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Where Have All the Net-Nets Gone?

June 08, 2011 | About:
Geoff Gannon

Geoff Gannon

407 followers


Where have all the Ben Graham bargains gone?

Warren Buffett’s teacher, Ben Graham, bought stocks that had low prices relative to their long-term average earnings, low prices relative to their net current asset values, and low prices relative to hidden values not shown on their balance sheets and hidden income not reported as earnings.

Ben Graham is best known for buying pure net-nets. Net-nets are stocks selling for less than the value of their current assets – cash, receivables, and inventory – minus all liabilities. Basically, stocks selling for less than their liquidation value.

But that’s not all Ben Graham did.

Sometimes the best bargains aren’t obvious. Sometimes you find them by looking in out of the way places – like Australia. Or by looking beyond the balance sheet – at the accounting methods used to prepare those balance sheets.

Today’s net-net article focuses on two mistakes investors make that lead to mispricing stocks: neglect and ignorance. Stocks are neglected for a lot of reasons. Today’s example of a neglected stock trades on the wrong stock exchange.

Investors are sometimes ignorant of a company’s true economic situation. This is less common. And it often involves accounting treatments that investors aren’t used to seeing.

Today’s example of a stock investors are ignorant about involves a common accounting quirk that causes stocks to be mispriced – the equity method of accounting.

Both of today’s stocks are very small and very illiquid. They aren’t really put forth as great investment ideas – though they may be. They’re being used here as illustrations of a bigger theme: why do net-nets happen? And how can you profit from them?

There are a lot of reasons investors misprice stocks so severely. But neglect and ignorance are two of the most common reasons. Learning to recognize these reasons for extreme mispricing will make you a better net-net investor.

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[b]Neglect


Ben Graham’s Old Example: National Presto (NPK) 1972

“We have mentioned protracted neglect or unpopularity as a second cause of price declines to unduly low levels. A current case of this kind would appear to be National Presto Industries. In the bull market of 1968 it sold at a high of 45, which was only 8 times the $5.61 earnings for that year. The per-share profits increased in both 1969 and 1970, but the price declined to only 21 in 1970. This was less than 4 times the (record) earnings in that year and less than its net-current-asset value. In March 1972 it was selling at 34, still only 5 ½ times the last reported earnings, at about its enlarged net-current-asset value.”

GuruFocus’s Modern Example: GLG 2011

GLG Corp. (GLG) is a super-illiquid Australian micro-cap. It’s an Australian stock in the sense that it trades in Australia. The company itself has nothing to do with Australia. Its customers are American companies. And its sales are in U.S. dollars. In fact, the company’s financial statements are prepared in U.S. dollars. Labor is provided by workers in Southeast Asia. Labor costs are in local Southeast Asian currencies. The company is headquartered in Hong Kong. The company’s founder is the majority owner. In other words, GLG is a controlled company.

GLG manufactures clothes for U.S. retailers like Target (TGT) and Pacific Sunwear (PSUN) who want to save money by using Asian labor.

Like National Presto back in 1972, GLG in 2011 has been the victim of protracted neglect. In 2007, the stock sold for $1 (stock prices are in Australian dollars) before dropping below 20 cents during the global financial crisis. A few shares sold as low as 15 cents. The stock briefly touched 40 cents in 2010. But otherwise, the shares haven’t really recovered from the global panic.

Average EBIT over the last 10 years was $4.88 million. That works out to 7 cents a share. The stock trades for 27 cents. That’s less than 4 times average earnings. The company had no operating losses in the last 10 years. There is no discernible sales trend over the past decade. Record operating earnings were reached in 2004. They were 17 cents a share (adjusted for the current share count). So, the stock trades for about 3.9 times 10-year average earnings of 7 cents a share, about 3.4 times trailing earnings of 8 cents a share, and about 1.6 times record earnings of 17 cents a share. All earnings numbers have been adjusted to eliminate non-operating items, assume a 35% tax rate (the actual tax rate has always been much lower), and adjust previous year share counts for the current number of shares outstanding.

By any measure, GLG’s stock sells for a low single digit multiple of its normal after-tax earnings.

