

II. Literature Review 7

III. Research Question and Hypothesis 18

IV. Data 21

V. Methodology 23

VI. Results 31

VII. Robustness Check 45

VIII. Conclusion and Implications 51

IX. Further Research 56

X. Limitations 56

XI. References 58

XII. Appendices 65

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I. Introduction

This thesis discusses the persistency of a potential market anomaly; stocks trading at a discount
to their net current asset value (NCAV). Discount net current asset value stocks offer a margin of
safety to equity holders, which gives substantial protection from further operating losses and loss
of principal in case of bankruptcy (Dodd and Graham, 2009). NCAV stocks are stocks whose
market value is trading at a discount to the current asset value after subtracting all liabilities and
claims. A purchase of a discount NCAV stock equates to buying stocks at a discount to
liquidating value. This is because current assets consist of inventories, receivables and cash
which can be distributed to shareholders without losing significant value (Dodd and Graham,
2009), (Whitman and Shubik, 2006). It is this discount that offers significant safety against loss
of invested capital while still exposing the equity holder to upside potential. A stock trading at
two thirds or less of NCAV already assumes bankruptcy and therefore any continuing positive
operating value is received at no cost. The strategy is a subset of the book/market anomaly
except that it includes only tangible current assets and therefore intrinsic value is easier to detect
(Fama and French, 1996). The strategy, first proposed by Dodd and Graham (2009), has shown
to produce risk-adjusted abnormal returns (Oppenheimer, 1986), (Bilsersee et al, 1993), (Arnold
and Xiao, 2008). It is proposed that the main reason for the risk-adjusted returns are due to
overreaction by investors and institutional constraints.

The main reason why this strategy needs to be revisited is to analyze the persistency of the
NCAV strategy. One of the tenants of the semi-strong form of market efficiency is, that
anomalies are inherently self-destructive, because public knowledge of the anomaly will increase
the funds allocated to the specific anomaly and reduce risk-adjusted abnormal returns (Malkiel,
2005). Furthermore according to the CAPM if a class of stocks trades above the security market
line (SML) it should be bought by investors as it has a highly favorable risk/return relationship.
Thus a rational investor armed with the evidence of the Oppenheimer study would buy these
stocks. If there are enough rational investors then this should reduce the abnormal returns
present and therefore this strategy should not show persistency. Evidence of persistency within
one market is not available for the anomaly and serves as the main reason why this strategy
should be revisited. Further arguments for this analysis are given next.

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This thesis serves as an expansion and update of the article by Oppenheimer (1986).
Oppenheimer (1986) studied the period from 1970 to 1983. This thesis analyzes the period from
1984 to 2008. There are important differences between the two sample periods. 1970 to 1983
was a period when stock prices were trading at relatively low multiples and lower market to book
values (Oppenheimer, 1986), (Shiller, 2005). During the late 1980‘s until the early 21st century
the stock market experienced a long run bull market. The bull market of this period increased the
average price paid for securities when measured by the 10 year rolling price to earnings ratio
(Shiller, 2005). Bildersee et al (1993) showed that there is a reduction in the both the availability
of discount NCAV stocks as well in the returns generated during a long-run bull market in
United States. The advent of behavioral finance during the last two decades has given the public
knowledge about psychological deviations from rational decision making. The knowledge
could have been used to exploit market anomalies and reduce overall returns to the NCAV
strategy. Finally Oppenheimer (1983) limited his risk-adjusted analysis to the basic CAPM
model. This model has since been proven to be an inadequate asset pricing model (Fama and
French, 1996). Thus the results by Oppenheimer (1986) could be due to a model specification
error and not true market inefficiency. This thesis adds to the discussion of this anomaly by
including several expanded asset pricing models. The Fama and French three factor model as
well the Carhart four factor model are used as the basis for testing the strategy (Fama and
French, 1996), (Carhart, 1997). The Chen and Zhang (2009) and Cremers et al (2008) models are
used as robustness checks to confirm the results. This should reduce the model specification
error. To test whether the discount NCAV anomaly has shown persistency over the 1984-2008
period the following research question is set up:

What is the performance of the Net Current Asset Value Strategy versus the broad based U.S.
indices 1984-2008?

Persistent abnormal risk-adjusted returns will further support the evidence for this anomaly and
potentially provide a profitable strategy for investors.

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To answer this question the following structure is setup: Chapter II discusses the prevalent
theory. Chapter III details the hypotheses that are set up. Chapter IV and V discusses the data
and the methodology used. After this section the results are presented in chapter VI . Section VII
provides a robustness test The thesis continues with a conclusion and implications section in
chapter VIII. Further research is discussed in chapter IX, limitations in X and finally references
are given in XI. The literature and theoretical foundation are discussed in the next section.

II. Literature Review:

This thesis examines the persistency of a market anomaly; stocks trading at a discount to net
current asset value. A firm trading at such a discount can be purchased for a price less than the
book value of the sum of inventories, receivables and cash after subtracting all liabilities (Dodd
and Graham, 2009). This naturally implies that discount NCAV stocks also trade at a market
discount to book value. The book/market anomaly is a well documented anomaly and is
incorporated into the Fama and French three factor model (Daniel and Titman, 1992), (De Bondt
and Thaler, 1985), (Fama and French, 1996), (Lakonishok et al, 1992). The discount NCAV
strategy is a subset of the market/book anomaly and therefore the explanations as well the origins
of the market/book anomaly are important to understand. The theory will allow the reader to
understand why persistency of the discount NCAV strategy can occur and why this strategy is a a
direct test of the market/book anomaly. The first step is to analyze the origins of this anomaly
and this is done by first reviewing the basic CAPM model.

The CAPM model introduced by Sharpe (1964) and Treynor (1961), and extended by Lintner
(1965a;1965b) is the first widely accepted model that determines the theoretically appropriate
required return of an asset. It determines the rate of return by taking into account the assets
sensitivity to non-diversifiable risk. This risk, termed beta, measures the covariance of the asset
with respect to the market compared to the overall variance of the market. The higher the Beta
the higher the non-diversifiable risk of the stock. A higher beta is equal to higher volatility with
respect to the market. Thus a stock that has a beta of two is twice as volatile with respect to the
market and is deemed to be twice as risky. The CAPM assumes that investors perceive volatility
as the main risk factor and then assumes that this is linked to expected returns. In the case of a
beta of two the CAPM predicts returns that are twice the market return after subtracting the risk

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free rate. The early empirical results provided by Sharpe (1964) and Treynor (1961) were
promising but later research did not confirm the results. Fama and French (1992) stipulate that
the beta is insufficient in explaining expected returns between 1941 and 1990. To improve upon
the standard CAPM model Fama and French (1993) introduce their three-factor model.

The three-factor model proposed by Fama and French (1993) included the standard CAPM but
expanded to model to include two more factors. These two factors are the Small Minus Big
factor (SML) and the High Book to Market minus Low Book to Market factor (HML). The first
factor captures the returns generated by small size firms and the second the excess returns of
high book to market stocks versus low book to market stocks. Fama and French (1993) offer a
rational explanation for the occurrence of these anomalies. The SML factor is explained as being
due to co variation in the returns of small stocks that is not captured by the market returns and is
compensated in average returns (Fama and French, 1993). A distress explanation is given for the
second anomaly, the HML factor. Fama and French (1993) propose that distress is linked to
human capital, which they state to be important to most investors. An employee in a firm under
distress will be unlikely to hold capital in the firm since the returns generated from his human
capital are at stake as well. This means that employees of distressed firms have an incentive not
to own capital in their own firm. Although the strategy is logically appealing Daniel and Titman
(1997) found evidence that the covariance‘s did not change after the firm became distressed. The
NCAV strategy is an extreme test of the HML factor and therefore the different explanations for
this anomaly are discussed further.

Fama and French (1993) were able to explain a significant degree of cross-sectional returns by
using their three-factor model. Their argumentation is based on rational behavior which not
supported by the evidence (Daniel and Titman, 1997). Another argument made for explaining
the HML factor is behavioral. Behavioral finance assumes that humans do not under all
circumstance behave rationally and this leads to systematic deviations in stock market returns
Hirsleifer (2001). The first article relevant to the behavioral explanation of the HML factor is
the article by de Bondt and Thaler (1985). Their findings show that investors overreact to past
information and extrapolate into the future. This causes past losers to outperform past winners.
De Bondt and Thaler (1985) claim that individuals do not adhere to Bayes‘ rule but rather

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overweight recent data and underweight prior data. This is in accordance to the representative
heuristic proposed by Kahneman and Tversky (1979). Where a heuristic is rule of thumb
individuals use to make decisions and representativeness is equated to using recently available
data. It is this phenomenon, that according to the De Bondt and Thaler (1985) causes the
outperformance of loser portfolios compared to winner portfolios. Fama and French (1993) state
that high book to market stocks are stocks have recently underperformed the market and is in line
the loser portfolio of De Bondt and Thaler (1985). As the De Bondt and Thaler (1985) article
was written before the Fama and French (1993) study, it fails to specifically address the HML
factor from a behavioral perspective. Lakonishok et al (1994) build on the De Bondt and Thaler
(1985) article to explain, among other anomalies, the HML factor on the basis irrational
behavior. Lakonishok et al (1994) state that value investors such as Dodd and Graham (2009)
have been able to outperform the market but that the reasons for this mispricing is not clear.
Their results confirm this last statement and they conclude that investors consistently
overestimate future growth rate of glamour stocks relative to value stocks. Lakonishok et al
(1994) argue that while there might be a metaphysical risk attributed to value stocks, the
evidence suggests a more straightforward model. They do not mention the rational distress
argument. The gap between value and glamour stocks is 10 percent per year and can be
explained due to systematic behavioral deviations and institutional constraints. Individual
investors might extrapolate past growth rates which are highly unlikely to persist in the future.
This is again evidence of the representative heuristic of Kahneman and Tversky (1979). Investors
could also view well-run firms as being equal to good investments and buy glamour stocks they
believe they cannot lose money on. According to Lakonishok et al (1992) institutional investors
suffer from the same bias towards glamour stocks because they are deemed to be prudent
investments. Although investing in prudent glamour stocks earns lower returns it can be a
rational strategy for a money manager unwilling to put his job on the line advocating stocks that
have done poorly in the past. The third and final factor is the short time horizon of most
investors. Investors often seek short term abnormal returns within months instead of 4 percentage
point over the course of 5 years. This is in line with the argument of practitioners, who claim that
time arbitrage will allow for abnormal returns (Pabrai, 2007). Institutional investors might have
even shorter time horizons due to their competition with other money managers to beat the
market because they can lose their jobs if they underperform over the short run. The overall

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conclusion drawn by Lakonisk et al (1992) is the tendency of investors to make judgmental
errors and tendency of institutional investors to tilt their portfolios toward glamour stocks to
make their life easier. The overall conclusion of the market/book anomaly can now be drawn.

The market/book factor was introduced to help explain the lack of explanatory power of the
traditional CAPM model. Fama and French (1993) posited a rational distress explanation for the
anomaly but the evidence reported by Daniel and Titman (1997) did not support the distress
situation. The behavioral explanation provided by Lakonishok et al (1994) reports that
overreaction, institutional constraints and a short term horizon are likely to cause the systematic
deviation between price and value in the case of the HML factor. The behavioral explanation is
rooted in experimental psychology Kahneman and Tversky (1979) whereas the institutional
constraints were investigated in Lakonishok et al (1992). The evidence for the irrational and
institutional constraints hypothesis is, according to the author, stronger than the rational
explanation. This thesis tests the persistency of these systematic deviations from an underlying
risk/return relationship. It does so specifically for the market/book value but on the basis of only
tangible current assets. To test the persistency of systematic deviation from underlying value, a
discussion is required of how to measure this value.

In order to compare the value of stock prices to the stated market price a definition is required.
The definition used in this thesis is intrinsic value. Lee et al (1997), state that there is widespread
consensus among financial economists that intrinsic value is equal to the present value of its
future dividends and cash flows. According to Lee et al (1997) there are only few studies
focusing on the problem of intrinsic value. They claim that academics view the securities price as
the best estimate of intrinsic value and view fundamental analysis as a futile exercise. This is in
line with the EMH, which states that if a market is semi-strong form efficient fundamental
analysis is useless (Malkiel, 2005), (Beechey et al, 2001). The issue with this is of course that
among others, Lakonishok et al (1992) have found widespread abnormal returns on the basis of
valuation criteria. Thus the securities price is not necessarily equal to intrinsic value otherwise
there would be a constant risk/return relationship, which evidence has proven not to be the case.
Therefore a model for measuring intrinsic value is required.

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Frankel and Lee (1996) posit that the basis for measuring the intrinsic value of the firm is book
value as well as expected earnings. Campbell and Shiller (1988) base their calculation solely on
earnings to predict future dividends. Penman and Sougiannis (1997) do so on the basis of
residual income. These three models have in common that they rely on the facts provided by
accounting figures to provide a measurement of intrinsic value. If these models are correct in
valuing a firm then firms trading below this price would yield abnormal returns whereas firms
trading above this price would yield subnormal returns. If this occurs then this implies an
inefficient market. The HML factor is linked to intrinsic value because book value is part of the
value of the firm . (Frank and Lee, 1996). Book value can be used to generate cash flows to the
shareholders if the firm is (partially) liquidated or if the assets are sold off. Thus a correct model
of pricing intrinsic value should pick up on high market/book stocks because these stocks would
have a higher intrinsic value than the current market price. It is this discrepancy between intrinsic
value and market price that causes the eventual abnormal returns for the high market to book
firms.

