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How Long Should You Hold a Net-Net?

February 13, 2012 | About:
Geoff Gannon

Geoff Gannon

407 followers
Someone who reads my articles sent me this email:

Hi Geoff,

In case a net-net stock price rises significantly when would you sell?

when the stock price reaches:

- net cash value

- ncav

- tbv

- bv

- something else?

My advice on net-nets is to wait one to three years.

I say this a lot. And I probably don’t do a good job explaining what I mean. I’m saying you should hold a net-net for a full year regardless of stock price appreciation.

Why?

Because net current asset value is cheap. And there’s this tendency for people to think a stock is expensive – or at least a good candidate for sale – once it rises 30% or 50% or 100%. Those just seem like big numbers. If you’re showing a gain like that in some stock it’s natural for you to want to sell.

But does that really make sense?

Let’s say a stock was trading at two-thirds of its net current asset value when you bought it. It has risen 50%. Sounds great, right? But that means it’s only just now reaching its net current asset value.

Think of how many stocks – how many lousy businesses – trade much higher than their net current asset value. Is now really the time to sell?

A stock that trades at its net current asset value is far from a beloved stock. In fact, most stocks that trade around 1 times net current assets are hated stocks. People don’t like the companies. They’re concerned about the management, or the industry, or whatever. But this is far from a pricey stock. It’s usually still cheap.

So even though you may be showing a gain of 50% in a stock, that doesn’t mean it’s expensive. This is common sense. But it’s harder to apply to net-nets than you might think.

Here’s why.

Phil Fisher-type companies are a hoot to own. You get to talk about the wonderful management, the great new products they have coming, the growth prospects for some emerging industry. It’s easy to watch a growth stock rise 50% and still convince yourself to hold on. It’s hard to watch a Ben Graham-type stock rise 50% and still hold on.

Now, some people will say that’s because you should hold the Phil Fisher stock even after a 50% rise – but not the Ben Graham stock. I agree. To a point.

There’s a reason Warren Buffett talks about Ben Graham stocks being “used cigar butts.” Net-nets are stocks with “just one puff” left in them. You shouldn’t hold a Ben Graham net-net for the long-term because the business probably sucks.

Net-nets usually aren’t companies earning high returns on equity. Sales, earnings and book value simply aren’t growing at many net-nets. Every day you spend owning a net-net is a day you are spending invested in a mediocre or sub-par business. It’s a day you’re stuck earning mediocre or sub-par returns on your investment capital.

That’s true. But I think the thing being wasted here is time. Not money. The issue isn’t whether a Ben Graham net-net should be held after a 30% or 50% run-up in its price. The issue is whether a Ben Graham net-net should be held after three or five years.

Those are two different questions.

I totally agree with the fear of getting stuck in a net-net. I don’t agree with the idea that you need to take your profits in a net-net because there’s been a price rise.

Value investing is an art. Not a science. Appraisal is an art. Not a science. What I’m trying to do – and this is all Ben Graham was ever trying to do – is to prove to myself that a stock is clearly worth more than the price it’s trading at.

It’s very hard to know whether a stock is worth 25% or 50% or 100% or 200% more than the price it’s trading at. Value investors don’t need to do that. All we need to do is make sure that the stocks we buy are clearly worth more than we pay for them. And then we need to make sure our portfolio stays that way. That it stays full of stocks that are worth more than they are trading for.

A one year ban on selling net-nets doesn’t seem outrageous to me. And it has several benefits. One, it keeps you focused on being really, really careful about the stocks you pick. Instead of worrying about selling stocks, you’re always 100% focused on making sure you pick the cheapest, safest net-net today.

This is the most dangerous part of net-net investing. Picking a new net-net is risky. You need to stick to safe stocks. Some net-nets will fall to zero. They will go bankrupt. You’ve got to sidestep those landmines. The way to do that is to focus very carefully on what you are buying when you are buying it.

A good way to stay focused on the safety of the stocks you’re buying is to spend as little time worrying about selling as possible. A one-year waiting period before you sell a net-net is a good way of making sure you stay focused on what matters most: your original purchase decision. The moment when you pull the trigger and buy a stock. That’s when you introduce risk into your portfolio. That’s when you need to be vigilant.

The other thing that a one year waiting period between purchase and sale does is reduce trading costs. This is very important. Net-nets are illiquid. It can be very expensive to trade them. Look at the bid/ask spread on some net-nets for proof of this. If you really just went out there and took the other guy’s price every time – you’d never make money investing in net-nets.

There’s no reason to make net-net investing more costly than it has to be. You want to minimize commissions, taxes and bid/ask spreads. Making sure you always hold your net-nets for a full year helps enforce this trading discipline.

The biggest mistake new net-net investors make is trading too frequently. They manage to fritter away several percentage points in annual returns by being impatient when it comes to how they place their trades.

If you read about the way Warren Buffett traded in his net-net buying days – boy, was he a stickler when it came to price. This was when over the counter stocks really did trade by appointment. Buffett would call his brokers at Tweedy, Browne. And he was merciless in not compromising by never just taking the price the seller was asking when he bought a stock.

Today, with super liquid stock markets – and online brokers – many investors are accustomed to getting all the shares they want today at the last trade price. As you know, that’s not how net-nets work. If you force yourself to forget about trading a net-net for a full year after buying it – you stay focused on the two things that matter most:

1. Picking the right stock

2. Holding that stock regardless of what the market does

Unless you were wrong (from a safety perspective) to buy a net-net in the first place you should always wait one full year before selling no matter how high it rises.

You're an investor. Not a trader.

