Notice the word you don’t see. Liquidation.
The myth about net-nets is that you buy them for their liquidation value.
The truth about net-nets is that you buy them to get liquid capital on the cheap. Then you hold them to wait for the return on capital to mean revert.
Net-nets are stocks that are clearly super cheap.
A stock selling for less than its net current assets is a lot like a stock selling for less than its book value.
At investing websites, you’ll often see a price-to-book value ratio shown for every stock you look up. That price-to-book ratio – even when it’s below 1 – is usually meaningless because it includes intangibles.
Intangibles are things like brand names. Economically, intangibles are very important. Even Ben Graham admitted that intangibles are probably a company’s most valuable property. Brand names are often worth more than any number of factories.
The problem with intangibles is in the accounting. Intangibles are not shown on the balance sheet at anywhere near their true economic value. This is obvious in the case of goodwill.
In accounting, goodwill is simply the purchase price an acquirer pays for a company it buys minus the identifiable assets of that business. If a buyer pays more than the seller’s book value, the buyer adds an amount called “goodwill” to his balance sheet to make up the difference. In Ben Graham’s day they called this kind of goodwill water.
Ben Graham actually wrote a very interesting article about goodwill giants – companies that went public at prices well above their book value.
Here’s what Graham had to say about these business that had once been floated on the stock market at prices above what the original owners put in:
“…the striking fact is not so much the large quantities of goodwill concealed in the plant account, but the extent to which most companies have succeeded in replacing this original water by real assets, and in creating a foundation of solid value for their (shares). The public has long had a general idea as to which companies were overcapitalized and which have been most successful in remedying this defect. But the question of tangible value has now assumed far greater significance than ever before because of the gradual progress of many of these issues into the investment class.”
Ben Graham used the article to show how some companies like General Electric had been completely successful in replacing this original goodwill – water – with tangible assets and in so doing justified their early lofty prices versus their stated book value. But other companies like U.S. Steel were unsuccessful in replacing this original goodwill with tangible assets.
Because U.S. Steel failed to earn extraordinarily high returns on its tangible invested capital.
A company with a lot of goodwill and a very high price-to-book ratio can still be a bargain as long as it earns very high returns on its invested tangible assets. Microsoft does that. Some value investors think Microsoft is a bargain even though it trades at more than 5 times its tangible book value.
Well, if you’re expecting a 7% return on your capital, then you’d better make sure a Microsoft can earn 35% on its tangible capital before you buy the stock. That’s the math. If you pay 5 times book value for a stock, you need that stock to earn 5 times what you’d be satisfied earning on your own money.
The math works the other way too. If you’re expecting a 7% return on your capital, and you find a stock trading at one-half of its tangible book value, you can earn a decent return on your capital even if the company only earns 4% on its own capital.
How is that possible?
Think of it this way.
When you buy a share of Microsoft today, you’re paying the guy selling the stock to you $24.89 a share. But Microsoft only has $4.75 a share in tangible book value. So, you’re trading $24.89 of your tangible capital for $4.75 of Microsoft’s tangible capital. That means you’re betting the capital inside Microsoft is worth more than 5 times what the capital inside your wallet is worth.
If you don’t believe that, don’t buy Microsoft.
What about Imation (NYSE:IMN)?
Imation is a buggy whip business. It makes CDs, DVDs, Blu-Rays, magnetic tape, and a lot of other stuff the world wants less and less of year after year. It’s an online world. And Imation is a decidedly offline business. Its future looks bleak.
So how much would you pay for $1 of Imation’s capital. How much less is a dollar inside Imation worth than a dollar inside your wallet.
What’s a fair trade?
Imation has $12.03 in tangible book value per share. The stock trades for $9.63 a share. So, Mr. Market thinks a fair trade is paying 80 cents for every $1 of Imation’s capital.
So far the discussion has only gone as far as tangible book value. But lots of stocks trade below their tangible book value – not just Imation.
So what makes a company like Imation special?
Imation is a net-net.
