When Is a Bad Business a Good Net-Net? (DNB, AAPL)

Someone who reads my blog sent me this email:


Hi Geoff,


A company is attractive if it is trading below NCAV and has earned a decent return on equity in the past. I can understand that.


But what about a company trading with a 30%+ discount to NCAV, but historically earned poor ROE, say, 7%? It is not really losing money. But it’s not making a profit over cost of capital. How should one approach this? With a stock price below book value, earnings yield will be bigger than its ROE. Does an earning yield like 15% compensate enough for the poor ROE?


My thinking is: a low ROE implies poor business and no moat, doesn’t it? And there is no reversion to the mean. So it will be a pass.


But is it that ‘there are no bad assets, only bad prices?’


John


That’s a great question. And there are a lot of ideas in there. So, I’m going to go through them one by one. Let’s start with the idea of a 30% plus discount to net current asset value.


Many of the stocks picked in the GuruFocus net-net newsletter have much smaller discounts to their net current assets than that. In other words, they are more expensive. They are not true Ben Graham bargains. That would be a stock selling for less than two-thirds of its net current assets.


Once again, I’ll remind everyone that:


A net-net is a stock selling for less than the value of its current assets – cash, receivables, inventory, and prepaid expenses — minus all liabilities. Basically, it’s a stock selling for less than its liquidation value.


John used that definition to show that a net-net must — by definition — always sell for less than its book value. And a stock that sells for less than its book value must also have an earnings yield (an inverted P/E ratio, that is E/P) greater than its return on equity. This is all true. A net-net that earns 7% on its equity — or book value — must earn even more on its net current assets because net current assets are always less than book value.


So, John’s hypothetical example of a stock selling at a 30% plus discount to its net current assets with a return on equity of around 7% and an earnings yield of around 15% is actually very believable. If a historically profitable company’s shares traded as low as two-thirds of book value they might very easily have an earnings yield of around 15%. This is just another way of saying the stock’s “normal” price-to-earnings ratio is less than 7. That’s because 1 divided by 15% equals 6.67.


So, should you buy a net-net with a normal P/E of 7 – even if the business is mediocre at best?


Yes. You probably should. If the stock is safe – you should buy it.


Here’s why. A P/E ratio under 7 is extremely cheap. A return on equity of 7% is low. There is no reason why a company with a 7% ROE should attract more competition than a company with a 30% ROE. In fact, it should attract less. Also, there’s no reason why a company should invest more heavily in a business that has a 7% return on equity than a business that has a 30% return on equity. In fact, it should invest less money in such a bad business.


Finally, a net-net with a 7% return on equity is probably unleveraged. By definition, net-nets have to have current assets greater than total liabilities. As I explained in last week’s article – most public companies fail this test. They have less liquid balance sheets than that. They have higher liabilities.


A quick detour here. I would feel totally different about a net-net that has averaged a 7% ROE with no leverage – or even some surplus cash – than a company that has averaged a 7% ROE using leverage. In other words, a company with an average return on assets of 3.5% that was levered up 2 to 1 in most years to achieve that 7% ROE is a totally different animal than an unleveraged company. It’s much less attractive. And quite possibly unsafe.


Now back to my point about how a bad business actually has some things going for it purely by being so utterly awful.


A net-net with a P/E ratio of 7 has the possible tailwinds of less competition, lower future investment, and increased future leverage raising that earnings number over time.


Stock with high ROEs can face the opposite situation: more competition in the future than the past, more aggressive investment in their own future, and already high leverage that has nowhere to go but down.


Now it’s not all sunshine here for the mediocre company. Obviously there is always a reason why a company has only earned 7% on its book value in the past. Likewise, there will be a reason why the company has used little or no leverage. It might be a risky business. The company could be controlled by a conservative family. They could hoard cash. They might remember a past bankruptcy. They might be fearful of the future. Or they might be clinging to a dying industry.


These human elements are real. And they really do hold stocks back. But it’s hard to handicap these situations. Would I rather invest in a net-net trading for 7 times earnings or a wide moat company trading for 7 times earnings?