The company has 24 cents a share in net current assets (when U.S. dollars are converted to Australian dollars at today’s exchange rate). Shares trade for 27 cents a share. So, GLG is not quite a net-net. However, it is the kind of stock Ben Graham would buy. Because GLG is basically National Presto.

Actually, National Presto (NPK) still exists and it’s still a public company. But GLG today is basically an analog for the kind of Ben Graham bargain National Presto was back in the early 1970s.

Ignorance

Ben Graham’s Old Example: Northern Pacific 1949

“The large earnings generated since 1940, however, have brought a tremendous improvement in the Northern Pacific’s position. These benefits were not reflected to any extent in the price at the end of 1947 – which was below the average of the year 1937. For this backwardness there appears to be two main reasons: first, the failure to pay more than a $1 dividend since 1942 – a rate which in turns seems to control the average price of the shares – and second, the understatement of true earnings of Northern Pacific stock in the company’s reports, because a number of important profit items are excluded from the income account.”

GuruFocus’s Modern Example: Zunicom (ZNCM)

Universal Power Group (UPG) is a traditional Ben Graham net-net. The stock price is less than the company’s net current assets per share. Probably a cheap stock. But there are about 70 such net-nets right now. If you exclude Chinese net-nets and companies no longer filing with the SEC, you’re left with about 50 of these straight up Ben Graham net-nets. Most are losing money. Universal Power Group isn’t. So, it’s definitely in the top half of that group. UPG deserves consideration in any net-net portfolio.

But this isn’t an article about UPG. It’s an article about Zunicom (ZNCM). Which is not a net-net.

Or at least Zunicom is not a net-net in the way any computer screen can recognize.

Zunicom owns 41% of Universal Power Group. If you check the boards of the two companies, the history of the public listing of Universal Power Group shares, and you pay special attention to who’s married to who – you’ll come to the conclusion that Zunicom doesn’t just own 41% of Universal Power Group. Zunicom has de facto control over Universal Power.

Regardless of accounting rules, Zunicom’s 41% stake in Universal Power Group means 41% of the assets and liabilities of Universal Power – and 41% of the operating income of Universal Power – need to be brought onto Zunicom’s financial statements before any honest investment analysis can begin.

When you do that, you notice that Zunicom shares are trading at about a 50% discount to their adjusted net current asset value. That’s the net current asset value of Zunicom calculated by keeping 100% of their own assets and liabilities – except for the equity method stake in Universal Power – and then tossing the equity method stake in Universal Power and replacing it with 41% of all balance sheet items shown in Universal Power’s own financials.

The resulting balance sheet would put the price of Zunicom shares at about half their net current asset value. It would also erase Zunicom’s operating loss. Zunicom’s losses are actually offset in full by Zunicom’s 41% stake in Universal Power.

Zunicom doesn’t appear on net-net screens. Because computers see Zunicom as a money losing non net-net. But human eyes can see Zunicom for what it really is: an extraordinarily cheap net-net that’s not really losing any money at all.

In today’s frothy stock market, stocks selling at a 50% discount to net current assets are extremely rare. Many of them are money losers.

That’s why it pays to investigate unusual accounting situations like Northern Pacific in 1949 or Universal Power and Zunicom in 2011.

Conclusion

This short article isn’t really about GLG or Zunicom. Both stocks are hard to buy. You can buy these stocks. And perhaps you should. But few readers will even try to buy stocks this small and illiquid.

This article is really about neglect and ignorance. It’s about the misperceptions – the little mental quirks – that keep providing modern day value investors with Ben Graham bargains. Both the stocks in this article – GLG and Zunicom – are clear Ben Graham bargains. There’s little doubt Graham would be interested in them. But neither GLG nor Zunicom is technically a net-net. GLG is just extraordinarily close to being a net-net and extraordinarily cheap on an earnings basis. Zunicom is a more complicated situation. It’s one of those examples where accounting obscures value instead of highlighting it for prospective investors.

