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Is Warren Buffett Advising Against Net-Nets?
Posted by: Geoff Gannon (IP Logged)
Date: March 12, 2012 01:16PM

Someone who reads my articles asked me this question:

Geoff,

…I recently read your article dated February 24, 2012 entitled "How Should You Divide Your Research Time?". In it, you stated the following:

"Warren Buffett didn’t switch from buying net-nets to buying Coca-Cola (KO) merely because he decided investing in big, high-quality companies was a better way to make money than net-net investing. He did it because he had too much money. And because stock prices had gone up since the 1950s. But mostly because he had too much money."

I agree that the size of funds with which Buffett is working would make net-net investing very difficult, but Warren's comments in his 1989 shareholder letter seem to contradict the idea that he "didn't switch from buying net-nets...because he decided investing in big, high quality businesses was a better way to make money..." Indeed, he says:

"If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the 'cigar butt' approach to investing...Unless you are a liquidator that kind of approach to buying businesses is foolish. First, the original 'bargain' price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces - never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns...Time is the friend of the wonderful business, the enemy of the mediocre...It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

I know Buffett has stated that if he were working with smaller funds, he would be investing in much smaller companies than those in which he invests today...However, in his comments above, he seems to be making a clear argument against a net-net strategy...is he really advising against net-nets?

Best,

Keith

*

That’s a great question. And a tricky one.

Let’s start with the easy part. If Warren Buffett had $1 million to invest and he had to choose from companies like Coca-Cola in every respect or like net-nets in every respect, which would he buy?

I think he’d buy net-nets. But that’s a false choice. The issue with companies like Coca-Cola (KO) is that they are bigger and trade at higher prices than net-nets. Both of these are disadvantages when working with small sums of money.

So why is it a false choice?

Because what Warren Buffett likes about net-nets is that they are super cheap relative to a conservative estimate of their value to a private owner.

But he hates the fact most net-nets are bad businesses.

The answer: buy better businesses that are also super cheap relative to a conservative estimate of their value to a private owner.

The best way to answer this question is to go straight to Warren Buffett. You quoted a letter Warren Buffett wrote to his shareholders in 1989. I’ll quote the answer Warren Buffett gave some University of Kansas students in 2005.

Here’s the question he was asked: “…you were quoted as saying ‘it’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.’ First, would you say the same thing today? Second, since that statement (implies) that you would invest in smaller companies, other than investing in small caps, what else would you do differently?”

And here’s what Warren Buffett answered:

“Yes, I would still say the same thing today. In fact, we are still earning those type of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today’s environment because information is easier to access.”

So, let’s talk about what I underlined there. Two points:

1. “We are still earning those types of returns on some of our smaller investments.”

2. “The best decade was the 1950s.”

Well, Coca-Cola is a big company. And Buffett isn’t earning 50% a year on it. It’s been closer to 15% a year. So, if you want to mimic Warren Buffett – apparently you should pay attention to Berkshire’s smaller positions.

We actually have a few clues here. One, Buffett has bought things that aren’t stocks. He could make higher annual returns on smaller amounts of money in those without us knowing about it. He mentioned high yield bonds in several places. Berkshire did well on its junk bond investments in 2002. We can assume he would make more investments like those if he had less money – he often had to buy baskets of bonds rather than the single most attractive issue.

Two, Buffett has said that unleveraged returns on arbitrage at Graham-Newman averaged 20% a year from 1926 to 1956. And that Buffett did even better in arbitrage for his partnership and for Berkshire. It’s also worth mentioning that Buffett was willing to leverage up an arbitrage position in his partnership – but not a general holding. He thought a 1 to 1 ratio of borrowed money was appropriate as long as the partnership did not borrow more than 25% of its equity and the borrowing was only used in connection with special situations like arbitrage – not buying a stock like American Express, Disney, etc.

If you watch Berkshire’s holding very, very carefully over the years – you’ll see some arbitrage positions and “workouts” appear in there. Off the top of my head I can mention the Dow Jones position Berkshire took in 2007 before Rupert Murdoch’s acquisition was complete. So, it was a bet on the deal going through at a higher price than Buffett paid. Buffett didn’t like the newspaper business at the time. Dow Jones was an arbitrage position pure and simple. And then Comdisco was a liquidation. This sort of thing is not new. Back in the 1977 letter to shareholders you can see Buffett owned shares of two different “Kaiser” companies – Kaiser Industries, and Kaiser Aluminum & Chemical . They were originally one company. And plans for the break-up of the company had been discussed extensively in newspapers. I’m sure Buffett was reading those papers. And I’m sure that’s why he bought Kaiser.

