Investing and Profit with Net-Nets

Investing in net-nets is really deep and pure value investing style. Net current asset value method is investing technique first introduced by Benjamin Graham in the 1930s.

Many research studies demonstrate that NCAV investment approach has produced clearly better than the average results already over 80 years. Benjamin Graham told himself: “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.”

When a company’s NCAV (the aforementioned current assets minus all liabilities) is more than a company’s market value it’s theoretically possible that the company could be liquidated and result in a gain for shareholders. In reality liquidations are extremely rare.

 

Different ways to use net-nets method

Although it’s very easy to quantitative define net-net stocks (current assets – total liabilities) there are many different ways to invest with this method.

The simplest way is just screen stocks valuing under their net current asset value and buy basket of them.

Many investors require some kind of margin of safety. For Ben Graham it was generally buying 2/3 under the value of NCAV. Some use 75 % of NCAV to their limit. The idea is to decrease downside risk if any unexpected bad information about the company (or concerning markets) is revealed.

For other investors simply NCAV valuation gives not enough downside protection. They are ready to value cash for 100 %, but think that receivables and inventories are more risk. For them There is net net working capital method. NNWC = Cash and short-term investments + (0.75 x accounts receivable) + (0.50 x total inventories) – total liabilities. This method of course shorten the list of possible investments clearly. And if you are very strict you have to remember that ongoing business losses can erode also cash very quickly. In other words if company is burning cash you should consider can you value it in the balance sheet 100 %. I think both Joel Greenblatt and Seth Klarman have reminded us about this problem in their old interviews.

Anyway all net-net stocks are dirty cheap and when analyzing net-nets you should concentrate to downside risk. As a group net-nets will work so well that most important is to avoid bad apples.

An investor should always try to identify why a company is selling for less than NCAV.  Once this has been done the investor should then determine of the discount for the given flaw is appropriate.  Not all net-nets are good investments, some have gone to zero for a variety of good reasons.

 

Risks with net-nets

The most common risks are fraud, rapidly eroding value and bankruptcy.

The risk of fraud is mostly related to the number of Chinese reverse merger companies that had both great numbers, and incredibly low valuations that turned out to be fraudulent.  Outside of the Chinese I don’t believe net-nets companies hold any more risk for fraud compared to other areas of the market.

A history of low profitability tends to produce perennial NCAV stocks. You should avoid stocks that always seem to trade below their net current asset value. Firms that constantly lose money are great at destroying shareholder value. If company’s net current asset value is rapidly eroding, it’s a big red flag.

Companies that have been unprofitable for years can burn big hole in your pocket. You have a chance of substantial economic loss and in worst case – bankruptcy – you may lose all the invested money.

Another danger to burn your money is by buying companies that don’t have existing operations.

Pharmaceutical research companies can burn their working capital without any real outcome. Also some companies sitting on a bank account just not doing much more – avoid them.

We can form a quick checklist of what should be avoided:

– Chinese net-nets

– Companies traded below NCAV for years

– Companies that don’t have existing operations

– Selling its own shares

– Gimmick or fraud accounting

– Biggest net-nets

 

Fine tuning net-nets

Can you get better than average results selecting net-nets by using additional criterion like profitability, low P/E ratio or paying dividends is very good question. There are different studies and different answers. Henry Oppenheimer (professor of finance at the State University of New York) examined the returns to Graham’s net current asset value strategy over a 13-year period. He found that net-nets stocks operating at a loss outperformed the portfolio of profitable and dividend paying net-net stocks.  Same tendency continued during the 30-year period according to Tobias E. Carlisle (updated examination to Oppenheimer’s study in his book “Deep Value”). On the other hand Victor J. Wendel (president of Wendl Financial Inc.) testify in his book “The Net Current Asset Value Approach to Stock Investing” that low P/E and dividend paying net-nets performed better than net-nets stocks on the average. Either way we have to remember investing our own money isn’t same as examinations including all net-nets stocks in the market.

Although diversification is desirable to investing net-nets you cannot buy them all. You need to form doable strategy to work with net-nets. As I mentioned at the beginning of this article avoiding the biggest mistakes is the most important thing. But you can also look for quality and that way reduce volatility, avoid some permanent losses and maybe you will also sleep better at nights.

What we are searching for?

  1. Size of the company

We are looking for small companies – market cap under 50 million (some investors prefer under 25 million). Generally, most of net-nets are underfollowed small stocks, but you should check company size. Net-net stocks of tiny companies tend to outperform the stocks of larger companies. Of course trading really tiny companies can be challenging because of illiquidity and large spread between bid and ask price.