GuruFocus’s Ben Graham Net Current Asset Bargains Newsletter focuses exclusively on stocks that actually are net-nets. That means the newsletter doesn’t cover stocks like GLG or Zunicom. In fact, the Ben Graham Newsletter focuses on domestic stocks – so GLG would never be considered.

But these two stocks are pretty good examples of the spirit of the Ben Graham newsletter. Each month the newsletter picks a stock that’s very similar to GLG and Zunicom.

In fact, last month’s pick – the issue went out to subscribers on Friday, June 3 – was a stock where some of the value was obscured in exactly the same way Zunicom’s value was obscured.

The newsletter’s June pick owns a 37% stake in another company. Just like Zunicom owns 41% of Universal Power. And just like Zunicom, last month’s pick carried the investment on its balance sheet using the equity method of accounting.

In that particular case, the equity method of accounting resulted in the business being carried at about 2 times earnings.

That’s a much lower valuation than private businesses are normally sold for.

And that’s why following in Ben Graham’s footsteps can still be profitable.

Learn More about the Ben Graham Net Current Asset Bargains Newsletter

About the author:

Geoff Gannon
Geoff Gannon


Rating: 3.8/5 (30 votes)

Comments

rjstcr
Rjstcr premium member - 3 years ago
As always, great
Paleface
Paleface premium member - 3 years ago
Good article. I remember as a teenager back in the 1970's thinking that "if" I ever played the stock market I would try to find companies whose stocks were worth the same as the company. ("If" such a thing were possible.) So it's just common sense and probably plenty of people thought of it but they weren't Ben Graham. Nor could most people conceive of doing their own research until the internet and PC. Nor could most people diversify among dark horse investments with the brokerage fees. Nor was value investing the well-understood predominant philosophy that it has become since the 1990's.

Today we have a diametrically opposite situation. With millions of online investors and thousands of blogs, databases and ezines, logically if a company's share price is down to the bone, the probability is much lower that this is because its situation is unknown. The probability is much higher that there is something wrong with the company. Therefore I would be more cautious than ever about net-nets.

I think you are on the right track to look into non-USA net-nets. However this seems most likely to pay off if it is most likely to be difficult. I.e., I suspect perhaps to make the risk and effort worthwhile, you would need to have reliable sources that most people do not have, or to do some experimenting until you gain an unusual level of understanding.

However, I personally am most interested in using NCAV as a valuation method for all stocks. Currently all NCAV screens seem to assume we only want to know those with the lowest values. Perhaps there is reason for this, I don't know. However if someone could please point me to a screener that shows the NCAV for all stocks, not just the very cheapest ones, I certainly would be interested in experimenting with it.
yaronguru
Yaronguru - 3 years ago
Hi Geoff!

Thank you for the article!

On GLG: It seems to me that the company suffers not so much from protracted neglect, as you note, but rather from rapidly rising commodity prices, in particular oil and cotton.

(see: http://www.indexmundi.com/commodities/?commodity=cotton&months=120 for the latter) It uses the first for shipments and the second for garments it produces. It operates in a very competitive environment and in its AR admits to having trouble passing on the costs to its customers.

Note, for instance, that in 1H of FY 2011, which ended on Dec 31 2010, the company saw its gross margins shrink to an all-time-low of 7.5% and was barely profitable, with net income of 1.3m on rev of 113.5. (That's not much wiggle room there! A small misstep and you're in the red.) What's more alarming is that the major increase in cotton prices (from 100 to 200) happened in the latter part of 2010 and early 2011, and hasn't yet revealed itself in the company's IS. In other words, it may no longer be profitable.

You are currently buying the company for a little below net-current-assets, namely for about 20m. Yet given the pressure on margins, the company can easily find itself in the hole, and on rev of upward of 200m losing ~5m a year.

Will it stop operations and liquidate in time, in that case? Or will it dig its heels and borrow money, deeming the commodity price pressure temporary?

The management are stake holders, and don't want to go broke, but how sure are you they will avoid the sentimental pull to save their business at all costs (literally) rather than close shop and go find another job? And if and when that happens, how much out of the 20m of the net-current-assets will still remain on the BS you think?

Would love to hear your thoughts!

Yaron

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