Buffett also mentions buying a stock after an announced event – something that appears in a newspaper as more than just a rumor – but before a deal is agreed to. He gives one specific example in his letter to partners. And he suggests there were more such situations over the years.

So, if we figure Warren Buffett can make more than 20% a year on his arbitrage positions without using leverage – and we figure he’d be willing to leverage up his arbitrage positions if he were working with small sums of his own money – you can see how we are now a lot closer to Buffett’s 50% a year returns than the 15% a year type returns a long-term blue chip investment like Coca-Cola can offer.

Let’s get back to exactly what Warren Buffett said to those University of Kansas students in 2005:

“You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3 a share when it was earning $20 a share! I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.”

And that’s what I suggest folks who are really obsessed with value investing do. If this is your passion, then find those off the map companies. I’ve tried to talk about off the map companies as much as possible.

It’s not easy because:

1. They’re illiquid

2. People prefer reading about companies they’ve heard of

Those are just the facts. And, at the end of the day, I write articles for people who read them. If folks have trouble buying the stock – that’s a problem. And if they’re totally uninterested in the subject matter – that’s an even bigger problem.

But I’ve always made it clear that obscure stocks are the way to go. If you have the drive to go out there and find stuff nobody knows about – do it.

I’m 50% in Japanese net-nets right now, because you can make a lot in Japanese net-nets. I found a handful of companies over there that are just far, far cheaper than anything over here. And last year most of them went nowhere for me but one of them got bought out. I more than doubled my money on the one that got bought out. And I was invested in the company for less than a year. I don’t even want to mention the kind of annualized returns you get on a stock like that. They’re insanely high. And basically one net-net that gets bought out like that can pay for 4 net-nets that do nothing for a year.

But if I write about a stock that is in the Dow Jones Industrial Average – more people will want to read that article than read about Japanese net-nets. One of those two articles can make you buckets of money. The other can’t. (What can I possibly know about a Dow 30 company that a hundred and six big fund managers don’t already know?) More people will probably read the article that can’t make you money.

Very few people who read this article now we’ll go look at Japanese net-nets because of it. That’s the way it was when Ben Graham got started in investing, that’s the way it was when Warren Buffett got started in investing, and that’s still the way it is today.

It’s amazing how little use we make of our good ideas.

There are lots of stocks nobody looks at. There are a few stocks everybody looks at. It doesn’t make sense. But that’s the way it is.

I’ve talked about Bancinsurance. I posted an article here about my experience with that stock. Before I wrote that article, I don’t think the Bancinsurance story was very well known. The stock certainly didn’t trade much. And I ended up making a very high rate of return on that investment. Now, the problem with both Sanjo Machine Works (in Japan last year) and Bancinsurance (in the U.S. back in 2010) was that you had to work very, very hard to get shares.

Yes, it’s a slight inconvenience. Bidding for illiquid stocks isn’t my favorite thing to do. But it’s hardly 40 hours of back breaking work a week. And if you do it right, it pays better.

Back to something like Bancinsurance or Sanjo…

First, some people just see it is super thinly traded and give up. If you’re someone with millions and millions of dollars to invest – that’s the right call. I’m not someone with millions of dollars to invest. So, I just went out and tried to buy every share of those companies I could.

They are really very boring stories. Both of them. There isn’t much t them. Sanjo was trading at a huge discount to net cash. And it wasn’t historically a money losing business. You could liquidate it for more than 2 times what I paid for the stock. Bancinsurance was an insurance company that was worth book value – it had a combined ratio under 100 in 28 of the last 30 years – that was selling for about 55% of book value. I was familiar with the company from a few years back when it looked cheap, but I didn’t buy shares then. So, yes, I had a small advantage in that I try to know a little bit about any decent over the counter companies I come across and keep them in the back of my mind. Anyone can create that advantage for themselves with a few hours of work a week dedicated to the pink sheets.

I started buying at $4.75 a share – book value was somewhere around $8.50 and it was worth book to a private owner – but I didn’t get very far. The CEO announced he was offering to buyout the company at $6 a share. That was clearly too low. So, from that point on I bought every single share I could get my hands on. The weird thing is that I was able to get my hands on any of the shares – and at $6 a share!