It has $9.70 in net current assets. The stock trades for $9.64 a share.
So, Mr. Market is willing to give you not just more than one dollar of tangible capital inside Imation for every one dollar you take out of your wallet. Mr. Market is actually willing to give you a smidge more than $1 of net current assets inside Imation for every $1 you take out of your wallet.
Why is that so important?
Here’s what’s included in current assets:
· Stocks and Bonds
· Prepaid Expenses
No factories. No brand names. No machinery. No land. If a net-net has any of that stuff – you get all those thrown in for free.
All you’re paying for when you buy a net-net is cash, stocks and bonds, receivables, inventory, and prepaid expenses.
You know what cash is. And you know what stocks and bonds are.
What about receivables?
Receivables are short-term promises to pay. Businesses extend credit to customers – they ship the customer a product before getting their cash – to grease the wheels of commerce. Most of these customers will pay. Some won’t. Companies maintain an allowance for doubtful accounts. This is what’s known as a contra-asset account. Don’t worry about the accounting jargon. Just know that the receivables number you see on a company’s balance sheet is already net of doubtful accounts. In other words, the actual money owed to the company is greater than the number shown. But the company expects some dead beats will never pay. So the accountants have kindly removed that amount from the balance sheet before showing it to you.
Receivables are considered very, very safe assets. For most businesses, they are short-term. Sometimes as short as 30 days. Banks lend freely against receivables. And factors will buy receivables at a discount to the amount shown on a company’s balance sheet and collect the receivables themselves.
Since receivables can be quickly and easily converted into cash, they’re considered a liquid asset.
At most companies, receivables quickly turn to cash as part of the normal business. When a company can’t wait that long, banks are usually happy to lend a company cash right away provided the amount of cash borrowed remains below the company’s receivables.
Remember that receivables grow with sales. That means they shrink with sales too. Many net-nets have shrinking sales. Therefore, cash may rise at some net-nets even when sales don’t. If sales are being made on the same payment terms month after month, a decline in sales causes more of the balance sheet to shift from receivables to cash.
The same is true of inventory.
It’s important to remember that inventory should not be valued on a liquidation basis unless the company has announced it plans to liquidate.
Some investors like to make estimates of what inventory would fetch in a liquidation scenario. Usually, that’s a dumb way to pick net-nets. The value in a company’s inventory depends on how quickly and easily the inventory can be turned into cash and how much the inventory will earn if it stays stuck inside the business.
Inventory that is truly stuck in a business earning pathetic returns on capital is worth no more than an equivalent amount of property, plant and equipment would be worth.
Which is basically nothing.
It’s stuck capital. And it’s worth only what it can earn inside the business.
However, inventory that is truly stuck is pretty uncommon. The reason for this is the relationship between inventory and sales. Machines are often worthless beyond their current use. A big reason for this is the lack of a clear relationship between a company’s level of sales and its ability to liquidate its machinery. Inventory can usually be repurposed fairly easily because the amount of inventory can be lowered as sales decline. The resulting salvage value of inventory is actually pretty high because inventory is stated at the lower of cost or market. Except under liquidation conditions, it’s not terribly common for companies to sell large amounts of inventory at a gross loss even though the company is operating at a net loss.
Sure. There are exceptions to these rules. Some businesses involve a fair amount of what could be called speculative inventory. This can be a big problem in boom-bust industries with inventory that becomes quickly outdated. But that’s a small segment of the economy. You’ll know it when you see it. You shouldn’t have any problem seeing the difference between raw material like steel which will stop building up if new orders decline and finished products like off the shelf electronics that can be close to worthless if produced in large quantities at the exact wrong moment.
At most companies, inventories are similar to receivables. Both assets tend to grow along with sales, customer pampering, and management error. An increase in receivables and inventories in lock step with sales is usually considered okay. When receivables and inventories grow faster than sales, that’s less okay. It means there’s been a decrease in efficiency. More capital is being tied up to do the same task.