I’d rather own the wide-moat stock. But it’s not that easy to know what a wide moat is. And it’s even harder to know if it’ll be around in the future. Personally, I would be inclined to own a company like Dun & Bradstreet (DNB, Financial) at 7 times earnings because I think that company has a wide moat. Others might want to buy Apple (AAPL, Financial) at 7 times earnings rather than a net-net. That’s fine. I’m not sure I would.


The problem there is the future. A wonderful recent past combined with bright future prospects will lead to more competition for a company like Apple. So you have to look at the organization. You have to believe in the people there. And the culture. And their ability to innovate. And to preserve a brand. To cultivate an image. And to hype things worldwide.


There is nothing wrong with making that kind of bet. But it’s hard to make on the past numbers alone. Because you know there will be factors – like competition and new product launches – that will transform the company. Will this tend to push the company’s return on equity toward the kind of ROE the average American company earns? Maybe. At a certain size, the push toward mediocrity will be pretty strong.


I’m not saying Apple is worse than a net-net. I’m just saying there are really three different types of stocks. You can – in my view – buy Dun & Bradstreet for its competitive position, you can buy Apple for its organization, and you can buy a net-net for its liquid assets. All are legitimate investments. All require different analysis. The P/E ratio is most applicable to Dun & Bradstreet. I think Apple’s P/E ratio has less meaning. And a net-net’s P/E ratio has even less meaning.


But, like I said in last week’s net-net article, the push toward mediocrity at a net-net will tend to raise the stock price rather than lower it. Any movement towards mediocrity at D&B or Apple will devastate the stock price. Both companies have stock prices that are not backed by tangible assets. Therefore, they need to maintain ultra valuable intangible assets or their stock prices will collapse. Net-nets are different. They are backed by tangible assets.


Let’s take your hypothetical net-net. You said it had a 15% earnings yield, a 7% ROE, and was selling at a 30% plus discount to its net current assets.


Let’s assume that means it is trading around half of its book value. If the company’s return on equity rose from 7% to 10%, its earnings yield would rise to 20%. In other words, it would have a P/E of 5. That’s because a company earning 10% on its book value and bought at half of its book value must be earning 20% on your purchase price.


Okay. Now, what is a normal price-to-earnings ratio. For most stocks, the answer is 15. What will this stock’s P/E ratio be? It’s hard to say. It depends on sentiment. Don’t overlook this. At some point in the next 3 or 5 or 10 years, it’s entirely possible investors will warm up to this net-net. It will – at that moment – achieve a P/E ratio of 15. That’s more likely than you think. Discounts do not last forever. Stocks tend to overshoot in both directions. That’s what Buffett meant when he talked about Ben Graham bargains as being used cigar butts. The puff is that little positive hiccup that happens. Nobody knows what it is. But something will happen – the company will get bought out, the stock’s industry will be back in favor on Wall Street. It could be a million different things. Most of them unforeseeable. Many of them temporary and – let’s face it – whimsical.


To some extent, you can tell ahead of time how likely a stock is to eventually trade at a normal P/E ratio. Investors like consistency. A net-net that has been profitable in 6 of the last 10 years isn’t just a dodgy stock from your perspective. It’s also unlikely to be rewarded with a premium P/E ratio.


A stock with 10 straight years of profits is different. Likewise, if that return on equity is lousy because the business is lousy you have a problem. If the company’s return on equity is lousy because it doesn’t use leverage – in fact it hoards cash – you have an opportunity. The cash probably isn’t being counted. At least, the company is unlikely to be getting full credit for both its earnings power – without the cash – and its pile of dough.


So, there’s no one-size-fits-all answer to this question. To take an extreme example, if the company actually earns a 15% return on its invested tangible assets – that is, a 23% pre-tax return on assets other than cash – than you should definitely buy it. In fact, it’s very likely one of the best stocks out there.


The reason for this is simple. A company can earn a 7% return on equity simply by holding a lot of cash that earns nothing. If a company has half its book value in cash, it can earn an after-tax return on equity as low as 7% even though its actual business is earning around 23% pre-tax. That’s because 23% before taxes becomes 15% after taxes (of 35% in the U.S.) and then only half the company’s assets earn this 15% return – the other half is in cash which earns zilch – thus resulting in a 7.5% return on equity.