The models of intrinsic value provided by mainstream academics is in line with Dodd and
Graham (2009), the originators of the NCAV strategy and more importantly the concept of
intrinsic value. They state that the intrinsic value of a security is determined by facts. Among
these facts are the assets, earnings, dividends, definite prospects and others. In line with the
belief that there is an independent intrinsic value to firms, they argue intrinsic value is
independent from the current market price. It is said that the calculation should not include the
price quotation because it can fluctuate on the basis of psychological excess, which is in line
with the arguments provided by Lakonishok et al (1992). Where Dodd and Graham (2009) and
practitioners as Warren Buffett (2009) differ from mainstream academia is that the calculation of
an intrinsic value based on the facts is an inherently imprecise calculation. The stated book
values can be worth less than the actual book values or the past earnings can prove to be
inherently unreliable in predicting the future. Buffett (2009) and Dodd and Graham (2009) note
that the higher the uncertainty of the business the higher the uncertainty of the intrinsic value of
the common stocks and underlying business. Therefore a calculation of intrinsic value entails a
range of estimates of the discounted cash flows that can be received from the firm. It is claimed
by Dodd and Graham (2009) that it is not necessary to achieve a precise figure in order to

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purchase a security. What is needed is for a range of estimates to be sufficiently below the
current market prices to warrant a purchase and to satisfy the safety criteria proposed by
Graham. Note that this last statement requires the market to inefficient otherwise no such safety
criteria would exist. In line with Frankel and Lee (1996), Campbell and Shiller (1988) and
Perman and Sougiannis (1997), Buffett (2009) believes that valuations are done on the basis of
valuing a firm as a private business owner and comparing that to the current market price. From
the perspective of Graham (2003) and Buffett (2009) the stock price is merely a benchmark one
can use to compare the valuation of the business with. They also state that higher volatility
reduces risk because it allows the investor to buy a larger portion of the same firm at a lower
price.

The models of intrinsic value argue there is a definite value to firms which can be derived from
publicly available information. This value is closely related to the HML factor because book
value is part of the intrinsic value of the firm. Thus in most cases the larger the market to book
value the larger the discrepancy between intrinsic and market value. The original concept of
intrinsic value was introduced by Benjamin Graham (2003) and he considered there to be a
strong relationship between net current asset value and intrinsic value. This implies that if firms
trade at a discount of market/net current asset value there is a discrepancy that will cause
abnormal returns to be generated in the future. To analyze why net current asset value is closely
linked to intrinsic value a discussion is given next.

First proposed by Dodd and Graham (2009), the Net Current Asset Value approximates the
liquidation value of the firm. Net Current Asset Value is calculated by taking current assets and
subtracting all short and long term liabilities. Long term assets are not included. This total net
current asset value is divided by the shares outstanding which gives the net current asset value
per share. If the current market value per share is lower than the NCAV per share then this
security is trading at a discount to NCAV. According to Graham, stocks that trade at a sizeable
discount to their NCAV should be profitable if sold to another firm or liquidated. A discount
NCAV stock can be seen as an inherently low risk strategy because the tangible book value
should already produce a profit for the investor. Dodd and Graham (2009) explain that no private

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business owner would sell their assets at such a low price to another investor. In one of his last
interviews Graham (1976) is quoted as saying this about the NCAV strategy:

―<The NCAV strategy> appears severely limited in its application, but we found it almost
unfailingly dependable and satisfactory in 30-odd years of managing moderate-sized investment
funds..

I consider <the NCAV strategy> a foolproof method of systematic investment--once again, not
on the basis of individual results but in terms of the expectable group outcome.‖

The EMH predicts that stocks that trade at distressed prices incorporate extra risk (Fama and
French, 1996). If a firm trades at a discount to NCAV, the EMH predicts that the firm will
continue to diminish the capital base of the corporation. A gradual reduction in firm value due to
poor business economics or mismanagement causes investors to price the share at a discount to
NCAV.
Dodd and Graham (2009) argue that there are several developments that can take place to
prevent this gradual reduction. A gradual reduction may occur but is unlikely to do so because;

1. The earnings power of the firm can increase. When earnings go up the return on assets will
increase thereby often increasing the share price. A business or industry with a record of low
profitability can improve because competition is reduced or the economics of the business
improve. A mean reversion to normal levels of returns often occurs according to Dodd and
Graham (2009). Another reason for an increase in earnings is due to a change in operating
policy. Unprofitable businesses can be closed down or (new) management can change the
strategy of the business. This can either be done voluntarily or they can be forced to change their
policy by the shareholders.

2. The firm might be sold to a competitor who is able to utilize the assets more efficiently than
the current operators. The competitor will at least pay the liquidation value of the assets.

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3. The discontinuation of the business. The firm is already trading at a discount to NCAV and
therefore liquidation would be profitable. This liquidation would release the value of the tangible
current assets.

If a diversified group of discount NCAV stocks is purchased there is a high probability that the
value of the discount will be unlocked. The amount of liquid assets limits the downside risk in
case of a bankruptcy while leaving the very real chance that the earnings power of assets will
increase. Although some discount NCAV firms will continue to diminish the assets of the
stockholder, the forces counteracting this trend should lead to satisfactory results within a
diversified portfolio of discount NCAV stocks.

In the case of a discount NCAV stock the intrinsic value is very likely to be higher than the
current share price. According to Dodd and Graham (2009) it is irrational to trade below
liquidating value because it assumes that continuing business operations have an overall negative
effect on the firm. The liquidating value is equal to a discount to net current asset value of at
least 1/3. While the continued diminishing of assets might occur occasionally, the author
considers this discrepancy to be due to behavioral and institutional constraints (De Bondt and
Thaler 1985), Lakonishok et al (1994).

The unique aspect of this test is that it is very straightforward to observe that the pricing of the
stock is irrational. This can also be the case for firms trading below M/B value but this value can
contain illiquid assets or intangible assets that do not hold value or cannot be liquidated without
continuing operations. It could be the case that long term assets have far higher book values than
true economic value. The NCAV strategy only takes into account current assets and does not
include assets that are difficult to value. This implies that it is a direct test of these phenomena
and a test of deviations from intrinsic value. The arguments advocating why a NCAV should pay
off have now been given. The next section will discuss the previous tests of the strategy.

Graham, the first known advocate of the strategy, has never released the official data but claims
to have produced returns equal to 20 percent over a 30 year period with this strategy (Graham,
1976). This is well in excess of the market returns over this period. Since Graham has not

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released his results, I will rely on the scarce academic tests that are available. The research that
is available shows positive abnormal risk adjusted returns if there are enough discount NCAV
stocks available to form a representative portfolio. This section will summarize the three papers
that, to the authors‘ knowledge, have been written about the topic. This thesis serves as an update
and expansion of the paper written by Oppenheimer (1986). Therefore this paper will be
discussed first.

Oppenheimer (1986) undertook this analysis during the 1970-1983 period in the United States.
He undertook this study because of the lack of academic analysis on this topic. The research was
limited to the United States, as is this thesis. The results show that the 13-year risk adjusted
returns were significantly greater than the market portfolio returns. The mean monthly returns for
this period were 2,45% for the NCAV portfolio whereas the NYSE-AMEX and the Small Firm
indices produced 0,96% and 1,75% respectively. Over this period a discount NCAV portfolio
worth 10,000 dollars would have grown to 254,973 dollars whereas the NYSE-AMEX index
grew to 37,296 dollars and the small-firm indices to $101,992 dollars. Taking into account risk-
adjusted returns the NCAV portfolio outperformed the NYSE-AMEX by 19% on a yearly basis
and the small firm index by 8%. These results were achieved by buying a portfolio of securities
that is at most two thirds of NCAV. The results also show that the lower the purchase price and
therefore the higher the discount to NCAV the higher the abnormal risk adjusted returns are.
Graham (2009) stated that in order to achieve adequate risk adjusted returns the firms should be
relatively profitable and have consistent dividends. Oppenheimer (1986) claims that this
argument does not hold for this specific sample. Firms without positive earnings and profitable
firms omitting dividend payments show higher returns. The overall results shows that discount
NCAV firms are able to produce consistent abnormal risk adjusted returns and that the degree of
undervaluation is important. Although not discussed by Oppenheimer (1986) one can argue that
the greater the undervaluation the greater the effect of the representative heuristic, regret
aversion and hindsight bias. This thesis will research the US stock market during the period from
1984-2008 to analyze if the discount NCAV strategy continued to produce abnormal risk-
adjusted returns. Although the US market will be investigated, other markets have been tested as
well.

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Bildersee et al (1993) examined the performance of Japanese common stocks in relation to their
NCAV. They wanted to research whether the discount NCAV strategy held in a country which is
different from the United States. Their sample ranged from 1975 until 1988. This sample
coincides with one of the largest bull markets of the past century. During this period the number
of firms trading below NCAV was almost non-existent and therefore they test all firms which
traded at values of 1,5 NCAV. This allowed a representative portfolio to be formed. The authors
posit that the lack of discount NCAV stocks is due to structural difference but it can also be due
to the large bull market which increased the prices of all stocks. A less stringent test implies that
the underlying value is not as a liquid and the value of the balance sheet is less certain. Even
though the authors had to stretch the parameters the results still showed that the NCAV strategy
produced abnormal risk adjusted returns. The results are not as robust as the Oppenheimer study.
The results are dependent on the holding period of the sample. This thesis also tests a period with
relatively high valuations and it will be interesting to see if there are enough discount NCAV
stocks available in the United State from 1984-2008. The last paper discusses a more recent test
of the NCAV strategy in London.

The working paper by Arnold and Xiao (2008) analyzes the NCAV strategy in London from
1981 until 2005. This paper is interesting because it analyzes a liquid stock market during a
period of high stock returns. The sample period partially overlaps the sample of this thesis and
the London market is almost as liquid as the United States stock market. The results show that
stocks trading at a discount to NCAV value produce significantly positive market-adjusted
returns. The results are up to 19,7% percent per year. The authors conclude that the results are
not due to the ‗size effect‘ and nor is the CAPM and the Fama and French three-factor model
able to explain the results. They conclude that the premiums that these stocks provide can be due
to irrational pricing by investors.

The three articles that have analyzed the NCAV strategy show that this strategy is able to
produce abnormal risk adjusted returns. Each article analyzes a different market and a different
time period. The NCAV strategy produces positive abnormal returns regardless of the location of
the market or the pricing of the stock market. It is interesting to note that the higher the overall
price level of the market the fewer opportunities there are to invest in discount NCAV stocks.

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The article by Bildersee et al (1993) showed that there were not enough discount NCAV stocks
available to form a portfolio during the bull market in Japan. The authors stretched the original
criteria to select stocks that were trading at relatively low premiums to NCAV. These stocks still
produced abnormal risk adjusted returns but the results were not as robust when compared to the
articles by Oppenheimer (1986) and Arnold and Xiao (2008). Overall one can conclude that the
results of these three articles provide evidence that the NCAV strategy produces abnormal risk-
adjusted returns.

Conclusion of the literature review:

The literature review has shown that traditional volatility is insufficient in explaining the
expected returns of stock market returns. By expanding the model to include other factors the
predictability is improved, but evidence by Daniel and Titman (1997) has shown that the
rational risk argument posited by Fama and French (1993) is insufficient. Lakonishok et al
(1994) argue that investors are not pricing in extra risk but that the returns are due to investor
irrationality and institutional constraints. These arguments give credence to the outperformance
of high book/market stocks. It is proposed that these stocks have an intrinsic value that is higher
than the market price. Academics, as well as very successful practitioners have attempted to
measure intrinsic value but have difficulty in estimating a single value due to the uncertainty of
future earnings (Buffett, 2009), (Dodd and Graham, 2009), (Frankel and Lee, 1996). The NCAV
strategy offers a unique measurement of intrinsic value because it takes into account only liquid
current assets which are easy to value and more importantly easy to convert to cash. The HML
factor also takes into account tangible and intangible long term assets which may or may not
have a definite value. Thus the NCAV test is a more thorough test of the systematic deviations
based on behavioral biases and institutional constraints. The literature review has given the
reader insight into the relevance of the NCAV strategy as a test of intrinsic value and systematic
deviations from the risk/return relationship. The next chapter will explain the need for this study
and why there should be a persistency test of this anomaly.

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III. Research Question and Hypothesis

Oppenheimer (1986) analyzed the NCAV performance in the United States between 1970 and
1983. This study showed the strategy yielded abnormal risk-adjusted returns. The main reason
why this strategy needs to be revisited is to analyze the persistency of the NCAV strategy. One
of the tenants of the semi-strong form of market efficiency is, that anomalies are inherently self-
destructive, because public knowledge of the anomaly will increase the funds allocated to the
specific anomaly and reduce risk-adjusted abnormal returns (Malkiel, 2005). No evidence is yet
available on the persistency of the anomaly and this thesis aims to provide this evidence. A test
of persistency is important, especially because of the differences between the two sample
periods.