  1. High F-Score and Z-Score

Particularly F-score but also Z-Score work well with net-nets. F-Score tells you how financial strong and healthy these bargain stocks are and it is just what you need to know. Z-Score tells you how distress company is and what is the risk of bankruptcy. Important information to know. Remember however that net-nets are always really cheap stocks with some kind of financial difficulties, distress and risk. You should also get to know financial statements (SEC filings) and annual reports.

  1. Adequate past earnings, retained earnings or paying dividends

If you get any signals that net-net stock turns to be profitable, first it means decrease of risk and secondly there could be a big upside potential. Retained earnings tell you much about the quality of net nets stock. They can help you to avoid some perennial money losers.

Already Ben Graham recommended dividend paying net nets. Times have changed but sustainable payment of dividends is still a sign of strength. Though dividend paying stocks trading below liquidation value can be difficult to find (Japan is an exception).

  1. Insider ownership and company is buying back stocks

It’s important to know that owners or management of the company are supping from the same bowl. It’s appropriate to require collectively Insiders owning to be at least 1 percent of company’s stocks. Every time a net nets company buys it’s own stock it increases the value of shareholders. It also shows a strong confidence in its own future.

  1. Low price to net current asset value and increasing net current asset value

The lower the price to NCAV the better the returns will be as an average. Benjamin Graham looked to purchase net nets which were valued at a discount to their net current asset value by 33% or more. It’s widely known truth that net nets can, although cheap, still quickly lose value. The lower the price to NCAV the bigger is your margin of safety and downside protection. If company’s NCAV is of the other hand increasing, it’s a good sign. A company is working in the right direction and balance sheet is getting stronger.

 

Selling net-nets

One of the oldest method is buying at the discount to NCAV and selling when the stock price reached NCAV. This method has worked a long time ago and maybe it’s still profitable, but I doubt that it is the best possible. Generally, I imagine that the biggest mistake of many investors is to sell net nets too early.

The two main reasons for it are, (1) when the price of the stock rises rapidly investors are in a hurry to collect profits, (2) when the value of the stock decrease or stay flat for many months, investors get bored and lose their faith. Usually you make mistake both ways.

When the price of the net nets stock rises rapidly, even over NCAV level, you should remember that it has been initially dirty cheap and when something positive come out the upside possibility can be enormous. Don’t cut the future of three, five or even ten bagger stock too early. Analyze always what has happened and how the fundamentals have changed and make your own conclusions is the stock still undervalued or already overvalued based on your new analysis.

The same applies when the value of the stock decrease or stay flat for many months. If you have chosen stock according the right criteria (remember this is the most important thing in net nets investing) you should keep it at least one year. The only exception is if you have made clear mistake when purchased.

In theory, maybe also, if you need the money to better investment. In this case you should be very sure of your choice.

Because net-net company rarely change its business at short period so much that you can consider it as a compounding quality company holding time is also shorter. Three years should be enough to see what happens. Often something like five years is the maximum time to keep them in your portfolio. You don’t have to look at your net-net portfolio every day, but you should re-evaluate your holdings every six months or at least fewest every year.

 

Want to learn more about net-nets?

Books:

Of course first you better read the most important books of father of value investing, Benjamin Graham who originally developed net-net investing method.

– Security Analysis

– The Intelligent Investor

 

There are also other interesting and useful books about this theme

– Deep Value (by Tobias E. Carlisle)

– Deep Value Investing (by Jeroen Bos)

– The Net Current Asset Value Approach to Stock Investing (by Victor J. Wendel)

 

Not so much about net-net investing technic but great story about Peter Cundill, one of the masters of this style

– There’s Always Something to Do (by Christopher Risso-Gill)

 

Other quality investing books that contain relevant information about this topic

– Value Investing (by Greenwald, Kahn, Sonkin and van Biema)

– Quantitative Value (by Wesley R. Gray and Tobias E. Carlisle)

– The Manual of Ideas (by John Mihaljevic)

– The Value Investors (by Ronald W. Chan)

 

From internet you can find lot of information. Some useful tips:

http://www.netnethunter.com/ (all about net net investing and great checklist)

http://www.oldschoolvalue.com/ (a lot of value investing information, also net nets)

http://www.oddballstocks.com/ (great articles – not only net nets)

http://stocksbelowncav.blogspot.fi/ (already name will tell you all)

http://greenbackd.com/ (writer of “Deep Value” and “Quantitative Value”)

http://www.valueinvestingblog.net/ (net nets and micro caps)

https://deepvalueideas.com/about/ (net nets investor from Germany)

– Geoff Gannon’s articles in GuruFocus (great deep analysis about net net investing and other very educational articles)

You can surely find a lot of more interesting resource searching from internet.

 

 

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