The best net-nets fit this pattern. They are not bad businesses. Some actually earn above-average returns on assets other than their cash. They’ve just allowed a huge pile of cash to build up over the years. One day, something will happen to this cash. We don’t know when. And we don’t know what. That’s why the stock is cheap. And that’s why you should buy it.


In cases like this, you simply buy the stock and keep it. Don’t try to figure out what the catalyst is. Don’t try to figure out how and when you’ll get paid. Don’t worry about whether it’ll take five months or five years. If you buy the stock when it is cheap enough, you can afford to hold the stock for as long as it takes.


Sanjo Machine Works (TYO:6437) is a good example of a company that fits this cash pile category. It is, however, not a good example of an above-average business. The core business doesn’t earn great returns on equity. But it’s a Japanese stock. By the standards of Japanese public companies, Sanjo’s return on assets is not as bad as it appears to Americans.


Regardless, Sanjo’s cash per share exceeded its stock price per share for long periods in the last year or two. This month, Sanjo announced it will be bought out for 468 yen a share. The stock frequently traded well under 200 yen a share. Despite the stock’s illiquidity, an individual investor could have easily made 130% in this stock. The opportunity was lying there in the market for months and months.


What special skills did earning this 130% return require? You didn’t need smarts. The key information – the cash and securities per share – was publicly available. Anyone could find it on the Internet. And the gap was egregious. If you looked at hundreds or even thousands of stocks – in Japan and around the world – Sanjo would’ve popped as a Ben Graham bargain.


No. You didn’t need smarts. You didn’t need any real insight or appetite for risk or anything like that. You just needed to embrace uncertainty.


Sanjo was certainly worth more than 200 yen a share. A lot more. No reasonable person would deny this. But most reasonable investors probably wouldn’t buy the stock. Why? There was no catalyst. No reason for the stock price to rise. Sanjo is a Japanese company. It’s a micro cap. Stocks like that don’t get bought out.


As it turns out, Sanjo’s largest shareholder had been in “intensive discussions and price negotiations with management over the last year.” So there was a catalyst. It’s just that nobody – except the company’s biggest shareholder and its president – knew about it.


That’s the uncertainty in net-nets. Most of the best net-nets have this certain/uncertain duality. It is certain the stock is selling for less than it’s worth. It is uncertain how the stock will ever sell for what it’s worth.


Net-nets are half about knowing and half about believing. They are part knowledge and part faith. If you can’t accept both of those ideas at once – you’ll never be a good net-net investor.


You can only know the stock is selling for less than it’s worth. You simply have to believe the stock will someday sell for what it’s worth.


Sometimes, it never will in the open market. Sanjo is an example of that. The company’s stock price never rose from 200 yen a share to 400 yen a share on its own. Market sentiment never changed. Management just agreed to buy the company. That’s the uncertainty with these stocks. I never would’ve guessed that a Japanese net-net would be bought in a management-led takeover. Never. The thought didn’t cross my mind. But I still bought a basket of Japanese net-nets.


You can look at that two ways. One way is to say I was very, very dumb. There’s a lot of truth in that. I didn’t see how I was going to make money in a stock. In retrospect, the possibility should’ve been obvious. But I never considered it.


That was dumb. But it’s the kind of dumb that doesn’t hurt you. Really, it only matters what stock you buy and whether or not you hold that stock through to the happy conclusion. All the analysis around those two decisions are helpful only insofar as they get you to make those key decisions. Buy and hold. Those are the only decisions that matter.


So it isn’t necessary to be super smart in your analysis as long as you are super smart in your actions. The big problem for a lot of would-be net-net investors is not bad analysis. It is bridging the gap between analysis and action.


And this is the key point to make about net-nets that earn low returns on equity. You don’t have to see how mean reversion will occur for it to occur.


The future does not care if you can envisage it ahead of time. It comes whether you see it or not. The good news: You can bet on things you can’t imagine.


You need a few things. One, you need to know the stock is safe. Two, you need to know there is some hope that the company’s return on equity can rise. Generally, this means you want to avoid “stuck capital.” I’ve talked about stuck capital before.