1970 to 1983 was a period when stock prices were trading at relatively low multiples and lower
market to book values (Oppenheimer, 1986), (Shiller, 2005). During the late 1980‘s until the
early 21st century the stock market experienced a long run bull market. The bull market of this
period increased the average price paid for securities when measured by the 10 year rolling price
to earnings ratio (Shiller, 2005). Bildersee et al (1993) showed that there is a reduction in the
both the availability of discount NCAV stocks as well as in the returns generated during a long-
run bull market in Japan. If the same relationship holds in the United States then the results will
not be persistent.

The release of the article by Oppeheimer (1986) provided the public information about the
lucrative returns of this strategy. According to the EMH this public knowledge should reduce the
abnormal returns as more funds are allocated to inefficient strategies (Malkiel, 2005).
Furthermore according to the CAPM if a class of stocks trades above the security market line
(SML) it should be bought by investors as it has a highly favorable risk/return relationship. Thus
a rational investor armed with the evidence of the Oppenheimer study would buy these stocks. If
there are enough rational investors then this should reduce the abnormal returns present and
therefore this strategy should not show persistency.

18
The advent of behavioral finance during the last two decades has given the public much
knowledge about psychological deviations from rational decision making. The knowledge could
have been used to invest more money in value stocks and increase the public interest in
anomalies such as the discount NCAV strategy. Finally Oppenheimer (1986) limited his risk-
adjusted analysis to the basic CAPM model. This model has since been proven to be an
inadequate asset pricing model (Fama and French, 1996). Thus the results by Oppenheimer
(1986) could be due to a model specification error and not true market inefficiency. The factor
that should reduce the abnormal returns is the HML factor, of which the NCAV strategy is a
subtest. NCAV stocks intrinsically trade at a deep discount to market value and therefore it is
important to know whether the HML factor is able to explain the returns of this strategy. This
thesis adds to the discussion of this anomaly by including several expanded asset pricing models.
The Fama and French three factor model as well the Carhart four factor model are used as the
basis for testing the strategy (Fama and French, 1996), (Carhart, 1997). The Chen and Zhang
(2009) and Cremers et al (2008) models are used as robustness checks to confirm the results.
This should reduce the model specification error. In order to test whether the discount NCAV
anomaly has shown persistency over the 1984-2008 period the following research question is set
up:

What is the performance of the Net Current Asset Value Strategy versus the broad based U.S.
indices 1984-2008?

To analyze this persistency, the stocks will be selected at a 2/3 of MV/NCAV value if there are
sufficient stocks available. The value of 2/3 of MV/NCAV is selected because this is the value
originally prescribed by Dodd and Graham (2009). This value offers considerable safety from
loss of capital. If the amount of available 2/3 MV/NCAV stocks is below 5 then a portfolio of
MV/NCAV discount stocks is selected instead. The selection is only done if there are not a
sufficient amount of stocks available to form a portfolio and therefore the next best option is
selected. A robustness check is also run to test the performance of all stocks trading at a discount
to NCAV. Depending on the sufficient availability of discount NCAV stocks, it is expected that
the stocks will continue to deliver abnormal risk-adjusted returns. The arguments for the
expected abnormal risk adjusted returns are given next.

19
During a long-run bull market risk-adjusted returns are expected to continue because of the
safety from loss of principal inherent in a portfolio of discount NCAV stocks (Dodd and
Graham, 2009). The article by Oppenheimer (1986) could have caused more money to be
invested in NCAV stocks but as the publication was 22 years ago, it is not expected to have
greatly influenced the returns of NCAV stocks. The publication could have caused a decrease in
the availability of NCAV stocks, thereby eliminating the strategy as a possibility but is not
expected to do so for the whole sample period. The public knowledge might have caused a
temporary switch in investment strategies but over the long run it is believed that behavioral
biases and institutional constraints will prevail as they are inherent to human nature and industry
design. The advent of behavioral finance has given the public information about systematic
deviations in human nature. Behavioral funds have been launched by academics to profit from
this deviation (Lakonishok et al 1993), (Haugen and Baker ,1996). It is not expected that these
funds will have an impact on the NCAV strategy, because the strategies differs from the
approach of the LSV and Haugen funds. Although public knowledge is available about
systematic deviations from rational behavior, it is not expected that investors as a group will be
able to change their behavior. Indeed the book/market anomaly has performed strongly from
1977-2004, even with the knowledge available to the public (O'Shaughnessy, 2005). As this
thesis is an extreme test of the book/market anomaly, the results are expected to be in line with
the book/market anomaly. Finally, the results of the study by Oppenheimer (1986) could be due
to model misspecification. It is not expected that the introduction of improved asset pricing
models will significantly reduce the abnormal risk-adjusted returns. The study by Arnold and
Xiao (2008) showed that the NCAV strategy still produced abnormal risk-adjusted returns when
using the Fama and French three-factor model (Fama and French, 1996). The above given
arguments make a clear case for why the NCAV strategy should continue to produce risk-
adjusted abnormal returns during the 1984-2008 period. This leads to the following main
hypothesis:

H1 (a) A portfolio of stocks trading at a discount to Net Current Asset Value yields abnormal
risk-adjusted returns during the period of 1984-2008.

20
Using the arguments given, It is expected that the strategy will yield abnormal risk-adjusted
returns. Various tests will be run to detect whether or not stocks trading at a discount the their
Net Current Asset Value conform to expectations.

This main purpose is to test the performance of the discount NCAV portfolio. One of the reasons
why the topic requires an update is the long bull market during the sample period. It is expected
that higher relative stocks prices will lead to a lower amount of discount NCAV stocks. Discount
NCAV stocks are stocks that have a depressed value and a higher overall stock market is
predicted to lift the prices of all stocks and reduce the availability of NCAV stocks. The ancillary
hypothesis is:

H2 (a) Higher relative stock market prices leads to fewer discount NCAV stocks available for
purchase

To test the main and ancillary hypotheses the data and methodology will need to be explained
next.

IV. Data

The data for this thesis is segmented into three parts :


1. Financial Statement and Monthly Stock Return data
2. The gathering of comparable index returns and factor loadings to run the required analysis
3. Data with respect to the relative price of the stock market required to answer the ancillary
hypothesis.

1. Financial Statement and Monthly Stock Return data

The sample period of this thesis lasts from June 1984 until December 2008. The data selected
covers three markets in the United States, the NYSE, AMEX and NASDAQ. The United States
was chosen as it is the world‘s most liquid market with strong financial regulation to prevent

21
erroneous reporting. This is in line with the study by Arnold and Xiao (2008). Stock market
returns were retrieved from the CRSP (Center for Research in Security Prices). Financial
accounting data was retrieved from COMPUSTAT. The data was merged using the CUSIP
identifier. There are some differences between COMPUSTAT and CRSP with respect to the
CUSIP identifier but after a random sample analysis of the data, the impact was concluded to be
negligible. See limitations for a further explanation. The dataset includes only domestic
companies as international regulating standards might differ and this thesis attempts to analyze
only the United States stock market. I have excluded financial firms from the analysis due to the
high leverage ratios that are inherent to this industry, also in line with Arnold and Xiao (2008).
High leverage reduces the margin of safety concept proposed by Benjamin Graham. It does so
because a relatively small fluctuation in the value of assets and/or liabilities can eliminate the net
current asset value of the firm.

The COMPUSTAT data contains identifying information as well as the required balance sheet
information. The required balance sheet data are: All Current Assets (ACT), All Liabilities (LT)
and Preferred Stock/Preferred Capital stocks (PSTK). The CRSP data includes the price of the
stock (PRC) and the number of stocks outstanding (SHROUT) This data was merged using the
CUSIP identifier as well the date. Extensive definitions can be found in appendix 1. The exact
selection criteria for both COMPUSTAT and CRSP can be found in appendix 2.

Factor data

The risk free rate were downloaded from the Kenneth French site
(http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html). The risk free rate is
the 30 day treasury bill rate. The factor loadings for the Fama and French three-factor model
(1992) and the Carhart (1997) momentum factor were downloaded from the Kenneth French site
(http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html). The data for the
Chen and Zhang (2009) model is retrieved from the personal site of Lu Zhang
(http://apps.olin.wustl.edu/faculty/chenl/linkfiles/data_equity.html). The Cremer et al (2008) is
retrieved from the personal site of Antti Petajisto (http://www.petajisto.net/data.html).

22
The factor loadings for the various asset pricing models are compatible with the NCAV dataset
as they cover the same sample period and the same equity market.

Relative stock market price data

The 10 year price to earnings ratio was retrieved from the website of Robert Shiller.
(http://www.econ.yale.edu/~shiller/data/ie_data.xls). Although this dataset measures the
price/earnings ratio of the S&P 500 instead of the NYSE/AMEX/NASDAQ, the author is of the
opinion that the S&P 500 gives representative measurement of the overall pricing of the
American market and can therefore be used to analyze the effect that the 10 year rolling P/E ratio
has one the amount of NCAV stocks available.

V. Methodology

This section will explain the methodology that is used to analyze the retrieved data. The
calculations and procedures required to achieve the results will be discussed in sequence. The
methodology is for a large part in line with the procedure adopted by Arnold and Xiao (2008).

1. Total Stock and NCAV Portfolio Count

The merged data from CRSP and COMPUSTAT allowed for the calculation of the total stock
sample from which the NCAV portfolios were formed. This excluded all financial firms and only
took into account domestic firms. Domestic firms are firms which are incorporated in the United
States and operate from the United States. ADRs and firms with only a stock listing in the United
States are therefore excluded. The total stock count is equal to all stocks remaining in the sample
which was repeated for every year.

To count the amount of NCAV stocks in a given year, the NCAV portfolios needed to be
formed. The selection criteria is based on stock trading at a 1/3 discount to Net Current Asset
Value as well as the total sample of a NCAV discount NCAV stocks (NCAV < 1). The 1/3
discount is taken because this was prescribed by Benjamin Graham as his original strategy (Dodd

23
and Graham, 2009) In order to calculate this value, the following data from the merged dataset is
required; Stock Price (PRC), number of shares outstanding (SHROUT), all current assets
(ACT), all liabilities (LT) and preferred/preference stock (PSTK). The balance sheet data is
taken from the previous year and is coupled to monthly stock price data starting in June 1984 and
ending in May 2008. This procedure is then repeated for the length of each holding period (one
year, three years or five years) To arrive at a value for NCAV the following calculations are
done:

This calculation is in line with the original formula prescribed by Dodd and Graham (2009).

These three calculations lead to a ratio which gives the market value relative to its Net Current
Asset Value. This leads to a total overview of discount stocks as well the total selected sample of
stocks trading on the AMEX/NYSE/NASDAQ. The next step is to calculate the raw returns for
each year.

2. Yearly Returns NCAV Portfolio versus NYSE/AMEX/NASDAQ

To give an overview of the returns generated by the NCAV portfolios, the yearly holding period
returns are calculated. The NCAV portfolio are formed at the beginning of June and held until
the end of May. The main test is run using stocks that trade for at least a 1/3 discount to NCAV.
If there are less than 5 stocks available that meet this criteria then a portfolio is formed on the
basis of stocks trading at an absolute discount to NCAV. This would be the total sample of
discount NCAV stocks instead of the selection of discount NCAV stocks trading at at least a
discount of 1/3. The robustness check analyzes this total sample. The weighing is done on an
equal and value weighted basis. The holding period returns are calculated using monthly returns.
To achieve holding period returns the following calculation is applied:
24
This is done for each stock that meets the requirements of the NCAV portfolio. By performing
these calculations the holding periods returns for a specific year are arrived at. Following this the
weightings of the portfolios are calculated. The equal weighted returns are calculated by adding
all the holding period returns for the stocks in the NCAV portfolio. Equal weighted portfolios
are calculated as follows:

The value weighted portfolio is calculated by multiplying the holding period return for an
individual stock in the NCAV portfolio with the market value of the stock. This value is then
divided by the total market value of the NCAV portfolio. By adding up all the market weighted
returns for the individual stocks, the returns for the portfolio are arrived at. The calculation is as
follows:

This gives the holding period return for the total portfolio of discount NCAV stocks for each
period on a value and equal weighted basis. This data gives an overview of the raw returns, it
does not give any information about the relative performance of stocks vis-à-vis the market or
about mean returns of the different holding period returns. The setup of this analysis is discussed
next.

3. Cumulative Portfolio Returns for Different Holding Periods.

25
The next analysis is used to get an overview of the overall mean return of the NCAV strategy.
There are three main holding periods: A 1 year, 3 year and 5 year holding period. All holding
periods are created at the beginning of June until the end of May at the end of the holding
period., The mean return for the specific holding period is calculated. Thus in the in the case of
the 1 year holding period, all 24 years are used in the calculation of the mean returns (where year
1 is p1, year 2 is p2). For the other holding periods the same procedure is used, but with fewer
different holding periods. The formula for the geometric mean for the Equal Weighted returns
and Value Weighted returns is as follows:

After this a t-test is run see if the returns are significant. This is done by applying the following t-
test formula. The raw returns and the statistical significance give an indication statistical
significance of the returns that can be generated by holding a diversified portfolio of NCAV
stocks. It does not however give any indication of the risk profile of such a stock. Before
continuing with a risk analysis, the standard deviation is analyzed.