That’s the strange part of these stories. Not that so few shares trade in these stocks – that’s totally understandable. The unbelievable part is that someone was selling Sanjo at no more than half of its liquidation value. And someone was selling Bancinsurance at something like a 30% discount to book value – at the exact price the controlling shareholder was offering! I mean, someone will sell shares in a company to you that’s clearly undervalued and won’t even ask for a penny more than a control buyer is offering.

Well, the deal might fall through?

Sure. I totally considered that possibility. And I said to myself – worst case scenario: “You own a decent company at a very low price. Best case: you get bought out.” The downside in this stock was about what the upside is in most stocks – you get a decent business at a cheap price but you don’t have a catalyst.

And yet someone sold under those circumstances.

It’s mind boggling. But it happens. My average cost in that stock was $5.82 a share. If anything, I was probably too stingy. Maybe offering just a smidge more than the CEO’s offer would’ve sent a few more shares my way. I can dream.

The big thing is just that when you find a situation like Sanjo or Bancinsurance you have to go out and just buy up the shares. You don’t think about “your portfolio” and how you are allocated and whether you are getting the exact perfect price and maybe it will trade down a bit and I can get a lower average cost and – no, wrong answer.

The right answer: buy.

And that’s how you make 50% a year annual returns. Now, I’m someone telling you that who has not earned 50% a year.

That’s a huge reason why I’m reluctant to hold too many small positions. My returns in the couple stocks a year where I was willing to buy without regard to portfolio weight – like Bancinsurance – have been on the level of those 50% returns. They’ve been extraordinary.

The problem…

My other decisions – the majority of my decisions which end up being 10% positions and so on – they have been utterly unremarkable. Japan is an exception, because I never thought of it as one position. It was a basket that I think of as a 50% position.

But basically I’ve made maybe 10 important investment decisions in the 12 plus years I’ve been investing – everything else was a wash. And probably a waste of time. Other than those 10 decisions, I would’ve been better off just holding cash and then adding that cash when the next unbelievably obvious investment idea came around.

Anyway, my point is that you should listen to Warren Buffett when he says these things. Because they are still around. Obscure stocks where you can make a lot of money for just using a tiny bit of common sense – they are around in 2012. They are rare. And you can’t go around buying one of these a month. You have to look where no one else is looking, you have to be satisfied with literally a couple great ideas a year, and then you have to just gobble up shares when you find an “anomaly”. Because that’s the right word for these things. They don’t make sense. They are beyond “a cheap stock”. They are just so clearly and bizarrely mispriced that you do feel as if someone just walked up to you and offered to sell you a dollar bill for 50 cents. Every time someone offers to sell you feel that way.

And there’s another stock I don’t want to keep mentioning – I’ve mentioned it a lot in the past, it was a net-net and a net cash stock when I bought it, but it is no longer – because it’s one of my favorite stocks in the whole world but it’s also super illiquid so we’ll get to the point where if you Google Search for this stock you’ll just get me yapping about it in 100 different articles.

So, the stock will go nameless. But the numbers and emotions are exactly true.

Anyway, I was trying to buy this stock that shall not be named (check my past articles – you’ll know it when you see it) and it traded maybe something like 1,000 shares a day on average. No more than that. I wanted 20 times the daily volume. And I had heard this stock was impossible to get – or at least some folks had put in orders that didn’t get filled. So, I’m preparing myself psychologically for not getting any shares.

Now, to set the scene, the stock is selling for net cash. This is a good business. I won’t bore you with the details. But it’s been profitable more than 90% of the time for the last couple decades, it’s got a free cash flow margin around 20%, and return on invested capital is very high. Without leverage, this company would be earning more than a 30% return on equity after-tax.

Of course, it isn’t. It’s earning a tiny ROE because it has a balance sheet overloaded with cash. The company has like 4 times more cash than all its other assets. I call this anti-leverage. I’m sure I stole the term from somebody else. But, basically, when a really good company has invested assets that are less than its book value you end up with anti-leverage. The business earns a 30% return on equity. But most of the company’s cash isn’t in the business. It’s sitting idle. So, the stated ROE drops to 10% or 5% or something utterly unremarkable. And so this stocks drops off the radar for folks who like to invest in lovely little companies. Everybody knows who earns 30% returns on equity.