On the sliding scale of stuckness and cheapness we have:


1. Cash


2. Quick assets (cash and receivables)


3. Current assets (cash, receivables, and inventory)


4. Tangible book value (shareholder’s equity minus goodwill)


The best net-nets are cheap relative to cash. Why? Because cash isn’t stuck. It can be taken out of the business today. The next best bargains are cheap relative to quick assets – cash and receivables – because these are financial assets. Receivables should be able to turn into cash once sales vanish. And inventory should be stated at a low value on the balance sheet relative to what it will sell for. Keep in mind how the company accounts for its inventory (FIFO or LIFO) and what the company’s gross margins are. This gives you some idea of how big the buffer is between what the company says it has in inventory and what that inventory actually sells for in normal times. As you can see, inventory is the most special and least reliable part of current assets. A bet on inventory is often very much the same as a bet on future earning power. This is less true of receivables. And not at all true of cash. The value of cash is independent of the business that created it.


Finally, yes, there are special categories of assets in there. Certain buildings are easy to convert to other uses. They can be sold. Lots of empty land can also be sold off pretty easily.


The net-net newsletter sometimes buys stocks with these kinds of assets. But they’re just kickers. For example, one of the net-nets in the newsletter’s portfolio owns 100 acres of land and some buildings that are carried on the balance sheet for less than they are worth. This was noted at the time of purchase. But it was noted in the way you’d note a lottery ticket. It was not the reason for buying that stock. Cash and securities was the reason for buying that stock.


What assets can’t be sold off easily?


Machinery. A lot of buildings outside of key locations. The kind of inventory unprofitable retailers get stuck with. Which is often the same slow moving inventory duplicated at a dozen different locations. Basically, anything that’s specialized. Special assets have value to the extent they produce earnings. So the worst business in the world is a business that has highly specialized assets and earns low returns on those assets. In that case, you’re screwed.


Most of this is common sense. You instinctively know that if a stock is profitable and sells for less than its net cash, that stock is mispriced. But a stock that’s profitable and sells for less than its tangible book value is open to debate.


Above all, what you need to see in a mediocre business is liquidity. That gives you value and flexibility. As long as you are paying less for something than it’s worth and the assets can be changed into something else over time – you’ve found yourself a bargain.


So, in the situation you’re describing – a net-net earnings a 7% return on equity – the issue isn’t really whether or not the company is earnings its cost of capital. The issue is what the company can do with its capital.


That means you want to see low levels of inventory and high levels of cash. You want to see very low liabilities. This is key. Net-nets need high ratios of liquid assets to total liabilities. The higher that ratio is, the more change the business can handle. The lower that ratio is, the more the stock’s survival depends on making the status quo work.


Also – and this probably isn’t obvious – you want to see insider ownership. Not employee ownership. That’s different. I’m talking about management owning a lot of the company. Maybe even the founders or their family owning a controlling block of shares.


What you want to avoid is situations dominated by professional management. You don’t want people who own 1% or less of the company making decisions about how to use the company’s cash. They are the folks who are most likely to buy growth instead of preserving capital.


Controlled companies are better at preserving capital. So my answer to your question would depend on factors like how liquid the balance sheet is and how high insider ownership is. As long as the answers to those questions were satisfactory, I’d definitely buy a net-net with only a 7% return on equity.


If the balance sheet is very liquid and insider ownership is very high – there’s a good chance something will happen. I have no idea what. And I have no idea when. But someday, something will happen to increase the return on those assets.


Sometimes it’s as simple as returning the assets to shareholders, using net cash to make a management buyout super cheap, or using net cash to buy a totally different business.


I can’t stress this enough. When you buy a net-net you are not buying future earnings. You are buying future assets. What I’m talking about here is asset conversion. At some point, you are expecting today’s assets will be converted into something you can profit from. Something a control investor will pay for. Or something the market will reward.


If you’re looking at a company with stuck capital – where capital is going to stay stuck in inventory and never get turned into cash – you’re looking at the hardest kind of asset conversion story. You want assets that are liquid. They should be likely to hold their value. And they should be worth something outside the business.


So don’t obsess over how big a stock’s discount to net current assets is. Sometimes, a stock selling for 95% of its net cash is a better bargain than a stock selling for 65% of its net current assets.


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