4. Standard deviation of Portfolio and Market

A calculation of the standard deviation will show the relative dispersion among the mean. It
implies risk but only in so far as the mean of the portfolio is similar to the market. If this mean is
significantly higher then any downward risk will still yield higher returns than the portfolio.
Thus caution needs to be taken when comparing the results. The next step is to calculate the
CAPM.

5. CAPM

26
The first analysis that incorporates risk adjusted returns, utilizes the standard asset pricing model;
the capital asset pricing model. The risk-adjusted returns are calculated on the basis of monthly
returns. The following CAPM model is set up analyze both value weighted and equal weighted
returns. Once the results have been calculated the following regression is run:

Rit R ft ai bi ( RMt R ft ) eit

On the left hand side of the equation R ft is the monthly risk free rate, Rit is the monthly return

generated by the portfolio. On the right hand side of the equation, ai is the alpha. bi is the

sensitivity of the asset returns to market returns. eit is the error term.

The standard CAPM gives information on risk adjusted returns but solely on the basis of the
volatility of the portfolio and the correlation with respect to the market. The next step is to
include the Fama and French Three-factor model.

7. Fama and French Three Factor Model

The three factor model takes into account the premia for small and high book-to-market stocks.
Fama and French stipulate that these factors compensate for inherent risk. Whether or not this is
true it does take into account, the Book-to-Market and Small Minus Big factors which are
predictive of value premia. These are often stocks who have underperformed the market. This is
in line with the NCAV strategy as these stocks have extremely high book-to-market values and
have often underperformed the market in the past. The factors loadings are retrieved from the
Kenneth R. French online database
(http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html) and the calculations
for these factors are in line with Fama and French (1996). By including these factors and keeping
to the same procedure as the CAPM, we arrive at the following regression:

Rit R ft ai bi ( RMt R ft ) si SMB hi HML eit

27
On the left hand side of the equation R f is the monthly risk free rate, R j is the monthly return

generated by the portfolio. On the right hand side of the equation, a i is the alpha of the model.

RMt is the monthly return of the market. R ft is the monthly return of the 30 day risk free rate.

si SMB is the small minus big factor. hi HML is the high minus low factor. eit is the error term.

8 Momentum

To momentum factor introduced by Chan et al (1996) is the last asset pricing model to be
introduced. The momentum factor is also retrieved from the Kenneth R. French online Database
(http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html) and follows the
calculation prescribed by Chan et al (1996). The momentum factor measures the premium of
stocks that have performed well in the past and because of this performance continues to do so.
The inclusion of this factors leads to the following regression analysis:

Rit R ft ai bi ( RMt R ft ) si SMB hi HML i MOM eit

On the left hand side of the equation R f is the monthly risk free rate, R j is the monthly return

generated by the portfolio. On the right hand side of the equation, a i is the alpha of the model.

RMt is the monthly return of the market. R ft is the monthly return of the 30 day risk free rate.

si SMB is the small minus big factor. hi HML is the high minus low factor. i MOM is the

momentum factor. eit is the error term.

9. Chen and Zhang improved Three-Factor Model

This three factor model takes a different approach from the traditional asset pricing models.
There are two factors that attempt to explain the returns. The first is the investment factor. The
expected return decreases with an increase in investment to assets. Thus firms with lower

28
investments have higher expected returns. The second factor is the return on assets factor, which
stipulates that firms with higher expected ROA should generate higher expected returns (Chen
and Zhang, 2009). This leads to the following asset pricing model:

Rj Rf aq b rMKT b rINVit b rROA e


MKT INV ROA

On the left hand side of the equation R f is the monthly risk free rate, R j is the monthly return

generated by the portfolio. On the right hand side of the equation, a q is the alpha of the model.

b is the sensitivity of the asset returns to market returns. RMt is the monthly return of the
MKT

market. R ft is the monthly return of the 30 day risk free rate. b is the investment to assets
INV

variable. b is the return on assets variable. eit is the error term.


ROA

10 Alternative factor model by Cremers et al (2008)

The alternative factor model by Cremers et al (2008) is the last model that is discussed. The
model strives to eliminate benchmarks from generating alpha. The authors claim that the Fama
and French three-factor model (Fama and French, 1996) makes it difficult for small-cap value
investors to earn alphas and easy for large cap growth stocks to outperform. Therefore the
models is expanded to included 7 factors. The model is listed below:

Rit R ft ai bi ( RMt R ft ) si RMS 5 hi R 2 RM ii S 5VS 5 g ji RMVRMG


k i r 2vr 2 g liUMD eit

On the left hand side of the equation R f is the monthly risk free rate, R j is the monthly return

generated by the portfolio. On the right hand side of the equation, a q is the alpha of the model.

bi is the sensitivity of the asset returns to market returns. RMt is the monthly return of the

market. R ft is the monthly return of the 30 day risk free rate. si RMS 5 is the mid minus large

29
cap factor. hi R 2 RM is the small versus large cap factor. ii S 2VS 5 g is the large cap value minus

growth factor. ji RMVRMG is the midcap value minus midcap growth factor. ki r 2vr 2 g is the

mid versus large cap factor. liUMD is the momentum factor. eit is the error term.

11. Price/Earnings ratio S&P 500 and availability of NCAV stocks

The last analysis is used to answer the ancillary hypothesis, which tests the relationship between
the amount of NCAV stocks available and the rolling ten year P/E ratio for the S&P 500.
Information can be drawn from the absolute values of the S&P 500 P/E ratio and the amount of
NCAV stocks available but we cannot draw any statistical conclusions. To draw conclusions the
relative change of P/E needs to be compared to the relative change in NCAV stocks. As the P.E
is an indication of the relative price level it offers no predictive power and therefore it does not
need to be lagged in order to compare to the relative change in NCAV stocks. It can be compared
directly. To calculate the relative change the natural logarithm is taken of both the S&P and
NCAV, the is done as follows:

The next step is to measure the correlation between these two factors to measure the impact a
change of the P/E has on the NCAV. The formula for the correlation between these two factors
is:

30
A regression is also run to test the predictive power of the relative price of the market indices on
the amount of NCAV stocks available. The following regression is run.

R ai bi eit

On the left hand side of the equation R is dependent variable. On the right hand side of the
equation, ai is the alpha or negative/positive returns generated beyond the predictive capacity of

the model. bi is the independent variable. eit is the error term.

VI. Results

This section will discuss the results of this thesis. It will discuss all the analyses that were
described in the methodology section. These results will serve as a basis to answer the main and
ancillary hypothesis. The first results are the total stock and NCAV count. The results are posted
below

31
Table 1: Total Sample and Discount NCAV Portfolio Count
Year Listed Companies MV/NCAV < 1 MV/NCAV < 0.67
1984 5486 6 1
1985 5494 13 0
1986 5537 6 0
1987 5566 6 1
1988 5601 22 4
1989 5690 24 5
1990 5750 38 18
1991 5836 43 14
1992 5898 45 15
1993 5985 40 11
1994 6053 50 12
1995 6140 38 14
1996 6172 28 9
1997 6216 42 14
1998 6262 46 20
1999 6272 68 22
2000 6276 75 25
2001 6292 163 91
2002 6307 162 72
2003 6284 85 28
2004 6267 16 5
2005 6256 22 7
2006 6267 19 3
2007 6252 18 3
2008 6264 89 31

Table 1: Total numbers of listed companies in the sample. Includes US based NYSE, AMEX
and NASDAQ stocks. Excludes financial firms, investment trusts and non US based firms.
Discount NCAV stocks are taken at formation date starting 1984 on the first trading day of June

The first table lists the amount of listed companies included in the total sample as well as the
firms trading at both a discount to MV/NCAV and at the most 2/3 (or 0.67) of MV/NCAV value.
No strong conclusions can be drawn from this table but observations can be made. During the
first years of the sample the amount of discount NCAV stocks was limited even though the
market traded at relatively low multiples. This is especially the case for firms trading below a 2/3
(or 0.67) MV/NCAV value. During this period the low amount of NCAV stocks available made
the formation of a diversified portfolio difficult because all invested capital had to be spread
among at the most 4 firms. This is why for the years 1984 to 1988 all firms traded at a discount
of MV/NCAV were used to form the portfolio. The aim of a discount MV/NCAV portfolio is to
maintain a large diversified portfolio of stocks and not to concentrate holdings among a few
firms. The minimum amount of stocks was 6, which according to Greenblatt (1998) Professor

32
of value investing at Columbia, should offer enough diversification. This is also in line with
Ross et al (2007). For our main test the number of firms trading at MV/NCAV < 0.67 increased
significantly after 1989. There was a decrease in availability after 2003 but the market downturn
in 2008 has once again increased the amount of stocks trading at a substantial discount to their
net current asset value.

For the whole sample of discount NCAV stocks the period of low availability ceased in 1988
where after there have always been at least 16 firms available whose stocks have traded at a
discount to NCAV. This decrease could be due to the publication of the Oppenheimer study in
1986, and the publication of this strategy. The EMH predicts that when public knowledge is
available of a stock market anomaly more capital is attracted and this will reduce the abnormal
risk adjusted returns of the availability of the stocks (Ross et al, 2007). This situation did not
continue and the amount of stocks increased after 1988. Another observation is that the amount
of available NCAV stocks increased significantly during the latter part of the stock market
internet bubble. The bubble caused an overall increase in the prices of stocks and severe
overvaluation among most sectors (Shiller, 2005). It is therefore interesting to note that during
the same time that most stocks might have been overvalued there were also a large amount of
stocks trading at depressed levels. It seems that during a time of stock market irrationality, stocks
can both trade are exuberantly high as well as exceptionally low prices. Pastor and Veronesi
(2009) claim that this is due to the high uncertainty inherent in the future profits of the firm. A
large downward revision coupled with high uncertainty leads to a large fall in stock prices.
Although the argument is logical, it does not hold for NCAV stocks. The lower the price of
NCAV stocks, the higher the certainty of the underlying assets. This is not compatible with the
logic of the Pastor and Veronesi (2009) model. Although more difficult to quantify, the ―Mr.
Market‖ parable based on behavioral arguments offers a better explanation. It is also interesting
to note that the evidence is not in line with Arnold and Xiao (2008) nor Bildersee et al (1993).
They showed a decrease in the amount of stocks trading at a discount of NCAV when the market
traded at relatively high multiples, the inverse of the results shown here. The relationship
between the price level of the market and the amount of NCAV stocks is discussed at end of this
chapter. With the exception of the last analysis the remainder of this chapter will discuss the
returns and the compositions of the returns for a portfolio trading at the most 2/3 (or 0.67) of

33
MV/NCAV value (with the exception of years with fewer than 5 stocks where the whole sample
of NCAV stocks is selected). The first is a list of yearly raw returns based on a 12-month holding
period.
Table 2: Yearly Discount MV/NCAV < 2/3 returns and Total market Sample Returns
Discount NCAV Market Discount NCAV Market
1984 1996
Value weighted 26.53% 31.17% Value weighted 8.33% 22.29%
Equal weighted 17.78% 17.36% Equal weighted 1.92% 1.92%
1985 1997
Value weighted 13.58% 34.68% Value weighted 36.49% 29.59%
Equal weighted 27.84% 29.48% Equal weighted 48.04% 24.85%
1986 1998
Value weighted 51.72% 16.16% Value weighted 5.39% 16.66%
Equal weighted 40.33% 8.08% Equal weighted 42.58% -0.50%
1987 1999
Value weighted 0.85% -6.94% Value weighted 35.51% 10.98%
Equal weighted 11.90% -11.82% Equal weighted 67.51% 19.48%
1988 2000
Value weighted 17.58% 25.50% Value weighted -5.74% -10.13%
Equal weighted 24.62% 15.36% Equal weighted -18.03% 5.65%
1989 2001
Value weighted -5.93% 12.57% Value weighted 24.26% -12.00%
Equal weighted -4.03% -1.76% Equal weighted 31.20% 5.46%
1990 2002
Value weighted 5.94% 11.35% Value weighted 40.22% -6.36%
Equal weighted 16.11% 10.05% Equal weighted 35.60% 6.12%
1991 2003
Value weighted -1.24% 11.08% Value weighted 72.12% 21.05%
Equal weighted 19.33% 24.58% Equal weighted 111.84% 45.49%
1992 2004
Value weighted 32.16% 13.32% Value weighted 1.12% 10.02%
Equal weighted 46.86% 22.84% Equal weighted -9.95% 11.05%
1993 2005
Value weighted 43.38% 4.27% Value weighted 23.15% 12.58%
Equal weighted 57.18% 10.56% Equal weighted 30.54% 20.17%
1994 2006
Value weighted 1.08% 17.11% Value weighted 2.92% 23.08%
Equal weighted 81.12% 9.53% Equal weighted 38.70% 18.91%
1995 2007
Value weighted 25.23% 30.68% Value weighted -31.16% -4.74%
Equal weighted 16.50% 41.83% Equal weighted -37.25% -13.50%

Statistics Value NCAV Equal NCAV


Aritmethic Average 0.1765 0.2909
Standard Error 0.0460 0.0657
Median 0.1558 0.2919
Standard Deviation 0.2253 0.3216
Minimum -31.16% -37.25%
Maximum 72.12% 111.84%
Sum 4.2350 6.9823
Count 24 24
Table 2: 1 year holding period returns. Based on equal weighted and value weighted returns. The portfolios
are formed at the beginning of June in 1984 and held for 12 months. This procedure is repeated for each year
up to and including 2007. The portfolios includes US based NYSE, AMEX and NASDAQ stocks. Excludes
financial firms, investment trusts and non US based firms. If there are fewer than 5 firms trading for at the most
2/3 MV/NCAV the whole sample of absolute discount NCAV stocks is selected (MV/NCAV < 1).