If you say “small company, high ROE”, in a second I’m saying:

· United Guardian (UG)

· Utah Medical Products (UTMD)

· Psychemedics (PMD)

I’ve never owned those companies. I’m not an expert on them. They aren’t in the top few hundred companies I know best. But I know their names.

Why?

Because they are small and have earned high returns on equity. That’s a good group of companies to know. And it’s really easy to screen for.

But if a company uses anti-leverage. If it becomes a giant cash pile it can drop off some of those screens.

So this company had no catalyst, didn’t do anything with its cash, and it will also connected to residential housing – which in 2010 was not the place to be.

So there are reasons why people wouldn’t want to buy the stock when I was looking at it. But why exactly would someone sell the stock? That part still baffles me.

But to really set the scene you have to understand the company is buying back shares. Not just this quarter or last quarter or last year – they’ve been doing this for a decade. It’s not a big amount of shares relative to the market cap. But it’s big relative to the float. And it’s huge relative to what actually trades. And they aren’t issuing stock. Literally every single year they end up with an equal or lesser amount of shares.

For a company that trades below cash to be doing this – flashing lights need to go off or something to alert you to a stock like that. Because chances are it belongs near the top of your list of stocks to consider buying. A net cash stock that is paying a dividend and buying back shares is usually a stock you want to buy.

Okay. So, we’re back in 2010. The stock is now trading at net cash. When I say net cash I actually mean a mix of mutual funds, municipal bonds, etc. Also, they have like a million dollars in a local bank. Anyway, so we are at net cash and I get most my shares over a long period of time around there. But what’s interesting – baffling really – is that at about 35 cents over net cash something like 100,000 shares trades. More than that maybe. We’re talking something like 5% of the shares not in the hands of the controlling family.

Now, you’re thinking that’s understandable. The company was trading above net cash. It’s totally illiquid. All these things are true.

But let me tell you what the company earned in 2010:

30 cents a share. And they paid 17 cents a share in dividends.

So, someone sold over 5% of the non-family controlled portion of the company for net cash plus 1.16 times earnings and net cash plus 2 times dividends.

In fiscal 2011, they earned 40 cents a share and the dividend was 20 cents.

This year – their fiscal year ends early in the calendar year – they’re on track for about 50 cents in earnings and 23 cents in dividends.

And someone was willing to sell what – for that company – was a really big block of the tradeable stock for just the company’s cash and investment plus 35 cents.

That’s the part that I don’t understand. I never believe it until I see it. But there are still companies that trade for as much as they’d be worth in liquidation. They’re off the map. Way off the map. But they’re out there. And sometimes, you’ll suddenly be offered $500,000 worth of their stock. And you don’t know that until you find the stock and go out there and bid for it. You could never guess anyone would offer to sell at that price. But it happens.

Here’s Warren Buffett talking to those same University of Kansas students:

“Other examples: Genesee Valley Gas, public utility trading at a P/E of 2, GEICO, Union Street Railway of New Bedford selling at $30 when $100 a share is sitting in cash, high yield position in 2002. No one will tell you about these ideas, you have to find them.”

But I think this is where Warren Buffett really says it best:

“I know more about business and investing today, but my returns have continued to decline since the 50s.”

Buffett knows not to buy Hochschild Kohn today. He knows to buy Coca-Cola instead. He knows the importance of good management. If he had it to do over – do you think he ever would have sold out of Capital Cities the first time he owned the stock?

Would he have sold out of Disney if he had it to do over again?

Would he have sold out of American Express?

Would he have bought Berkshire Hathway?

Remember, Buffett didn’t completely liquidate his partnership. In a sense, he sold out of shares of companies like American Express and Disney and kept shares of Berkshire Hathaway. Yeah. I don’t think he’d make that choice again.

No. He would’ve used insurance companies as a source of investable cash and he would’ve bought and held wonderful businesses like Walt Disney, American Express, and Capital Cities.

But would that have earned Buffett the kinds of returns he made in the 1950s?

No.

You can be really dumb about a lot of things when you’re managing millions of dollars that you can’t be dumb about when you’re managing billions of dollars. Managing small sums of money really depends on just being smart about a couple things.

Does that mean you have to invest in net-nets if you are working with small sums of money?

No. In fact, if it’s against your nature to invest in net-nets – steer clear, you’ll find a way to screw it up.

Can you beat investing in net-nets? Is there another way to compound small sums of money at really high annual returns?

