Every investor is looking for ways to beat the market but how can you actually do it? Is there a simple strategy that you can implement to beat the market?
While beating the market consistently seems like a difficult proposition, it is certainly possible to do it if you know what is the best strategy to implement. Today, we bring to your attention a simple strategy that can certainly help you or assure you beat the market - the negative EV strategy.
How enterprise value (EV) works
One way of thinking about enterprise value is to imagine how much it would cost to own a company debt free. So if you were to buy a publicly traded company without any debt, the cost of it would be the current market capitalization added to the debt, and subtracting the current cash and equivalents the company has.
This is the basis for the strategy today because although most companies have a positive enterprise value, some actually have a negative enterprise value.
What negative EV means
A negative enterprise value means that the company has more cash than its current market cap and its total debt. It is rare to find a stock with a negative enterprise value, because in theory you could buy the whole company debt free, and pay yourself a dividend of the same amount, even considering taxes.
This makes it a very enticing investment to buy stocks with negative enterprise value because it offers investors a large margin of safety. In theory, you are buying a business for free, since the money it has is enough to pay for the whole company (market cap), and its debt. Additionally, you get a business that is generating revenue or even earnings.
What is the best metric to evaluate a stock to beat the market?
While investors use all sorts of metrics to determine whether or not a stock will beat the market, there is a clear stock metric that has predicted consistently which stocks will outperform - EV.
EV stands for enterprise value, and it is calculated by adding the market capitalization of the company, as well as the total debt, and deducting the cash and cash equivalents.
EV=Marekt Cap + Total Debt - Cash and Cash Equivalents
Why is EV so important?
According to a research study conducted by Alon Bochman, during the period between 30 March 1972 and 28 September 2012 all of the 2,613 stocks that traded at a negative EV had an average return over the next 12 months of 50.4%.
Obviously, the returns do not account for fees, commissions, and taxes, but the performance is still incredible and it shows how some strategies allow you to beat the market.
This shows how deeply undervalued stocks based on negative EV can outperform the market, and all you had to do over that period was to monitor stocks with a negative EV and add them to your portfolio.
How to beat the market with negative EV stocks
In order to understand how we can take advantage of this strategy, we need to analyze the data from Alon Bochman’s research. One of the most noticeable aspects that stand out is that most of the stocks that had a negative EV during the period were small caps. In fact, 70% of the stocks with a negative EV during those 40 years had a market cap under $50M.
While investors like to look at the large caps, and some of the major tech companies, the alpha is looking into small caps. From the study, only 3% of the companies had a market cap above $500M, which shows you that you will have far fewer opportunities to find if you only look at larger companies.
Additionally, what Alon Bochman found is that the location of the stock is also important. The stocks that had 12-month returns above the average (50.4%) were headquartered in:
- Ireland (157%)
- Israel (143%)
- France (72%)
- Cayman Islands (66%)
- Hong Kong (56%)
- Canada (55%)
How to use the negative EV strategy
There are a few ways of using the negative EV strategy to beat the market:
- Invest in a basket of stocks with negative EV
- Pick stocks within the negative EV pool
Invest in a basket of stocks with negative EV
Perhaps the simplest way to apply this strategy is to take an index fund approach, whereby you track every stock with a negative EV, and buy them. This is perhaps the best way of approaching this strategy for inexperienced investors who are unable to pick individual stocks.
You can even pick stocks within specific locations that tend to have the highest returns, although the results may be slightly skewed due to the specific time period when the research was conducted.
Pick stocks within the negative EV pool
For stock pickers, the best approach is to filter through stocks using a stock screener and research every single negative EV stock. This is perhaps the best approach because it might allow you to remove the losers, and pick only the best-performing stocks.
This also allows you to manage the portfolio and allocation in a different way, and it is certainly the best approach for experienced investors who know how to pick and value stocks.
Additionally, the study also showed that the average stock has a negative EV during a period of ~10 months which gives investors enough time to research and pick stocks. It will also be crucial to look at the small caps, that are mostly disregarded by large institutional investors.
What kind of stocks have a negative enterprise value?
There are a few different types of stocks that can have a negative enterprise value:
- Deeply undervalued stocks
- Unprofitable companies
- Companies whose numbers are not trusted by the market
Deeply undervalued stocks
One of the most common types of stocks with negative enterprise value is undervalued stocks. Valuations shift as investors change their perception of the company, and it reflects the fact that the market is not completely efficient.
Some of these companies may be struggling for a few quarters or years, with declining earnings and revenue. They might even be in an industry that is slowly declining or struggling.
Unprofitable companies
It is also common to find companies with negative EV that are unprofitable. Even though the company has plenty of cash and cash equivalents, its constant losses could push investors to sell the stock.
It is common for the company to trade at an extremely low valuation. These stocks tend to perform exceptionally well, especially when there are tailwinds and they return to profitability. It is usually followed by a re-rating of the stock both by the market in terms of valuation and also by analysts.
Companies whose numbers are not trusted by the market
There are also some situations where it is better to avoid, or at least spend more time researching. These stocks usually have a low valuation based on their current assets, and a negative EV because most investors believe the company is cooking the books.
This is clearly a matter of concern because if it is in fact true that the cash and cash equivalents are overstated the stock can collapse at any time.
Risks of using the negative EV strategy
While this strategy seems like it can work, there are certainly risks involved.
Some companies are frauds
There is a reason why some companies have a negative EV - their cash and cash equivalents are overstated. There are plenty of fraudulent stocks out there, and sometimes it is far too difficult to see through this, and not even auditors are able to evaluate whether or not the company has those assets, or is overstating them.
The study also reflected this, especially when we look at companies headquartered in China and Bermuda, which had a much lower 12-month return. This shows how some of those companies were outright frauds.
Volatility
Despite working in theory, negative EV stocks also had a negative performance in some years, especially those with a market cap between $50M and $500M. This is something to keep in mind if you want to apply this strategy.
Conclusion
There are plenty of investing strategies that promise market-beating returns, but most of them do not work. Historically, buying negative EV stocks seems to work over the long term, however, there is no guarantee that this same strategy will work over the next 10 or 20 years. For that reason, this is something you can implement, or try with a small part of your portfolio, to see if it actually works.
With that said for value investors and stock pickers, analyzing and researching stocks with a negative enterprise value seems to be a good way to start to find stocks that beat the market.