No statistical conclusion as yet can be drawn from this table, but observations can be made. The
average raw returns generated are the subject of the next table and thus the discussion is based on
generalized finding. This first observation is that the performance of both the value weighted and
equal weighted discount NCAV portfolios is in the majority of cases higher than the comparable

34
market indices. Furthermore there are a few specific years when the returns of the NCAV
portfolios are substantially higher than the market returns. The equal weighted returns for 2003
are 111,84% and for 1999 they are 67.51% while the market generated 45,49% and 19.48%
respectively. This is not a direct test, as the analyses are done separately. The results are in line
with Oppenheimer (1986), who also showed that equal weighted returns also generated returns in
excess of 100%. To analyze this further, the average raw returns as well as excess raw returns are
shown below in the next table.

Table 3: Raw Returns and Market-Adjusted Returns for Discount at combination of 2/3 and 1 Discount NCAV portfolios

Table 3 A: Average raw buy and hold returns


1 Year 3 year 5 year
Value weighted discount NCAV stocks 14.89% 37.21% 60.12%
Value weigthed market returns 11.28% 41.55% 54.88%

Equal weighted discount NCAV Stocks 23.00% 74.92% 113.25%


Equal Weighted market returns 11.50% 42.45% 51.72%
Table 3 B: Average market adjusted buy and hold for Discount NCAV portfolios
1 Year 3 year 5 year
Discount NCAV value weighted, index value weighted 3.61% -4.34% 5.24%
t-test 0.172833 0.128193 0.356963147
p-value 1.403279 1.724932 1.040258029
Discount NCAV equal weighted, index equal weighted 11.49% 32.47% 61.54%
t-test 0.004484 *** 0.035632 ** 0.067601161 *
p-value 3.123049 2.596001 2.160067874
NYSE/AMEX/NASDAQ stocks are selected for the discount NCAV portfolio of their MV/NCAV is lower than 2/3 at the beginning
of june 1984 and for each portfolio formation until end of may 2008. If there are not at least 5 stocks trading at 2/3 of NCAV value,
a portfolio of maximum of 1 MV/NCAV is selected. For the yearly returns 2008 is excluded because only 6 months of data is
available, for 3 and 5 year holding periods 2008 is included. Average raw and market adjusted are calculated for
portfolios that are held for 1, 3 and 4 years post-formation. The share count includes all shares except for
financial institutes, non-US firms and investment trusts. The returns listed are geometric averages for the 26 years.
geometric averages for the 26 years. The t-tests are based on excess returns above the market rate.
Statistical signficance:
*** Significant at 1% level
** Significant at 5% level
* Significant at 10% level

The table describes the raw equal weighted portfolio returns of the NCAV portfolio as well as
the raw market adjusted returns for the NCAV portfolios. The formulas for the raw portfolio
returns are described in the methodology section. The returns are split into 1 year, 3 year and 5
year holding periods. The results for table 3 a) will be discussed first. The 1 year results for the
NCAV portfolio is higher for both the value weighted NCAV stocks and the equal weighted
NCAV stocks. The returns for the equal weighted portfolio are higher than the market returns by
11,50% while the value weighted returns are also strong but weaker than the equal weighted
returns. This could be due to the small size premium. An alternative could be that there is less
liquidity for small firms and that trading costs are higher and that the returns generated here

35
exclude liquidity and trading costs. A portfolio with an annual geometric compounded rate of
interest of more than 23% would generate very generous returns over a period of 26 years. The
other two holding periods also show outperformance. Before drawing any conclusions a
preliminary t-test is run to test the significance of these results. The results in table 3 b) show that
there is very strong significance for a 1 year holding period of equal weighted NCAV stocks.
The tests for the equal weighted indices show significance at the 1% level. The value weighted
portfolio outperforms the market but this is not statistically significant according to the t-test.
This does show that the one year holding period strongly outperforms that market indices over a
period of 26 years. The longer the holding period becomes the lower the statistical significance
is. This can be attributed to the original discrepancy between the market value of the stock and
the balance sheet value. The difference between the discount to NCAV and the market value can
be a reason for this discrepancy. Therefore when the market has increased the value to a point
where it is no longer trading at a discount to NCAV it can no longer be expected to generate
excess abnormal returns. This statement holds for the value-weighted portfolio but the equal
weighted portfolio continues to show strong outperformance. It might be the case that small
capitalized stocks which are overweighed in the equal weighted portfolio contain a higher
intrinsic value which is neglected by the market. Although Dodd and Graham (2009) proposed a
longer holding period of at least two years, this analysis shows that the optimal holding period
(of the three choices presented) is one year. The high returns reported here are in line with
Oppenheimer (1986) who reported annual returns of 28,2% based on an equal weighted
portfolio. Our results analyze a longer sample period during a bull market. If there were more
discount NCAV stocks available during the beginning period the results might have been even
higher. Strikingly the results shown for the combined 2/3 and 1 discount NCAV strategy are very
close to the results claimed by Benjamin Graham (1976) as stated below:

―We used this approach extensively in managing investment funds, and over a 30-odd year
period we must have earned an average of some 20 per cent per year from this source. For a
while, however, after the mid-1950's, this brand of buying opportunity became very scarce
because of the pervasive bull market. But it has returned in quantity since the 1973-74 decline. In
January 1976 we counted over 300 such issues in the Standard & Poor's Stock Guide--about 10

36
per cent of the total. I consider it a foolproof method of systematic investment--once again, not
on the basis of individual results but in terms of the expectable group outcome.‖

The next table describes the standard deviation of the portfolio:

Table 4: Standard Deviation Standard Deviation (σ)


NCAV Value Weighted 9.78%
NCAV Equal Weighted 9.87%
Market Value Weighted 4.29%
Market Equal Weighted 5.11%
This table shows the standard deviation for the portfolio
during the 1984-2008 period. It is based on the monthly returns
generated.
The standard deviation does show that the dispersion among the mean is higher for the NCAV
portfolios than for the market indices. Higher standard deviations implies that there is higher
volatility. If the average mean returns of the market and the NCAV are equal then this would
imply extra risk to the investor. As the NCAV mean monthly returns are significantly higher the
chances of the portfolio returning less than the market (see table 4) are slight. This is the last
descriptive statistics test and the next test will analyze the risk adjusted returns:

Table 5: CAPM, Beta: Value Weighted and Equal Weighted Portfolios


NCAV Value Value Equal Equal
Market Value Equal Value Equal
α 0.0164 0.0155 0.0171 0.0150
β 0.9852 1.0362 0.8154 1.0425
T(α) 3.1195 *** 3.1698 *** 3.0963 *** 3.0259 ***
T(β) 8.0905 *** 10.9497 *** 6.4042 *** 10.9110 ***
Adj. R^2 18.34% 29.29% 12.24% 29.14%
This analysis is based on the monthly returns of the NCAV portfolio. The NCAV portfolio is equal and value
weighted. These results are regressed against both equal and value weighted market portfolios of the NASDAQ/
NYSE/AMEX. The test period last from 06/1984 until 06/2008. The risk free rate is the 30 day treasury bill.
Under these assumptions the following standard CAPM regression analysis was run
The Portfolio consists of stocks trading at 2/3 of MV/ NCAV value whenever there are at least 5 stocks available
at a discount to this value. Whenever this is not the case, all stocks trading below a MV/NCAV are taken

R it R ft ai b i ( R Mt R ft ) e it
Statistical signficance:
*** Significant at 1% level
** Significant at 5% level
* Significant at 10% level

37
The results of the CAPM analysis show that on the basis of monthly returns of the portfolios, all
portfolio returns whether matched with equal or value weighted indices are significant. The risk-
adjusted returns on the basis of volatility risk is statistically significant for all comparable time
periods. The alphas that are produced by this analysis show that this portfolio is able to attain
monthly risk-adjusted returns on a like-for-like basis of 1,64% and 1,50%, for the value and
equal weighted portfolios respectively. The portfolios are able to earn significantly higher returns
while taking on less volatility risk than the market. This first risk analysis supports the
alternative hypothesis that a widely diversified portfolio is able to produce abnormal risk-
adjusted returns. This evidence runs counter to the efficient market hypothesis. The large
discrepancy between tangible and relatively liquid assets and the market price can be used as an
explanation for the abnormal returns. The margin of safety takes into account the worst case
scenario, therefore any positive event, yields outsized returns. It is also in line with the concept
of intrinsic value which was discussed earlier. This confirms expectations that there is a
difference between the intrinsic value of the firm and the price of a security. If this gap is large,
as is the case in NCAV stocks then this should yield abnormal returns, regardless of the
underlying reasons for these returns. It can almost be described as a mechanical realignment of
stock prices to intrinsic value. It is most likely due to irrational behavior and institutional
constraints but the arguments for this are drawn in the conclusion. In order to gain further
evidence more factors need to be included. The next step is to increase the analysis to include the
Fama and French three-factor model.

38
Table 6: Fama French 3 factor model: Value Weighted and Equal Weighted
NCAV Value Equal
Market Value Equal
α 0.0172 0.0142
β 0.8404 1.0505
ѕ 0.8314 0.1283
h -0.0146 0.2091
T(α) 3.3244 *** 2.8199 ***
T(β) 6.4423 *** 8.5339 ***
T(s) 4.9779 *** 0.6838
T(h) -0.0743 1.1406
Adj. R^2 24.53% 29.02%

This analysis is based on the monthly returns of the NCAV portfolio. The NCAV portfolio is equal and value weighted
These results are regressed against both equal and value weighted market portfolios of the NASDAQ/NYSE/AMEX
The test period last from 06/1983 until 12/2008. The risk free rate is the 30 day treasury bill. The SMB and HML factors
were retrieved from: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.
The calculations for these factors are based on the NASDAQ/NYSE/AMEX data and is therefore compatible with our dataset
This leads to the following Fama and French 3 Factor model:
R it R ft ai b i ( R Mt R ft ) s i SMB h i HML e it
Statistical signficance:
*** Significant at 1% level
** Significant at 5% level
* Significant at 10% level

The Fama and French three factor model incorporates two factors that compensate investors for
taking on specific risks. The two factors compensate investors for taking on firms with a relative
high probability of financial distress. One would expect a high correlation between these factors
and the NCAV strategy. NCAV strategy are often small firms with very high book-market-
values. If the Fama and French model is a good predictor then these factors should have a strong
predictive power. This is however not the case. The small-minus big factor is statistically
significant and the predictive power of the model also increased (on the basis of the adjusted r-
squared). This High minus Low factor is an extreme test of the book to market and should
correlate strongly with our test. This is not the case. This runs counter to expectations. If the B/M
value is not able to explain the NCAV returns, the question arises what the validity is of this
model.
These results further strengthen the evidence for the alternative main hypothesis that the discount
NCAV portfolio produces abnormal risk-adjusted returns. The next risk-adjusted test also
includes the momentum factor. This last table is listed below:

39
Table 7: Momentum + Fama French 3 factor model : Value Weighted and Equal Weighted
NCAV Value Equal
Market Value Equal
α 0.0226 0.0173
β 0.7642 0.9519
ѕ 0.8970 0.2338
h -0.0821 0.1582
i -0.5581 -0.2647
T(α) 4.4326 *** 3.3224 ***
T(β) 6.0462 *** 7.3011 ***
T(s) 5.5669 *** 1.2140
T(h) -0.4317 0.8617
T(i) -4.9191 *** -2.1820 **
Adj. R^2 30.23% 29.95%

This analysis is based on the monthly returns of the NCAV portfolio. The NCAV portfolio is equal and value weighted
These results are regressed against both equal and value weighted market portfolios of the NASDAQ/NYSE/AMEX
The test period last from 06/1983 until 12/2008. The risk free rate is the 30 day treasury bill. The SMB and HML factors
were retrieved from: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.
The calculations for these factors are based on the NASDAQ/NYSE/AMEX data and is therefore compatible with our dataset
This leads to the following Fama and French 3 Factor model:
Rit R ft ai bi ( R Mt R ft ) s i SMB hi HML i MOM eit
Statistical signficance:
*** Significant at 1% level
** Significant at 5% level
* Significant at 10% level

Thos risk-adjusted model also includes the momentum factor. The momentum factor describes
the ‗hot-hands‘ phenomena where firms that have done well over the past year will continue to
do so. NCAV stocks are often stocks that trade at depressed levels. As they are trading at
depressed levels they have often experienced negative stock returns to be trading at a discount to
NCAV. Therefore one would expect a negative correlation between the momentum factor and
the NCAV portfolio. This appears to be the case and is statistically significant. The adjusted R^2
increases. A momentum or ‗hot-hands‘ effect is shown to further add to the abnormal risk-
adjusted returns for the equal weighted portfolios and therefore a statistically significant negative
correlation increases the monthly risk-adjusted returns that are generated. This last test further
strengthens the case for the alternative hypothesis. The conclusion and the implications for
theory and practice will be given in the next chapter but first the robustness checks for two
alternative models are run. The first table is listed below:

The next step is to analyze the results of the Chen and Zhang three factor model. This table is
shown below:

40
Table 8: Chen and Zhang 3 factor model: Value Weighted and Equal Weighted
NCAV Value Equal
Market Value Equal
α 0.0275 0.0174
rMKT 0.6661 0.9659
rINV -0.0024 0.0073
rROA -0.0067 -0.0033
T(α) 5.0962 *** 3.2413 ***
T(rMKT) 5.0020 *** 8.0021 ***
T(rINV) -0.8486 2.6468 ***
T(rROA) -5.7713 *** -2.5452 **
Adj. R^2 26.70% 31.93%

This analysis is based on the monthly returns of the NCAV portfolio. The NCAV portfolio is equal and value weighted
These results are regressed against both equal and value weighted market portfolios of the NASDAQ/NYSE/AMEX
The test period last from 06/1984 until 5/2008. The risk free rate is the 30 day treasury bill. The IA and ROA factors
were retrieved from: http://apps.olin.wustl.edu/faculty/chenl/linkfiles/data_equity.html
The calculations for these factors are based on the NASDAQ/NYSE/AMEX data and is therefore compatible with the dataset
This leads to the following Chen and Zhang 3 Factor model:

Statistical signficance: Rj Rf aqj bj rMKT bj rINVit bj rROA e j


MKT INV ROA
*** Significant at 1% level
** Significant at 5% level
* Significant at 10% level

The Cheng and Zhang three factor model incorporates two factors that attempt to predict
expected stock returns. The two factors are expected return on assets (ROA) and expected
returns based on investment to assets (I/A). This model has not shown to be a better predictor of
the book/market anomaly. As this study is a test of the book/market anomaly it is not expected to
reduce the abnormal returns. Although the model is both intuitively as well as mathematically
complex (the derivation of the factor loadings, not the regression), it actually does worse than the
standard CAPM model with respect to reducing alpha. The adjusted R^2 is higher showing that it
is better at predicting the returns than the standard CAPM model. Chen and Zhang (2009)
already state that this model is not able to predict the book/market anomaly more successfully
than the Fama and French three factor model (Fama and French, 1996). Thus this study is in line
with their own analysis. The alpha increases for all two comparisons.

These results further strengthen the evidence for the alternative main hypothesis that the discount
NCAV portfolio produces abnormal returns. This last table is listed below:

41
Table 9: Cremers, Petajisto and Zitzewits index-based 7 factor model
NCAV Value Equal
Market Value Equal
α 0.0241 0.0187
β 0.7870 1.0260
ѕRMS5 0.3607 -0.5381
hR2RM 1.1678 0.6843
iS2VS5g 0.0203 -0.1066
jRMVRMG -0.2782 0.0844
kR2VR2G 0.1645 0.1778
lUMD -0.5456 -0.2204
T(α) 4.6302 *** 3.4926 ***
T(β) 5.6139 *** 7.3985 ***
T(s) 0.9701 -1.4213
T(h) 3.9657 *** 2.2285 **
T(i) 0.0675 -0.3520
T(j) -0.8183 0.2476
T(k) 0.4322 0.4740
T(l) -4.3902 *** -1.6793 ***
Adj. R^2 29.88% 30.41%

This analysis is based on the monthly returns of the NCAV portfolio. The NCAV portfolio is equal and value weighted
These results are regressed against both equal and value weighted market portfolios of the NASDAQ/NYSE/AMEX
The test period last from 06/1983 until 12/2008. The risk free rate is the 30 day treasury bill. The seven factors
were retrieved from: http://www.petajisto.net/data.html
The calculations for these factors are based on the NASDAQ/NYSE/AMEX data and is therefore compatible with our dataset
This leads to the following Factor model:
Rit R ft ai bi ( RMt R ft ) si RMS5 hi R2RM ii S 5VS5g ji RMVRMG
Statistical signficance: K i R2VR2G liUMD eit
*** Significant at 1% level
** Significant at 5% level
* Significant at 10% level

The last factor model is the model by Cremers et al (2008). This model improves upon the Fama
and French three-factor model by attempting to remove benchmark alphas. The small versus
large cap factor is significant, showing a positive relationship between the size of the firms and
the returns generated. This is in line with the higher equal weighted returns, because small cap
firms generate higher returns than large cap returns for the NCAV portfolio. The adjusted R^2
increases in the four analyses. Cremers et al (2008) states that one of the goals of the model is to
improve the benchmarking of strategies. If this model achieves its goal, then it is clear that the
strategy produces significant alpha. This last test further strengthens the case for the alternative
hypothesis. The conclusion and the implications for theory and practice will be given in the next
chapter but the results for the ancillary hypothesis still need to be discussed. The first table is
listed below:

42
Table 10: Average 10 year price earnings ratio vs amount of stocks available
Year Price Earnings Ratio Firms Trading at a Discount to NCAV
1984 9.01 6
1985 10.81 13
1986 13.89 6
1987 16.83 6
1988 14.77 22
1989 16.64 24
1990 17.82 38
1991 18.02 43
1992 19.32 45
1993 20.61 40
1994 20.29 50
1995 22.72 38
1996 25.97 28
1997 31.26 42
1998 36.80 46
1999 42.18 68
2000 42.78 75
2001 33.07 163
2002 26.39 162
2003 24.83 85
2004 26.40 16
2005 26.06 22
2006 24.74 19
2007 27.41 18
2008 22.41 89
Correlation -0.38413
This table lists the average price earnings ratio on the basis of the Shiller data. The Shiller data was
retrieved from http://www.econ.yale.edu/~shiller/data/ie_data.xls).

The results show that during the first 3 of the first 4 years the amount of discount NCAV stocks
available was lower than 7, even though the price earnings ratio for a representative market as
the S&P 500 was at the lowest level during the entire sample period. The original hypothesis
assumed that lower relative price/earnings levels would lead to more stocks trading at a discount
to their NCAV value. This is however not the case. As the average price/level trended up during
the sample period the amount of discount NCAV stocks available increased. Discount NCAV
stocks are stocks that trade at a depressed price level. When market participants bid up the
overall price level in expectancy of higher returns, one could assume that there is a reduction in
the availability of these stocks. The dichotomy between a large amount of stocks trading at a
discount to NCAV and a high overall price/earnings ratio is most apparent during the internet
bubble of 1999-2002. As the rolling 10 year price/earnings ratio increased to over 42,78 the
amount of NCAV stocks increased. Furthermore in the succeeding years when the price/earnings

43
ratio remained at historically high levels the amount of discount NCAV stocks increased to over
100. The correlation between the Price/earnings ratio and the amount of discount NCAV stocks
is negative implying that there is some relationship between lower overall price/earnings ratios
and more firms trading at a discount to NCAV but this does not include any test of statistical
significance... The occurrence of these two phenomena during the same time period might
provide evidence against the efficient market hypothesis, but the analysis is too weak to draw
any strong conclusions. The last table gives the results of the regression analysis run to analyze
the relationship between the price/earnings ratio and firms trading at a discount to NCAV in
order the analyze the statistical significance of the relationship:

Table 11: Regression Analysis: Price/Earnings Ratio


versus availability of stocks

α 0.1731
β -1.7954
T(α) 1.3911
T(β) -1.9953 *
Adj. R^2 11.05%
The following regression is run on the basis on yearly
Log returns
R a i b i e it

Statistical signficance:
*** Significant at 1% level
** Significant at 5% level
* Significant at 10% level

The results show that there is a negative correlation between these two factors but the
explanatory variable is only capable of explaining 11,05% of the total returns. The results show
that there is statistical significance at the 10% level. Although it was expected that there would a
strong negative relationship between the rolling P/E ratio and the amount of discount NCAV
stocks the results show that is a weak relationship but not substantial evidence. This evidence is
also only based on 26 annual data points and should be not considered the definitive answers.
Therefore the null hypothesis cannot be strongly rejected that there is a decrease of discount
NCAV stocks when the overall price level of the market is higher. This is not fully in line with

44
the Bildersee et al (1993) analysis of Japan which found few discount NCAV stocks available
during the bull market in the 1980‘s.

This last analysis ends the results section. The results have shown strong evidence for the
alternative main hypothesis and weak evidence for the alternative ancillary hypothesis. To
further analyze the results a robustness check will now be run. This will consist of the entire
universe of stocks trading at a discount to MV/NCAV. The conclusion of this thesis is drawn
next.

VII. Robustness Check

The robustness check is run to analyze the strength of the strategy. A combination of portfolios
trading at value of at the most 2/3 MV/NCAV and if not available a selection from the entire
sample of discount MV/NCAV stocks is expected to produce risk-adjusted abnormal returns.
This strategy selected severely undervalued stocks with a high margin of safety. This robustness
check will check the impact that a reduction in the margin of safety has on the returns that are
generated by the portfolio. According to the arguments brought forth by Graham and Dodd
(2009), the lower the margin of safety the lower the returns should be.

Instead of selecting a combination of stocks and setting the most stringent benchmark the entire
universe of stocks trading at a discount to NCAV is selected. This lowers the margin of safety
but does not mean the stocks are not undervalued. These stocks still trade a discount to NCAV
and should therefore provide adequate protection against capital loss. As a robustness check one
further modification is made. Instead of excluding 2008 for the risk-adjusted return analyses,
they are included. They were not included in the full analysis because the holding period only
lasted for six months. It is also interesting to see if, by including all of 2008 (the last test only
incorporated the first 6 months) the returns do not severely deteriorate. The first test analyzes the
raw returns generated by this portfolio and are depicted on the next page.

45
Table 12 Yearly Discount NCAV returns and Total market Sample Returns
Discount NCAV Market Discount NCAV Market
1984 1997
Value weighted 26.53% 31.17% Value weighted 30.90% 29.59%
Equal weighted 17.78% 17.36% Equal weighted 30.85% 24.85%
1985 1998
Value weighted 13.58% 34.68% Value weighted 18.85% 16.66%
Equal weighted 27.84% 29.48% Equal weighted 28.34% -0.50%
1986 1999
Value weighted 51.72% 16.16% Value weighted 8.72% 10.98%
Equal weighted 40.33% 8.08% Equal weighted 57.95% 19.48%
1987 2000
Value weighted 0.85% -6.94% Value weighted -8.60% -10.13%
Equal weighted 11.90% -11.82% Equal weighted -10.88% 5.65%
1988 2001
Value weighted 17.58% 25.50% Value weighted 17.04% -12.00%
Equal weighted 24.62% 15.36% Equal weighted 29.80% 5.46%
1989 2002
Value weighted 4.02% 12.57% Value weighted 10.92% -6.36%
Equal weighted 0.63% -1.76% Equal weighted 19.10% 6.12%
1990 2003
Value weighted 12.52% 11.35% Value weighted 70.90% 21.05%
Equal weighted 10.79% 10.05% Equal weighted 104.81% 45.49%
1991 2004
Value weighted 11.41% 11.08% Value weighted -9.13% 10.02%
Equal weighted 32.52% 24.58% Equal weighted -10.00% 11.05%
1992 2005
Value weighted 20.23% 13.32% Value weighted 26.89% 12.58%
Equal weighted 32.86% 22.84% Equal weighted 33.63% 20.17%
1993 2006
Value weighted 7.43% 4.27% Value weighted 2.92% 23.08%
Equal weighted 18.64% 10.56% Equal weighted 38.70% 18.91%
1994 2007
Value weighted 1.59% 17.11% Value weighted -31.16% -4.74%
Equal weighted 14.90% 9.53% Equal weighted -37.25% -13.50%
1995 2008
Value weighted 25.36% 30.68% Value weighted -43.62% -38.16%
Equal weighted 25.40% 41.83% Equal weighted -49.92% -44.26%
1996
Value weighted 2.56% 22.29%
Equal weighted -7.06% 1.92%

Statistics Value NCAV Equal NCAV


Aritmethic Average 0.1390 0.2234
Standard Error 0.0411 0.0548
Median 0.1197 0.2501
Standard Deviation 0.2015 0.2686
Minimum -0.3116 -0.3725
Maximum 0.7090 1.0481
Sum 3.3365 5.3619
Count 24 24
Table 2: 1 year holding period returns. Based on equal weighted and value weighted returns. The portfolios
are formed at the beginning of June in 1984 and held for 12 months. This procedure is repeated for each year
up to and including 2007. The portfolios includes US based NYSE, AMEX and NASDAQ stocks. Excludes
financial firms, investment trusts and non US based firms. The whole sample of discount NCAV stocks is taken

This first observation is that the performance of both the value weighted and equal weighted
discount NCAV portfolios is in the majority of cases much higher than the comparable market
indices. Furthermore there are a few specific years when the returns of the NCAV portfolios are
substantially higher than the market returns. The equal weighted returns for 2003 are 104,81%
and 2001 29,80%, while the market generated 45,49% and -5,46% respectively. The results are