Selling below NCAV is an extremely low price. Stocks tend to overshoot. Why not hold for a full year? Especially if there's a tax advantage in doing so. But even when there isn't my advice is never to sell a net-net in less than one year.

There are two exceptions:

1. If you made a mistake

2. If you need to buy something else

The “need to buy something else” hurdle should be very high. But if you find a net-net you really love in terms of management, industry, history of profitability, competitive position, etc. and are convinced it's much safer than anything else you own you can sell anything you already own to buy it.

Only you can make this decision. It's really about your comfort. You can always sell a stock to raise cash and buy something that's clearly better, safer, etc. Just make sure it's not added excitement you're after but added comfort. When you find something truly special you're always allowed to sell the things you own to buy it. Otherwise, don't sell due to a price increase until you've held the stock for a full year.

The three-year advice is just that you shouldn't sell something for lack of action. Maybe you thought some corporate event would happen or something would turn around or whatever. Wait three years. If it's the stock price you are waiting for – I wouldn’t sell before three years just because I get tired of owning the stock.

As for five years, I think it's unwise to hold any lower quality companies – however cheap – more than five years. The math is against you. If you own a business compounding book value, EPS, etc. by 0% or 2% for a full five years it's hard to argue any level of cheapness is going to provide you with enough of a pop in the stock price to make up for passing on a better business for half a decade or more.

That’s how I get to the idea that a one-to-five-year holding period is the right length for net-nets. If you want to sell a net-net because it’s gone up in price but it hasn’t been a full year yet – wait. If you believe in a company and you know it’s safe, but you haven’t seen any price movement yet – wait for three full years. And then, don’t fool yourself. It doesn’t make sense to hold a net-net for more than five years. If you want to hold the same stock for more than five years, you need to make sure it’s a super high-quality business.

Never plan to hold net-nets for more than five years. Look, if you happen to find a true gem trading as a net-net – which is really, really rare – you can hold it for as long as you want. The five-year thing is just me saying there's a difference between a Phil Fisher/Charlie Munger growth/moat type business and a Ben Graham net-net. You can't afford to hold cigar butts forever. So never expect to hold a net-net for more than five years.

Three years is a good amount of time to give any stock when you believe in the cheapness and safety of the business. If a net-net is sound (as a business rather than a stock) you can afford to wait three years. If you own something like 10 net-nets at once, holding them for three years at a time will mean you're always selling some stocks and you’re always buying new stocks. You’ll be plenty busy.

When would I sell?

I'd hold a net-net for one year no matter what. This is actually a rule in the net-net newsletter. And it's my rule. I think it's a good one. I think most people sell net-nets too fast.

As far as selling at net cash value, tangible book value, etc. it depends on the business. I would never sell a net-net just because it reached NCAV. NCAV is still really, really cheap. A stock trading at NCAV tends to be cheaper than most stocks. The price can look high on one year's (bad) earnings or something. But you would need some real proof in terms of price-to-sales and price-to-normal-earnings to believe NCAV was the right value for a business. This is especially true – if historically – the company has not lost money.

For a company with no operating business, you could definitely sell at net cash. So you could sell Cadus (KDUS) at net cash. And if you think the operating business at Gencor (GENC) is a net negative for the stock, you could sell that when the investment portfolio's value is equal to the stock price. So net cash is an appropriate sale price for stocks that have no real value besides their surplus cash.

I'd be willing to sell something at tangible book value if I had a really good reason for believing it will never have sustained earnings to justify a higher than tangible book value price. That's pretty rare. I can think of examples where it could happen. Insurance is a good example. If you have a non-niche insurance business trading at tangible book – I might sell that especially if I wanted to buy something with less risk. But it pretty much has to be an industry-wide issue. Something about the industry tends to make businesses worth no more than their tangible assets. I wouldn't sell most net-nets just because they reached tangible book value.

What I would do is re-evaluate every net-net one year after buying it. If it's no longer a net-net and I can find good net-nets today, I'd sell it.

Likewise, I'd consider re-evaluating anything I'd owned for three years and never gotten results from. I'd look to see if I'd made a miscalculation of some sort. Or if I was only hanging on to the stock because it hadn't gone up yet and I was being stubborn.

It really depends on the person. For example, the last one – being stubborn, waiting for a stock to go up, show green before selling, etc. – that’s a problem I don’t have. I'm quite willing to sell something – even at a small, quick loss – if I find something better. I'm pretty merciless when I think I've found an upgrade for my portfolio. I've taken a lot of small losses on stocks. Some people don't like doing that. But it's never been something that bothered me. I'm more bothered by the possibility of big losses.

Barnes & Noble (BKS) is a good example. Basically, once the Burkle lost the proxy fight and it was clear B&N was spending huge on the Nook – I got out. Overall, it was not a big loss. But I'd written about Barnes & Noble a lot on GuruFocus and it was definitely a "contrarian" position that had gotten me a lot of grief. So, it would've been natural to want to hold B&N until I could show a small gain. I was never tempted by that. That's just a personality thing.

We all have our flaws. I trade too much. But it's rarely because I sell too fast. Rather, it's because I buy too fast when I've got cash. Cash is very dangerous for me. Having 30% or 50% of my portfolio sitting in cash tends to make me lower my standards a lot – without admitting it – and this is a big character flaw. For other investors, that risk might not be there. For most people, I'd say picking an unsafe net-net with a lot of upside potential and simply selling net-nets too soon are the two most common net-net investing mistakes I see.

So my advice is to take your time when buying net-nets and when selling them.

The ideal holding period for a net-net is usually longer than you think.

Talk to Geoff About Holding Net-Nets geoff@gurufocus.com

About the author:

Geoff Gannon
Geoff Gannon


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