The next issue of GuruFocus’ Ben Graham Net Current Asset Bargains Newsletter comes out tonight at 8 p.m.
The net-net newsletter is available to all GuruFocus Premium Members. But I’ll be writing this series of weekly net-net articles for both members and non-members. We’ll focus on net-net investing generally rather than specific stock picks. The newsletter has those.
Today, I thought we’d start with two of the most basic questions everybody asks about net-nets.
How many net-nets are out there? And are all net-nets micro caps?
The best net-net screen I know of says there are 142 net-nets as of yesterday.
Personally, I wouldn’t count some of these stocks as net-nets. Or at least not net-nets in the Ben Graham sense of the word. To Graham, a net-net was interesting because it was an actual business selling at less than its net current assets.
Yes, there are 142 stocks that meet the technical definition of a net-net. However, there are not 142 stocks that are actual operating businesses. Some of these stocks are just piles of cash.
One example is a company that sold its original business but hasn’t returned cash to shareholders. In fact, the company may never return cash to shareholders. It might buy an entirely new business.
Another example is a biotechnology company. When a biotech company that never really had a viable product is about to run out of cash it can choose to cut expenses to the bone. It can literally fire almost everybody. This leaves it in much the same position as a company that had a real business and sold it.
In both cases, the result is just a pile of cash.
A pile of cash counts as a net-net. But that isn’t the kind of company I’m talking about here. Some of the 142 stocks that count as net-nets fall into this cash pile category. It’s a small number. But it exists.
So, the actual number of Ben Graham type net-nets – legitimate businesses selling for less than their net current assets – is a bit less than 142.
Before we go on, I should lay out the exact definition for a net-net. Most of you know it. But it’s worth repeating.
A net-net is a stock with a market capitalization (last traded share price times number of shares outstanding) that is less than the company’s cash, receivables, inventory and prepaid expenses minus all of its liabilities.
This is different from two other – stricter – definitions of net-nets. The two other definitions you hear are basically a two-thirds of net current asset value formula and a kind of liquidation value.
The two-third of net current asset value formula is also based on Ben Graham’s writings. He mentions buying stocks at less than two-thirds of their net current asset value. Records show that Graham bought stocks at prices greater than two-thirds of net current asset value as well. And he knew stocks trading between two-thirds of net current asset value and 100% of net current asset value were extremely cheap.
No one disputes that.
The issue was one of practice. Graham wanted a margin of safety. He felt 33% was a good margin of safety – for any stock – as long as you were buying a diversified group. There is nothing magical about the two-thirds of net current asset value formula. It was just Ben Graham’s way of making sure there was a margin of safety in every stock he bought.
For much of Ben Graham’s career, it was possible to buy dozens of stocks at less than two-thirds of net current assets. That is not true today. As I mentioned, there are only 142 stocks trading below their net current asset value right now. Some of those are what I’d call false positives. They aren’t really businesses. And a lot of the real businesses trade somewhere above two-thirds of their net current asset value.
This makes it hard to buy a basket of stocks trading at less than two-thirds of their net current asset value.
Is it possible there will one day be a wide selection of stocks trading below two-thirds of their net current asset value?
In the U.S., a lot of net-nets appeared in the wake of the 1929 crash. They became most noticeable in the 1930s. There were plenty of perfectly decent businesses trading as net-nets at some point from about 1932 until 1942. One of America’s biggest retailers – A&P – was a net-net in 1937.
But even outside that remarkable decade, there was often a steady supply of net-nets among small and unloved U.S. stocks. Graham focused on poorly known stocks. He rarely bought well-known stocks.
And among small and poorly known stocks, you could find net-net throughout the entire 1930 to 1960 period. By 1965 – when Warren Buffett was closing his partnership – net-nets were in short supply. But they reappeared in the 1970s.