This is a more common problem at growing companies than at net-nets. Some net-nets are growing companies. But most net-nets are companies with disappointing sales trends that Mr. Market only expects to get more disappointing over time.
As a result, net-nets tend to overachieve on converting receivables and inventories into cash while high flying companies underachieve. In other words, while business at net-nets is often very bad – it’s rarely worse than it appears to be. These ugly ducklings are usually not quite as ugly as they appear to be. Some net-nets can even eke out cash increases in the face of constant sales declines.
Those are the kind of net-nets you want to look for.
Net-nets that try to grow their way out of trouble – but can never seem to actually post a profit – are the riskiest net-nets. Run from them.
Still, there are some net-nets that plainly have too much inventory and receivables.
You have to ask yourself what the inventory and receivables are worth. There are two parts to that question.
1. Will the company be able to turn inventories and receivables into cash and remove that cash from this awful business?
2. If the company can’t do that and the capital is permanently stuck in the form of inventory and receivables – what kind of returns will that capital earn in this business?
This is the truth of net-nets. Buying liquid capital on the cheap.
The myth about net-nets is that you buy them hoping they’ll liquidate.
The truth is that you buy net-nets hoping their returns on capital will revert to the mean.
Just as high returns on capital attract competition and bring down the profits of once high flying companies that failed to build a moat around their business, low returns on capital repel competition. They actual send competitors racing out of the industry.
When researching net-nets, you’ll often come across descriptions like this one found in Imation’s 10-K:
“While demand for data storage capacity is expected to grow, the removable media market size is expected to decline in terms of revenue. The magnetic tape industry has consistently addressed the growth in demand for storage capacity with new non-proprietary storage formats with higher capacity cartridges resulting in a lower cost per gigabyte and a decline in actual number of units of media shipped. In addition, these non-proprietary formats experience greater price competition than proprietary formats. The market for non-proprietary format tape continues to gain share against proprietary formats and is typically more competitive with lower gross margins than proprietary formats. These factors inhibit the overall revenue growth of the industry. In addition, lower cost disk and storage optimization strategies such as virtual tape and de-duplication remain a factor in certain sectors of the market. As a result, we expect our tape revenue and margins to continue to be under pressure as these factors contribute over time to a decline in the size of the total tape media market and a shift in the mix of total tape revenue toward lower margin open formats.”
Who would want to enter an industry like that?
If you read Imation’s history, you’ll actually see that some companies have been quite eager to exit that business.
Sometimes the problem with a net-net isn’t the general industry but the specific business model. That’s actually pretty rare. Net-nets are usually companies that were never profitable or which the market thinks will never be profitable again.
Net-nets like Duckwall-ALCO (DUCK) are rare.
Duckwall-ALCO is a rarity among net-nets because it’s been profitable over its history and it will likely be profitable in the future. However, the company’s profits are anemic beyond belief. The more you dig into the data showing how the company actually works, the less you believe it’ll ever earn a decent return on its current assets.
Duckwall-ALCO is a rare net-net. It isn’t facing the sudden risk of bankruptcy. It hasn’t always been a money loser. But it has earned terrible returns on capital for a very long time.
Most net-nets aren’t so predictable. They face some risk of bankruptcy. They maybe haven’t been profitable in the past. But there’s some hope they will one day be more profitable than Duckwall-ALCO could ever hope to be.
The best way to think about net-nets is in terms of their possible returns on capital.
One way of doing this is by taking very long-term averages. You should always check a net-net’s 10-year pre-tax return on capital. Basically, EBIT/Tangible Invested Assets.
You shouldn’t count on earning a return on the stock that’s greater than the price-to-tangible book ratio you’re buying the stock at divided by the long-term average return on invested assets.
For example, Solitron Devices (SODI) has a 10-year average pre-tax return on capital of about 10%. Assuming Solitron will eventually pay a normal 35% tax rate on its earnings, you’d expect the company to earn 6.5% on its invested capital after-tax.
