In times of market sell-offs like these days, there are more and more opportunities for stocks selling below their liquidation values — stocks Benjamin Graham called net-nets. Simply put, it was the investing strategy to consistently buy the stocks which are trading less than the stockholders would receive in the worst case — going bankrupt. Benjamin Graham suggested taking the current assets minus the total liabilities (including preferred stocks) to come up with roughly the liquidation value of the business.
Over his entire investment career, Benjamin Graham used this strategy to select his investments, especially when the Great Depression struck in the beginning of 1930, and business were sold as cheap as peanuts. And until now, when the whole market is bleeding, there are more and more net-nets available. However, there are several important points that value investors should carefully take into account when dealing with net-nets.
Margin of safety
This is one of the most important of the three pillars for value investing, in addition to Mr. Market and Circle of Competence. For net-nets, investors should only buy in when the stock price is at most 70% or lower compared to its liquidation value, as the liquidation value is a rough number, not the exact figure. We should leave some room for error either in terms of valuation or market judgments for a typical position. Personally, 70% margin of safety leaves me in a comfortable zone.
Don’t put all eggs in one basket
Cheap stocks (such as net-nets) have been called “cigar butts” by Warren Buffett. He said it was like you saw a cigar on the street which had one puff left. You picked it up and you smoked it. It was bad, but at least it was free. According to Graham, liquidation value positions often worked around 80%-90%, and there were 10%-20% of the positions which would never turn into good results. That is why diversification is encouraged when a liquidation value discipline in stock investment is chosen. Benjamin Graham preferred around 30 positions in his portfolio for ample diversification.
Positive earnings should be a bonus with asset-play net-nets
Value investors need to bear in mind that this strategy is an asset play, not an earnings play. Normally investors will come across net-nets which have negative earnings or earnings on the downtrend, or poor quarterly results which pushed the stock price south. Of course, it would be best that the company have positive earnings and the stock price hasn’t reflected it fully, still trading at ridiculously a low level.
The quality of current assets
As this strategy is an asset play, so the quality of assets is very important. The more liquid, the better the asset is. Actually in terms of determining the liquidation value, each asset is given a certain weight. Cash and cash equivalents are 100% value, account receivables 80%, inventories 60%, etc. Further, investors should look at the historical long-term basis of average five years to see whether there are any downtrends in the reduction of net working capital value over time. Otherwise, if the speed of wiping out the assets is faster than the reduction in the stock price, the net-nets would not be net-nets anymore, and the stock price would keep falling.
Inventory is an item which should be considered quite carefully. Determining whether the fair value of the inventory reduces fast over time is one of the crucial items in selecting net-nets, especially with the ones with large amounts of inventories as a percentage of current assets. Companies which produce technology items, such as cell phones, have easy–to-be-obsolete inventory. With those, it is not very sustainable to use the current valuation for the inventory. In addition, companies using LIFO give value investors more cushion as it undervalues the fair value of inventory in inflationary periods.
Be aware of hidden liabilities
Last but not least, there are quite a few companies which often hide their liabilities in financial statements by moving them off their balance sheets. Several retail stores have used operating leases instead of capital leases to avoid recording the true liabilities of the company in the financial statement. Investors should look into the commitments and contingencies in the footnotes to financial statements to figure it all out, taking it back into the balance sheet before accepting the easy, rough calculation to rush into positions.
Do not hold for too long
For any net-nets which have bad businesses, investors shouldn’t hold for too long. As Warren Buffett put it, “Time is the enemy of the poor business and the friend of the great business.” Benjamin Graham has the rule that net-nets should be sold out when the stock had advanced 50%. You might miss a lot of gain out there, but you would never be poor taking out the profits.
Patience! Patience! Patience!
As always, any value investors should have great patience. Investors should think that the stock price is meant to go down right after it is bought. So the short-term downward price movement shouldn’t affect investors’ emotions much. As long as there is no deterioration in the current assets of the net-nets or increase in the liabilities, value investors can still sleep well with the net-nets in their diversified portfolios.
Over his entire investment career, Benjamin Graham used this strategy to select his investments, especially when the Great Depression struck in the beginning of 1930, and business were sold as cheap as peanuts. And until now, when the whole market is bleeding, there are more and more net-nets available. However, there are several important points that value investors should carefully take into account when dealing with net-nets.
Margin of safety
This is one of the most important of the three pillars for value investing, in addition to Mr. Market and Circle of Competence. For net-nets, investors should only buy in when the stock price is at most 70% or lower compared to its liquidation value, as the liquidation value is a rough number, not the exact figure. We should leave some room for error either in terms of valuation or market judgments for a typical position. Personally, 70% margin of safety leaves me in a comfortable zone.
Don’t put all eggs in one basket
Cheap stocks (such as net-nets) have been called “cigar butts” by Warren Buffett. He said it was like you saw a cigar on the street which had one puff left. You picked it up and you smoked it. It was bad, but at least it was free. According to Graham, liquidation value positions often worked around 80%-90%, and there were 10%-20% of the positions which would never turn into good results. That is why diversification is encouraged when a liquidation value discipline in stock investment is chosen. Benjamin Graham preferred around 30 positions in his portfolio for ample diversification.
Positive earnings should be a bonus with asset-play net-nets
Value investors need to bear in mind that this strategy is an asset play, not an earnings play. Normally investors will come across net-nets which have negative earnings or earnings on the downtrend, or poor quarterly results which pushed the stock price south. Of course, it would be best that the company have positive earnings and the stock price hasn’t reflected it fully, still trading at ridiculously a low level.
The quality of current assets
As this strategy is an asset play, so the quality of assets is very important. The more liquid, the better the asset is. Actually in terms of determining the liquidation value, each asset is given a certain weight. Cash and cash equivalents are 100% value, account receivables 80%, inventories 60%, etc. Further, investors should look at the historical long-term basis of average five years to see whether there are any downtrends in the reduction of net working capital value over time. Otherwise, if the speed of wiping out the assets is faster than the reduction in the stock price, the net-nets would not be net-nets anymore, and the stock price would keep falling.
Inventory is an item which should be considered quite carefully. Determining whether the fair value of the inventory reduces fast over time is one of the crucial items in selecting net-nets, especially with the ones with large amounts of inventories as a percentage of current assets. Companies which produce technology items, such as cell phones, have easy–to-be-obsolete inventory. With those, it is not very sustainable to use the current valuation for the inventory. In addition, companies using LIFO give value investors more cushion as it undervalues the fair value of inventory in inflationary periods.
Be aware of hidden liabilities
Last but not least, there are quite a few companies which often hide their liabilities in financial statements by moving them off their balance sheets. Several retail stores have used operating leases instead of capital leases to avoid recording the true liabilities of the company in the financial statement. Investors should look into the commitments and contingencies in the footnotes to financial statements to figure it all out, taking it back into the balance sheet before accepting the easy, rough calculation to rush into positions.
Do not hold for too long
For any net-nets which have bad businesses, investors shouldn’t hold for too long. As Warren Buffett put it, “Time is the enemy of the poor business and the friend of the great business.” Benjamin Graham has the rule that net-nets should be sold out when the stock had advanced 50%. You might miss a lot of gain out there, but you would never be poor taking out the profits.
Patience! Patience! Patience!
As always, any value investors should have great patience. Investors should think that the stock price is meant to go down right after it is bought. So the short-term downward price movement shouldn’t affect investors’ emotions much. As long as there is no deterioration in the current assets of the net-nets or increase in the liabilities, value investors can still sleep well with the net-nets in their diversified portfolios.