The biggest issue in finding net-nets is the overall level of stock market valuations. Usually, net-nets are the result of a sustained disconnect between the level of current assets – cash, receivables, inventory, and prepaid expenses – and the level of stock prices.
Although there are more net-nets after market crashes, it really isn’t a huge drop in stock prices alone that causes net-nets. It tends to be a long-term lousy market.
As I mentioned earlier, the period from 1932 to 1942 had a lot of net-nets. So did the period from 1972 to 1982. And Japan in the last few years has also been home to a lot of net-nets. In each case, net-nets could be found many years after the market top. It was really the extremely slow pace of recovery in stock prices that created and maintained net-nets.
That’s because current assets grew during such plodding periods even while market caps shrunk.
Market crashes can create net-nets. But so can market slogs.
This is especially true when the market for small stocks is worse than the market for big stocks. In fact, while U.S. stocks were cheap across the board from 1932 to 1942 – U.S. small cap stocks stayed cheaper longer. Graham wrote about this in some of his books. And after the war, the list of stocks Graham’s fund owned was tilted very heavily toward small and unknown companies.
In the 1950s, net-nets tended to be small stocks.
The same is true today.
We can argue about stock prices. A lot of people say stocks are cheap right now. While I won’t argue they are especially expensive – though I think there’s an argument to be made there – I will say that the U.S. stock market as a whole is not at the kind of levels seen from 1932 to 1942 or 1972 to 1982 in the U.S. And it’s not at the levels we see in Japan today.
Those markets are examples of places where you find a lot of net-nets. Whatever the level of U.S. stock prices is today – it’s clearly not low enough to produce large amounts of net-nets.
There are 142 net-nets in the U.S. Despite the fact that a slight majority of stocks traded in the U.S. have a market cap over $100 million, only a tiny minority (13%) of net-nets have a market cap over $100 million.
Even if you were willing to buy every net-net with a market cap above $100 million, you’d only be able to buy 19 stocks right now. The vast majority of net-nets are small stocks. Right now, six out of every seven net-nets are stocks with market caps under $100 million.
These are small stocks. And therefore tend to be small companies.
To be fair, net-nets are often priced very low relative to assets, sales, gross profits, employees, etc. These low valuations mean that using stock market capitalization as a measure of company size is somewhat misleading. There are cases where net-nets actually have the same size business – in terms of assets, sales, etc. – as public companies that have market caps that are two or three times greater.
In other words, a net-net with a market cap of $90 million is sometimes really about the same size business as another company with a $270 million market cap. It’s just that the market values one company much lower than the other. This could be because of business trends, bad management, scandal, etc.
It’s impossible to generalize. But it is worth mentioning that in the land of net-nets, stock market capitalization is rarely a perfect indicator of a business’s actual size.
Net-nets are above all else cheap stocks. Whether or not they are good businesses, you don’t get to be a net-net by being richly valued in the stock market.
But you do get to be a net-net by being small.
If you aren’t willing to buy stocks with a market cap under $100 million, you are going to be extremely restricted in the number of net-nets you can research – and the pickiness you can apply.
At the moment, the largest net-net is Ingram Micro (NYSE:IM). It has a market cap of $2.7 billion.
I won’t argue for or against Ingram Micro’s inclusion in a net-net portfolio. But I will point out that it does not score particularly high on most measures of business quality.
For starters, Ingram Micro’s gross margin is perpetually less than 6%. And no, that’s not a typo. I did say 6%. And I did say gross.
In fact, if I covered the name Ingram Micro and that whopper of a market cap, you would never put this company near the top of a list of net-nets you wanted to research in depth.
To be fair, Ingram Micro would likely be in the top half of the field of net-nets in terms of how eager I’d be to read the 10-K and 10-Q. The reason for this is simple. Ingram Micro has been able to turn a profit more consistently than most net-nets.
Even though there are 142 net-nets at the moment, you can quickly cut the field in half by insisting on actual companies with more than just a year or two of profits in their history.