Solitron actually has only about 81 cents in invested tangible book value. The company shows up as a net-net, because it’s got a lot of cash. Those are the best kinds of net-nets.
When analyzing net-nets like Solitron, you need to separate the invested tangible assets from the cash. It’s often appropriate to calculate the value you expect to get for your stock in 3 years or 5 years (no sooner) if it traded for a normal multiple of operating earnings plus the stock got full credit for its cash per share.
The difference between Solitron Devices and Duckwall-ALCO is the difference between a business that takes a small amount of capital to run and a business that takes a huge amount of capital to run.
Neither Solitron Devices nor Duckwall-ALCO are bad net-nets. Right now, there are about 60 net-nets in the U.S. Solitron and Duckwall would both rank in the top half of that group in terms of attractiveness to an investor simply because they’ve been profitable in the past.
A huge number of the current crop of net-nets have been unprofitable for their entire history.
Buying those kinds of net-nets is a bad idea. That’s not what Ben Graham intended.
Some modern value investors go astray by focusing on liquidation value when picking their net-nets.
Don’t do that.
Use the approach GuruFocus’s Ben Graham Net Current Asset Bargains Newsletter uses.
Here is a good description from the January 2011 issue. The bullet points below were discussing that month’s specific net-net stock pick. But the basic ideas could be applied to each and every stock pick the newsletter makes.
(The stock’s name has been removed for this article)
· …is an old, established business. It has tended to eke out a profit in most years. It’s cyclical, but it’s stable. Unfortunately, while…is long-run consistent it is also consistently mediocre in the long-run.
· …business performance is not as bad as its financial reports suggest. Clearly…is intentionally using accounting that understates its true performance. It uses LIFO accounting which overstates the cost of goods sold and it uses rapid depreciation which overstates expenses. The combination of these two accounting choices – and…reluctance to break out certain lines on the income statement – makes…profit margins look much thinner than they really are. The cash flow reality is that…cost of production and overhead are both lower than they appear to be. Gross profits and net profits are higher than they appear to be. The income statement is a pretty inaccurate representation of…business.
· …business is much smaller than it appears to be. Most of the company’s assets are not tied up in actual production. Sales are very modest compared to …net book value. Even if…competitors were somehow able to undercut…so deeply as to cause…to operate at a loss for an extended period—those losses are unlikely to be large relative to… investment portfolio, land, and buildings. The losses on the income statement will be throwing pretty small punches into a pretty big pillow. When you invest in…you’re actually really well cushioned from possible losses in the operating business. You’ve got a lot of univested assets relative to the most the company could possibly lose in its actual business operations. Ironically, once a business is established—it’s hard to lose a lot of money on a small amount of sales. It takes lots of sales to destroy lots of value. And…sales are quite small relative to its univested assets.
As you can see, the net-nets chosen in the newsletter each month aren’t sexy stocks.
They aren’t chosen for their growth.
But they aren’t chosen for their liquidation value either.
That’s a myth.
You should buy net-nets because you’re getting liquid capital on the cheap. And returns on liquid capital will tend to mean revert.
If you add a little human selectivity into the mix – like GuruFocus does in its monthly net-net newsletter – you can avoid the landmines among net-nets and focus on the long-established net-nets with a serious shot at mean reverting returns on capital.
That’s the big difference between net-nets and below book value stocks.
Stocks trading for less than book value are trading at a discount to the stated value of their assets. But those assets include factories and machinery that are hard to repurpose.
Net-nets are trading at a discount to their cash, receivables and inventory. Liquid assets that can be put to more productive uses over time.
Current assets usually aren’t stuck capital.
There are exceptions. Duckwall-ALCO is one example of a net-net with massive amounts of capital stuck in a lousy retailing model.
But there are also net-nets like Solitron Devices. Net-nets that do eventually turn much of their current assets into cash. Net-nets that manage to get some of that valuable capital out of the business over time.
Those are the net-nets to focus on.
Learn More About GuruFocus’s Net-Net Newsletter