46
lower during most years than the more stricter main test but still appear to be higher than the
overall market returns. To analyze this the holding period returns are given next:
Table 13: Raw Returns and Market-Adjusted Returns for Discount NCAV portfolios

Table 13 A: Average raw buy and hold returns


1 Year 3 year 5 year
Value weighted discount NCAV stocks 9.18% 37.21% 106.40%
Value weigthed market returns 9.25% 41.55% 54.88%

Equal weighted discount NCAV Stocks 14.78% 74.92% 112.33%


Equal Weighted market returns 9.02% 42.45% 51.72%
Table 13 B: Average buy and hold for Discount NCAV portfolios
1 Year 3 year 5 year
Discount NCAV value weighted, index value weighted -0.07% -4.34% 51.52%
t-test 0.438583 0.128193 0.147899902
p-value 0.787167 1.724932 ** 1.790294475
Discount NCAV equal weighted, index equal weighted 5.76% 32.47% 60.61%
t-test 0.019946 0.035632 0.070999859
p-value 2.486306 ** 2.596001 ** 2.126848343 *
NYSE/AMEX/NASDAQ stocks are selected for the discount NCAV portfolio of their MV/NCAV is lower than 1 at the beginning
of june 1983 and for each portfolio formation until end of may 2008. Average raw and market adjusted are calculated for
portfolios that are held for 1, 3 and 4 years post-formation. The share count includes all shares except for
financial institutes, non-US firms and investment trusts. The returns listed are geometric averages for the 26 years.
geometric averages for the 26 years. The t-tests are based on excess returns above the market rate.
Statistical signficance:
*** Significant at 1% level
** Significant at 5% level
* Significant at 10% level

The returns show that only the equal weighted discount NCAV stocks outperform the market
significantly for a one year holding period. This outperformance is still statistically significant
especially as this test includes all of 2008 (only a 6 month holding period). This period has been
excessively poor for discount NCAV stocks and it is unlikely that this degree of
underperformance will continue. It will be more likely that the returns revert to the mean. The
longer holding periods for equal weighted portfolios all show significant outperformance. The
difference between these two weightings could be ascribed to the premium given to small
companies which are weighted more heavily in the equal weighted portfolio. The results do show
that the results are robust for equal weighted portfolios but that the returns are also much lower
than for the stricter benchmark. These results are in line with expectations. The standard
deviation is discussed next:

47
Table 14: Standard Deviation Standard Deviation (σ)
NCAV Value Weighted 7.80%
NCAV Equal Weighted 8.15%
Market Value Weighted 4.48%
Market Equal Weighted 5.28%
This table shows the standard deviation for the
portfolios and the market returns. It is based on
the monthly returns
The equal weighted portfolio once again shows that the risk/return relationship is not always
positive. One can attain higher returns by lowering the volatility risk. This is simply done by
setting up a more stringent benchmark which increases margin of safety

Table 15: CAPM, Beta: Value Weighted and Equal Weighted Portfolios
NCAV Value Equal
Market Value Equal
α 0.0123 0.0067
β 0.9227 1.1487
T(α) 3.1734 *** 2.1045 **
T(β) 10.7241 *** 19.0930 ***
Adj. R^2 27.94% 55.29%
This analysis is based on the monthly returns of the NCAV portfolio. The NCAV portfolio is equal and value
weighted. These results are regressed against both equal and value weighted market portfolios of the NASDAQ/
NYSE/AMEX. The test period last from 06/1983 until 12/2008. The risk free rate is the 30 day treasury bill.
Under these assumptions the following standard CAPM regression analysis was run

R it R ft a i bi ( R Mt R ft ) e it

Statistical signficance:
*** Significant at 1% level
** Significant at 5% level
* Significant at 10% level
These results, although weaker in absolute terms, are all statistically significant. This robustness
check increases the validity of the main test. The results are weaker but because it also includes
2008 and has less of a margin of safety. It is in line with expectations. The value weighted
portfolios also contain less volatility risk than the equal weighted portfolios and the market and
gives it superior volatility risk adjusted returns. The most interesting conclusion that be drawn
from the analysis is that the Beta for the equal weighted portfolio is significantly higher than for
the main test. Thus the stricter benchmark runs far less volatility risk while generating 8,11%
more on annual holding period basis. This definitely confirms the margin of safety argument by
Graham and Dodd (2009). The efficient market hypothesis assumes there is a linear positive

48
risk/return relationship and the relationship between the main and robustness check is actually
strongly negative. One can wonder how these results could ever be included in the framework of
the efficient market hypothesis. The next tables are the four remaining risk-adjusted models.
Table 16: Fama French 3 factor model: Value Weighted and Equal Weighted
NCAV Value Equal
Market Value Equal
α 0.0128 0.0074
β 0.7451 1.0774
ѕ 0.7510 0.1947
h -0.0760 0.0556
T(α) 3.3662 *** 3.0433 ***
T(β) 7.7842 *** 5.6042 ***
T(s) 6.1283 *** 5.3188 ***
T(h) -0.5252 1.1718
Adj. R^2 33.87% 19.70%

This analysis is based on the monthly returns of the NCAV portfolio. The NCAV portfolio is equal and value weighted
These results are regressed against both equal and value weighted market portfolios of the NASDAQ/NYSE/AMEX
The test period last from 06/1983 until 12/2008. The risk free rate is the 30 day treasury bill. The SMB and HML factors
were retrieved from: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.
The calculations for these factors are based on the NASDAQ/NYSE/AMEX data and is therefore compatible with our dataset
This leads to the following Fama and French 3 Factor model:
R it R ft ai b i ( R Mt R ft ) s i SMB h i HML e it
Statistical signficance:
*** Significant at 1% level
** Significant at 5% level
* Significant at 10% level

Table 17: Momentum + Fama French 3 factor model : Value Weighted and Equal Weighted
NCAV Value Equal
Market Value Equal
α 0.0162 0.0105
β 0.6971 0.9749
ѕ 0.7924 0.3043
h -0.1184 0.0027
i -0.3514 -0.2753
T(α) 4.2772 *** 3.1044 ***
T(β) 7.4336 *** 11.4540 ***
T(s) 6.6271 *** 2.4210 **
T(h) -0.8397 0.0228
T(i) -4.1739 *** -3.4753 ***
Adj. R^2 37.49% 54.67%

This analysis is based on the monthly returns of the NCAV portfolio. The NCAV portfolio is equal and value weighted
These results are regressed against both equal and value weighted market portfolios of the NASDAQ/NYSE/AMEX
The test period last from 06/1983 until 12/2008. The risk free rate is the 30 day treasury bill. The SMB and HML factors
were retrieved from: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.
The calculations for these factors are based on the NASDAQ/NYSE/AMEX data and is therefore compatible with our dataset
This leads to the following Fama and French 3 Factor model:
Rit R ft ai bi ( R Mt R ft ) s i SMB hi HML i MOM eit
Statistical signficance:
*** Significant at 1% level
** Significant at 5% level
* Significant at 10% level

49
Table 18: Chen and Zhang 3 factor model: Value Weighted and Equal Weighted
NCAV Value Equal
Market Value Equal
α 0.0190 0.0095
rMKT 0.7196 1.0606
rINV -0.5295 -0.2005
rROA 0.1601 0.2291
T(α) 4.7205 *** 2.6286 ***
T(rMKT) 7.2609 *** 13.1186 ***
T(rINV) -6.1174 *** -2.3379
T(rROA) 0.7509 1.2472
Adj. R^2 33.93% 53.63%

This analysis is based on the monthly returns of the NCAV portfolio. The NCAV portfolio is equal and value weighted
These results are regressed against both equal and value weighted market portfolios of the NASDAQ/NYSE/AMEX
The test period last from 06/1984 until 5/2008. The risk free rate is the 30 day treasury bill. The IA and ROA factors
were retrieved from: http://apps.olin.wustl.edu/faculty/chenl/linkfiles/data_equity.html
The calculations for these factors are based on the NASDAQ/NYSE/AMEX data and is therefore compatible with the dataset
This leads to the following Chen and Zhang 3 Factor model:
Rj Rf aqj bj rMKT bj rINVit bj rROA ej
Statistical signficance: MKT INV ROA

*** Significant at 1% level


** Significant at 5% level
* Significant at 10% level

Table 19: Cremers, Petajisto and Zitzewits index-based 7 factor model


NCAV Value Equal
Market Value Equal
α 0.0183 0.0112
β 0.6693 0.9953
ѕRMS5 0.4018 0.0075
hR2RM 0.8268 0.3631
iS2VS5g 0.0399 -0.0335
jRMVRMG 0.1610 -0.0497
kR2VR2G -0.4374 0.0092
lUMD -0.3341 -0.2709
T(α) 4.7476 *** 3.1546 ***
T(β) 6.4405 *** 10.8689 ***
T(s) 1.4592 0.0301
T(h) 3.7897 *** 1.7905 *
T(i) 0.1791 -0.1675
T(j) 0.6393 -0.2207
T(k) -1.5512 0.0372
T(l) -3.6291 *** -3.1268 ***
Adj. R^2 37.40% 53.92%

This analysis is based on the monthly returns of the NCAV portfolio. The NCAV portfolio is equal and value weighted
These results are regressed against both equal and value weighted market portfolios of the NASDAQ/NYSE/AMEX
The test period last from 06/1983 until 12/2008. The risk free rate is the 30 day treasury bill. The seven factors
were retrieved from: http://www.petajisto.net/data.html
The calculations for these factors are based on the NASDAQ/NYSE/AMEX data and is therefore compatible with our dataset
This leads to the following Factor model:
Rit R ft ai bi ( RMt R ft ) s i RMS5 hi R2 RM ii S 5VS5 g j i RMVRMG
Statistical signficance: K i R2VR2G l iUMD eit
*** Significant at 1% level
** Significant at 5% level
* Significant at 10% level

50
These results further confirm the previous analyses and add to the robustness of the findings. No
further comments need to be made.

This concludes the robustness check. This robustness check has further strengthened the
evidence for the alternative hypothesis. Furthermore it has shown that the original test runs less
volatility risk while earning 8,11% more on an annual basis. This is very strong evidence for the
persistency of this anomaly. The conclusion of this thesis is drawn next.

VIII. Conclusion and Implications

The main purpose of this thesis is to analyze the performance of discount NCAV stocks versus
the broad based United States indices between 1984 and 2008. This analysis serves as a test for
the persistency of the anomaly. The results are clear and show that the strategy has produced
significant abnormal-risk adjusted returns during the sample period. Based on the Carhart four
factor (1997 ) model the results show that the abnormal risk-adjusted monthly returns are 2,27%
for value weighted and 1,73% for equal weighted returns. Most interestingly the HML factor is
not statistically significant even though this is a study of liquid current book value. All other
tests and robustness checks run confirm these results. The strongest results are found for a one
year holding period. The abnormal risk-adjusted returns decrease for the longer holding periods
of three and five years. The model by Chen and Zhang (2009) is also not able to predict the
returns of the NCAV strategy. The ancillary hypothesis tests whether there is a negative
relationship between the relative price level of the market and the availability of NCAV stocks.
Only weak evidence is found. The results are in line with Oppenheimer (1986) and Arnold and
Xiao (2007), but a similar study in Japan by Bildersee et al (1993) showed less significant
results.

Proponents of the efficient market hypothesis assume that the market price fully reflects all
available information and risks. Achieving higher returns requires the investor to take on more
risk. Malkiel (2003) and Schwert (2002) argue that anomalies which generate systematic
abnormal risk-adjusted returns will be exploited by investors and then disappear. They state that
anomalies such as the January-effect have disappeared after publication. Although the

51
argumentation behind this statement may be sound, it does not apply to the discount NCAV
strategy. The NCAV strategy has received much attention and is a widely publicized strategy
which was promoted by Benjamin Graham during his career. This publicity and especially the
study by Oppenheimer (1986) has not reduced the abnormal risk-adjusted returns of the NCAV
strategy. Indeed it appears to be a very persistent anomaly . The strategy produced abnormal
risk-adjusted returns during the combined sample period of this and Oppenheimer‘s (1986)
study. Furthermore according to Benjamin Graham the strategy has always produced satisfactory
returns during his career (Graham, 1976). If I include his career then this anomaly has persisted
for well over 70 years and is clearly not self-destructive. The disappearance of anomalies
argument does not hold in this case.

A different argument asserts that the current asset pricing models do not capture all the risk
factors and are therefore incomplete (Malkiel, 2003). The Cremer et al (2008) model improves
the Fama and French three factor model and should capture most of the risk-adjusted abnormal
returns. The discount NCAV strategy is an extreme test of the book-to-market anomaly, but the
Fama and French 3 factor model (1996) is not able to explain the abnormal returns. Not only is
Fama and French (1996) model not able to explain the abnormal returns, the factor is not even
significant. One would have expected the market/book factor to capture at least part of a net
current asset value strategy. Although the 3 factor model is relatively successful in other
empirical tests, it appears limited in applicability. The discount NCAV strategy is an inherently
safe strategy due to the margin of safety given by the large amount of net current assets in
proportion to the total market value. It seems very unlikely that there is any other potential risk
factor to explain the abnormal returns. I can merely come to the conclusion that the returns are
not generated due to inherent risk but is due to other (irrational) market factors. The last
argument discusses the overall price of the market.