Maybe.

But, you have to remember, there are different kinds of net-nets. We aren’t saying you have to buy the worst businesses in the world. Just the cheapest.

Buffett explicitly said to the University of Kansas students in 2005 that he would buy things like Union Street Railway. Well, Union Street Railway was a declining business. Societal changes were definitely going against the company.

But it had $100 in cash and you could buy it for $30.

Buffett would buy a mix of companies. I’m not saying he would just buy net-nets. But he would just buy insanely cheap stocks like:

· Genesee Valley Gas

· Union Street Railway

· GEICO

· Western Securities

And so on. He’s talking about either a growth company like GEICO trading like a value investment, or stocks trading at P/E ratios in the low single digits, or stocks trading for less than their net cash.

He’s not talking about Coca-Cola.

That doesn’t mean you shouldn’t buy stocks like Coca-Cola. But, if you do, you need to lower your expectations.

You’re going to make a lot closer to 15% a year doing a great job of picking high quality companies. Even if you do everything right – in that kind of investing – you’re not going to make 50% a year.

That’s fine. If you can save and make 15% on those savings, you’ll retire just fine.

But if you want to become a billionaire you probably shouldn’t start with Coca-Cola. You should start with those little market anomalies Warren Buffett told the University of Kansas students about.

You should start with stocks that are way off the map.

Ask Geoff a Question about Warren Buffett and Net-Nets
Check out the Ben Graham: Net-Net Newsletter
Check out the Buffett/Munger Bargains Newsletter




Guru Discussed: Warren Buffett: Current Portfolio, Stock Picks
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Re Is Warren Buffett Advising Against Net-Nets
Posted by: aashiq (IP Logged)
Date: March 12, 2012 02:38PM


where can i find info on Japanese net nets?



Guru Discussed: Warren Buffett: Current Portfolio, Stock Picks
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Re Is Warren Buffett Advising Against Net-Nets
Posted by: coda (IP Logged)
Date: March 12, 2012 04:07PM

Sorry Geoff what's the name of the nameless company?



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Re Is Warren Buffett Advising Against Net-Nets
Posted by: jayb718 (IP Logged)
Date: March 12, 2012 05:50PM

Maybe I'm making this too simplistic but isn't value investing all about searching for companies selling for less than it's intrinsic value, buying them, then holding them until something changes.

Isn't net-nets and high ROE businesses both branches of that main idea?

I think if you take a businesspersons approach and look at everything you can, then invest in the best bargains, you'll do okay over time.

Am I missing something?



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Re Is Warren Buffett Advising Against Net-Nets
Posted by: hpmst3 (IP Logged)
Date: March 13, 2012 02:57AM

Geoff,

Great article!

I would be interested in reading about the specific company investments that were your 10 most important investment decisions during your 12 plus years of investing.

I also would be interested in reading more about obscure net-nets or low ev/fcf ev/ebit companies. I like best your articles concerning obscure small companies.

Thanks,

Hugh



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Re Is Warren Buffett Advising Against Net-Nets
Posted by: pmisleh05 (IP Logged)
Date: March 13, 2012 09:26AM


Fantastic article. Thank you.



Guru Discussed: Warren Buffett: Current Portfolio, Stock Picks
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Re Is Warren Buffett Advising Against Net-Nets
Posted by: prado (IP Logged)
Date: March 13, 2012 11:06AM

Great article Geoff, keep up the good work.



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Re Is Warren Buffett Advising Against Net-Nets
Posted by: softdude2000 (IP Logged)
Date: March 15, 2012 11:09AM

Buffett advice of thinking about 20-punch card when buying stock almost recommends KO style investment - buy a high quality company with a margin of safety and ideally never sell. For me, it is not a net-net investment style.



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Re Is Warren Buffett Advising Against Net-Nets
Posted by: sobko (IP Logged)
Date: March 15, 2012 06:28PM

Agree with Geoff. Noone is going to make 50% returns buying stocks on an intrinsic value basis. You need to be looking for companies where the 50% (or more) upside is clearly visible on the balance sheet.

This can take you into some strange territory where growth rates, PE ratios, and other standard metrics have no relevance.

You'd be more likely to wind up researching legal precedents for a stock where value is tied up in litigation (see GYRO), or researching the market values for relics that were recovered from the Titanic (see PXRI). These opportunities are out there, but not for those looking for stocks that are undervalued purely on an IV basis.



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