The list of net-nets that have been profitable in most years – like Ingram Micro – is even smaller. Probably about three out of four net-nets fail this test.
It’s a tough test to screen for. Human eyes are better at this one. For example, a growing company that was unprofitable in the first six years of the last decade but profitable for each of the last four years may or may not be a good investment – but it’s clearly established itself as having the potential to be profitable if the future is much like the recent past.
Meanwhile, a company that was in the red for two years at the start of the last decade, two years in the middle, and now the last two years is more of a borderline case.
You’ve got a mix of all kinds of profitability records in the land of net-nets. The most common type would be called “spotty.” Although there are actually a fair number of net-nets that have never been profitable. These are stocks Ben Graham would never buy. And the newsletter doesn’t consider them.
There’s also a small group of net-nets that have been consistently profitable. Usually the profits have been low in relation to sales and assets. They’ve almost always been low in relation to equity. It’s these consistent performers with histories of very few losses in their past and positive retained earnings on their balance sheets that the newsletter tends to pick.
And it’s a small field.
So how many net-nets are out there right now?
By a purely technical definition, there are 142 net-nets.
If you narrow the field to just legitimate business – not mere piles of cash – with some history of profits, we’re talking maybe 70 net-nets.
And if you just want to talk about stocks with a history of as few losses as something like Ingram Micro – we’re now talking maybe 30 or 40 net-nets.
It’s not a big group. And the vast majority of these stocks have a market cap below $100 million.
This tends to make them illiquid.
That’s why the net-net newsletter is released on a Friday night. This gives subscribers all weekend to read the newsletter and put in a buy order for the monthly pick before the market opens on Monday.
The newsletter has a model portfolio that puts in a buy order on Monday morning. This ensures that the price recorded as a stock’s cost reflects the actual cost for subscribers to buy that stock (after the newsletter is published) rather than just the last traded price (before the newsletter was published). For illiquid stocks, these two numbers don’t always match.
Just how illiquid is a net-net portfolio?
It’s hard to say. The net-net portfolio actually owns a sub $10 million market cap stock that is more liquid than some stocks with market caps three or four times bigger.
Things like insider ownership, the way shares were initially spread out when the company went public, and the industry the stock is in drive liquidity in ways that don’t always match up perfectly with market cap.
But, yes, the smaller the market cap the less liquid a stock tends to be.
And net-nets tend to be very small stocks.
One final comparison of the likelihood of finding a net-net among different market cap groups is particularly illustrative.
As of yesterday…
One out of 28 stocks with a market cap under $100 million was a net-net.
But only 1 out of 265 stocks with a market cap over $100 million was a net-net.
A lot of investors focus on stocks with a market cap over $100 million.
If that’s what you do, you might never see a net-net in the wild.
Even if you researched one stock a day – 7 days a week – there’s a good chance you’d only see a couple net-nets a year.
For these reasons, almost everybody who looks for net-nets does two things.
One, they use a computer to help them screen for net-nets.
And two, they look at stocks with a market cap under $100 million.
For those investors who only want to look at big stocks – your net-net choices are slim. But they do exist.
Here’s a taste of some net-nets you’ve actually heard of:
Ingram Micro (NYSE:IM)
Tuesday Morning (NASDAQ:TUES)
You may have noticed a technological obsolescence theme there.
Tech risks are common among net-nets.
We’ll take up that topic next week.
Until then, you might want to browse some blogs that cover net-nets in depth.
Some good choices are Oddball Stocks, Whopper Investments, Cheap Stocks, and Greenbackd.
UK investors will want to read Richard Beddard’s Interactive Investor Blog. The kind of stocks he writes about are very similar to net-nets even when they don’t fit the technical definition.
And, remember, the next issue of GuruFocus’ net-net newsletter comes out tonight at 8 p.m.
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The next issue of GuruFocus’ Ben Graham Net Current Asset Bargains Newsletter comes out tonight at 8 p.m.