Malkiel (2003) claims that periods of high relative market prices are due to uncertainty of future
forecasts of growth rates. This argument is in line with Pastor and Veronesi (2009). He also
claims that there might be periods when asset prices are irrationally high but that these periods
are the exception instead of the rule. The internet bubble during the end of the last and the
beginning of this century showed historically high relative market prices. What this thesis adds is

52
that undervaluation as well as overvaluation might occur during the same sample period.
Overvaluation might be present in the overall stock market as well as potential undervaluation in
the abundance of discount NCAV stocks available during this time. This evidences counters the
uncertainty of future growth rates argument of Malkiel (2003). If the market perceives the
economy and firms to experience high growth rates then firms should not trade below their net
current asset value. The conclusion can be drawn that the discount NCAV strategy produces
abnormal risk-adjusted returns, and the possible explanations for this risk-adjusted performance
are drawn next.

The results show that the strategy is persistent even after the publication of the Oppenheimer
study and that the asset pricing models have not been able to explain the abnormal returns. The
efficient market hypothesis and the Fama and French (1996) three factor model are not able to
explain the results and for that reason other explanations need to be introduced.

One possible reason why this strategy has not been exploited can be ascribed to institutional
constraints. Lakonishok et al (1992) proposed that the industry suffers from various agency
problems which causes chronic underperformance. The agency problems are largely caused by
the need for money managers to please the treasury department. This causes money managers to
pursue popular strategies and to adopt risk averse strategies. A relatively unknown strategy, such
as the discount NCAV strategy would be difficult to sell and would appear to have high risks
because the stocks selected have often done poorly in the past and can be in distress. The money
manager might not want to take this risk in fear of losing his customer and/or job. The size of
institutions is also believed to play a role. There is only a limited amount of discount NCAV
stocks available at a given time. By dedicating to a discount NCAV portfolio the institutions
overall performance would not be greatly affected. This small increase in performance would
often not be noticeable on the total size of the portfolio. Therefore there is no great incentive to
launch a specific discount NCAV fund. This has shown that there are institutional barriers but
has not discussed the potential for individual investors.

Aside from the institutional constraints, individuals also encounter barriers to form a portfolio.
Setting up a discount NCAV portfolio can be expensive. If one assumes that a single trade costs

53
$10, that the individual has a portfolio of 30 equal weighted NCAV stocks and that the holding
period is 12 months; the total costs would amount to at least 600 dollars a year. An investor
would need to hold a portfolio of at least 60,000 dollars to drop the annual costs below 1%. The
excludes any other potential costs (with the assumption of relatively low trading costs) and the
opportunity costs for setting up, searching and analyzing the stocks. It is doubtful whether there
is a large group of individuals who has the available capital, knowledge and is willing to invest at
least this amount in a diversified portfolio. The cost aspect is one possible barrier which prevents
the individual and the institutions from investing in a discount NCAV strategy but the most
salient argument is behavioral.

Deviations from rational decision making, could be the main reason for the occurrence and
persistence of this anomaly. The main behavioral concept that is applicable to the discount
NCAV anomaly is the representative heuristic. In line with De Bondt and Thaler (1985), the
market overreacts to past performance. In the case of the discount NCAV strategy investors
overreact to poor past performance and extrapolate this into the future, while underweighting the
potential of firms to recover. This overweighting of past performance causes the firms to trade
below liquidating (NCA) value. Consequently this expected poor performance does not
materialize and the stock is able to generate abnormal risk-adjusted returns. Overconfidence in
one‘s own judgment capabilities adds to the perceived expected performance and the actual
financial risks run. If it were not due to inherent limitations in the human psyche this anomaly
should have disappeared after the initial publication by Benjamin Graham and especially after
the Oppenheimer (1986) study. Emotional based anomalies are likely to be persistent because
each individual suffers from the same limitations to rational decision making. The three
different arguments for the persistency of this anomaly have now been giving, with the last
explanation being behavioral. The implications of the anomaly for theory and practice is the final
part of this conclusion.

The discount NCAV has shown strong persistency in delivering risk-adjusted returns. Although
further research is beyond the scope of this thesis, if this ‗value‘ strategy has provided positive
returns it can be expected that other similar strategies also perform better than the market. The
implication of this is that the models based on the EMH hypothesis might be less valid than

54
assumed. Advocates of the EMH prescribe that holding a passive index tracking portfolio yields
the best results but this thesis confirms that valuing a publicly traded firm on the basis as if it
were a private business can yield very satisfactory returns. Therefore one should question the
applicability of asset pricing models that are based on the EMH assumption and the deriving
advice to invest in index tracking funds. Perhaps the future of asset pricing models should not be
in trying to incorporate all risk factors into the current model but to review the basic foundations
that underlie these models. Furthermore if these models have poor explanatory power, why
should so much be invested in trying to teach these models to future financial academics and
business professionals. Would it not be wiser to invest more time in the analysis and valuation of
specific firms. As is this case in economics, perhaps a micro level approach to teaching
investing yields more explanatory power than a macro approach. The implications include a
possible invalidity of the aspects of semi-strong EMH model, the consequences that has on
academic research as well as investment advice and on the amount of time that is invested in
attempting to teach students these models. The final implication is that this strategy should
continue to deliver satisfactory results for investors able to overcome the cost and behavioral
constraints. The overall conclusion will now be drawn.

This thesis has documented the persistency of the discount to net current asset value strategy.
The results show that the strategy was able to produce risk-adjusted returns during the 1984-2008
period that are in line with the results produced by (Oppenheimer, 1986). It is proposed that the
abnormal risk-adjusted returns are due to institutional constraints, a high individual cost basis
and is strongly influenced by behavioral biases. The implication of these results is that one
should not underestimate the capacity of an individual who has a sound background in financial
analysis to outperform the market. The individual is able to do so on the basis of buying firms at
a value higher than the current market price of the security. It is my strong opinion that the
emotional vagaries of the market will continue to offer investors profitable opportunities if they
have the financial knowledge and emotional stability to counter conventional wisdom. The
results of this thesis underline and support this last statement.

55
IX. Further Research:

There are several avenues of research which can expand the results of this thesis. An
international meta analysis of the NCAV strategy would allow a direct comparison between
markets. If the results are persistent across countries using the same sample period this would
strengthen the evidence for the anomaly. Furthermore other analyses of value investment
strategies could be run. This could include other strategies identified by Benjamin Graham or a
strategy proposed by Warren Buffet; the study of high Return on Invested Capital stocks
(Graham, 2003), (Buffet, 2009). Another interesting field would be the study of corporate spin-
offs. Miles and Rosenfeld (1983) showed that corporate spinoffs produced significant abnormal
returns. An examination of the persistency of corporate spinoff returns would increase the
evidence against the semi-strong form of market efficiency. Finally during the analysis of
specific firms, it was noted that discount NCAV firms often experience goodwill write downs in
the previous 12 to 24 months. It could be interesting to analyze whether the market overreacts to
goodwill write downs and whether firms who have written down goodwill outperform the
market. Further research with respect to asset pricing models which contain behavioral proxies
could potentially allow for a model which is able to explain the returns generated. I recognize
that such a model is difficult to set up considering the complexities of quantitatively measuring
emotions. Research would nonetheless help clarify the persistency of this and other anomalies.

X. Limitations:

This analysis has several limitations. The first concerns a technical aspect of merging CRSP and
COMPUSTAT databases. The database of the University of Maastricht does not have access to
the merged CRSP and COMPUSTAT files. Therefore the data had to be merged manually. It
was merged using the CUSIP identifier. CRSP and COMPUSTAT use different means of
determining the CUSIP. This causes some stocks to be mismatched when merged. To examine
the degree of mismatches, several years of data was analyzed. There were a small number of
mismatches but as the years progressed the mismatched amount of stocks grew smaller. During
the last decade of the sample period almost no mismatches were found. The effect is therefore

56
minimal. Not only is the amount of mismatches very small compared to the total discount NCAV
portfolio but mismatches would occur randomly and weaken the results of the tests and not
strengthen them. As the results are significant, I believe that these few errors do not have a
sizeable impact on the overall results. The second limitation is possible differences between
accounting standards. While there might be differences, the impact should be minimal because
the firms are all publicly traded firms who have to meet SEC regulatory standards. The last
limitation is due to the inexperience of the author as a researcher. Although the author has
sufficient statistical knowledge, this is his first analysis of primary data. Thus small errors might
exist but it is believed that these errors should not influence the conclusions drawn in this thesis.

57
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XII. Appendices

Appendix 1: Balance Sheet and Stock Return Definitions: Compustat and CRSP

Used for the screening process

Current Assets – Total

The current asset item number is ACT.

The currents assets consist of the following items and is in accordance to US GAAP:

1. Cash and Short-Term Investments


2. Current Assets
3. Inventories
4. Receivables

This item represents cash and other assets that are expected to be realized in cash or used in the
production of revenue within the next 12 months.

Liabilities - Total

The Liabilities item number is LT.

The liabilities total consists of the following items and is in accordance to US GAAP:

1. Current Liabilities – Total


2. Deferred Taxes and Investment Tax Credit
3. Liabilities – Other
4. Long-Term Debt – Total

This item excludes:

1. Contingent liabilities reported supplementary to the Balance Sheet


2. Minority interest, included in Minority Interest (Balance Sheet

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Appendix definitions:

Preferred/Preference Stock (Capital) - Total

The preferred stock item is PSTK

The currents assets consist of the following items and is in accordance to US GAAP:

1. Preferred stock subscriptions


2. Utilities subsidiary preferred stock
3. Redeemable preferred stock
4. Preference stock
5. Receivables on preferred stock
6. Adjustment for redeemable preferred treasury stock.
7. Excess over par value of preferred stock when a separate breakout is not available

This item excludes:

1. Preferred stock sinking funds reported in current liabilities


2. Secondary classes of Common/Ordinary Stock (Capital)
3. Subsidiary preferred stock

This item is reduced by the effects of:

1. Par or carrying value of nonredeemable preferred treasury stock which was netted against
this item prior to annual and quarterly fiscal periods of 1982 and 1986, first quarter,
respectively
2. Cost of redeemable preferred treasury stock which is netted against Preferred Stock –
Redeemable

This item is the sum of:

1. Preferred Stock – Nonredeemable (PSTKN)


2. Preferred Stock – Redeemable (PSTKR)

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Shares Outstanding (SHROUT)
The number of publicly held shares on NYSE, Amex, NASDAQ, and NYSE Arca exchanges,
recorded in 1000s and adjusted for all price factors

Price (PRC)
Monthly — The closing price of a security for the last trading day of the month, adjusted for
distributions. If unavailable, the number in the price field is replaced with a bid/ask average
(marked by a leading dash).

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Appendix 2: Selection Criteria Compustat and CRSP

Use the following dataset

1. NYSE
2. AMEX
3. NASDAQ

- The years that are selected will be from 1983-2008

- Complete database is taken.

Compustat Stock Exchange Code:

1. NYSE: 11
2. AMEX: 12
3. NASDAQ: 14

CRSP Stock Exchange Code:

1. NYSE: 1
2. AMEX: 2
3. NASDAQ: 3

Selection criteria:

1. Only industrial firms are included, leverage of financial institutions makes it difficult to
compare.
2. Only domestic stocks are taken into account, international firms might have different
accounting standards and practices. It is also a test within the united states and nowhere
else.

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SIC codes: financial services = 6xxx

1. Steps to be undertaken in Compustat:

1. Select Compustat Database -> North America


2. Select Companies to be selected -> Entire Database
3. Select Date Range -> Jan 1983 until Dec 2008
4. Add to output -> Select only consolidated, financial, domestic, currency = usd, both
active and inactive
5. Conditional Statement 1 -> Exchange code = 11 NYSE, 12 AMEX, 14 NASDAQ
11 OR 12 OR 14
6. Conditional Statement 2 -> None
7. Identifying information -> Cusip, Ticker Symbol, exchange code
8. Select Fundamental data required ->

- All Current Assets = ACT


- Liabilities Total = LT
- Preferred Stock = PSTK

9. Select Date Format -> Default YYMMDDn8


10. Select Output format -> Stata
11. tostring fyear , generate(fyear1)
12. drop fyear
13. rename fyear 1 fyear
14. sort cusip fyear , uniqusing
15. Save, replace

2. Steps to be undertaken in CRSP:

1. Select CRSP Database -> Monthly Stock File

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2. Select Date Range -> Jan 1983 until Dec 2008
3. Search -> Entire Database
4. Conditional Statement 1: Share Code = 11
First Digit: Ordinary Common Stocks
Second Digit: Firms which need not be defined further
Fill in CRSP = 11
5. Conditional Statement 2: Exchange Code
Exchange codes: 1 = NYSE 2 = AMEX 3 = NASDAQ
Fill in CRSP <= 3
6. Identifying information: CUSIP TICKER EXCHANGE CODE
7. Time Series Information: Price

- Price
- Number of Shares of Outstanding, adjusted
- Holding period return, including dividends
- Holding period return, excluding dividends
- Value Weighted return, including distributions
- Value Weighted return, excluding distributions
- Equal Weighted return, including distributions
- Equal Weighted return, excluding distributions

8. Stata File
9. Select Date Format -> Default YYMMDDn8

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