Are Most Net-Nets “Uninvestable”?
I read an article the other day that stated… that only 1/6th of all net-net stocks are investable and the rest are frauds, value traps, etc.
As far as the 1/6 net-nets are investable comment – I don't know. I'd say I'm reasonably tough in terms of not liking just cash shells, Chinese reverse mergers, etc. And I'd have to put the number closer to one-fourth to one-third of net-nets standing out as attractive.
As I write this, there are – by my count (everyone's net-net count varies a bit) – 100 net-nets in the U.S.
I could – if I absolutely had to – come up with a portfolio of 30 net-nets that I would be confident would outperform the market – as a group – if equally weighted and held for 3 to 5 years. There are at least that many net-nets with acceptable F-Scores and Z-Scores. And if you are buying a big group of net-nets with good F-Scores I think you are investing intelligently. Of course, profitability is a mixed picture. You’d probably end up buying some companies with decent balance sheets that are reporting losses. The Ben Graham Net-Net Newsletter rarely picks stocks with losses. But then I only plan to take the Ben Graham Net-Net Newsletter’s portfolio up to about 13 – not 30 – stocks.
Right now, there are a bit under 100 net-nets. In fact, the number is almost exactly 100 as I write this. If only 1 out of 6 net-nets were “investable” that would mean there are 17 “investable” net-nets. Does that sound right? I mean, we started this month with 11 net-nets in the newsletter’s model portfolio. And I picked another one this month. So that’s 12 net-nets that I obviously considered investable. Are there more than 5 out there?
If retailers are “investable” – then the answer is yes. As you know, I have this really strong – let’s call it what it is, a phobia – about retail net-nets. I’ve never said they don’t work out as a group. In fact, I think you’ll hit some home runs investing in retail net-nets. But I don’t think they are – individually – safe stocks.
I think non-retail net-nets are less likely to go to zero. Or at least it’s easier to tell which net-nets are safer than others when you don’t throw retail net-nets into the mix.
And I try to keep the Ben Graham Net-Net Newsletter’s portfolio stocked with the net-nets I think are least likely to go to zero. So I pretty much toss out retail net-nets.
Off the top of my head, I can name a handful of retail net-nets most people would consider “investable”. Examples include:
1. Trans World Entertainment (TWMC)
2. Hastings Entertainment (HAST)
3. Books-A-Million (BAMM)
4. Tuesday Morning (TUES)
5. Duckwall-ALCO (DUCK)
If I was picking stocks for the Ben Graham Net-Net Newsletter’s model portfolio based purely on the numbers – I’m sure some of those guys would’ve slipped in. But whenever I’m given the choice between a net-net that’s a retailer and a net-net that’s not a retailer – I chicken out and pick the non-retail net-net.
If you want good analysis of retail net-nets, there are plenty of good bloggers out there who don’t share my (irrational?) fear of retail net-nets. Examples include:
1. Cheap Stocks
2. Whopper Investments
3. Oddball Stocks
They’re all good.
So, right there, if you’re willing to admit retail net-nets on equal footing with non-retail net-nets – and Ben Graham was – you’ve already got 17 investable net-nets. Which is about one-sixth of the total net-nets out there.
I don’t want to get into too much detail arguing about specific net-nets. Especially about whether they are investable or not. But I will say this. I’m looking at a list of exactly 100 net-nets right now. I picked 12 net-nets for the newsletter, there are certainly 5 retail net-nets I haven’t picked that most folks would call investable. In addition to that there are many net-nets owned by investors you’ve heard of. You can find some of these net-nets on GuruFocus by looking at the portfolios of those Gurus.
Just as a quick example, I can see net-nets on this list that aren’t owned by the Ben Graham Net-Net Newsletter but are owned by Mario Gabelli, Third Avenue, Whitney Tilson, etc. Maybe you and I don’t think those net-nets “investable” but some big time investors clearly did. So, objectively, I think we have to call those net-nets investable.
So, clearly more than one-sixth of all net-nets are investable. But could the number of investable net-nets be as low as one-fourth?
I don’t think it’s as high as half. I think close to half of all net-nets are stocks I wouldn’t consider buying. Certainly one-fifth of all net-nets (right now) are stocks I’d feel comfortable buying. So, somewhere between those two numbers is where I’d put the actual percentage of what we’re calling “investable” net-nets. It’s at least 20% of the total number of available net-nets. But it’s less than 50%.
At least that’s my entirely subjective guesstimate.
I should point out that there’s a big difference between buying an individual net-net and buying a group. I said about half of all net-nets are stocks I wouldn’t buy. That’s true – individually. But as a group even the bottom half of net-nets – as we see them– may work out fine. After all, we’re fallible. Some of what we call the best net-nets may turn out to be the worst and vice versa. Some of those low quality net-nets will turn into home runs. But I wouldn’t call them safe. And generally that’s what we’re looking for in the Ben Graham Net-Net Newsletter.
We’re trying to pick the safest net-nets out there.
Just to be clear, I didn’t choose 13 stocks as the portfolio size for the Ben Graham Net-Net Newsletter because there are only 13 “investable” net-nets. I chose 13 stocks as the size for the newsletter’s portfolio because I don't see the benefits of selectivity beyond that point. At least not selectivity on qualitative grounds. If I was buying 30 net-nets or more, I wouldn't bother analyzing them myself. I would use a set of standard metrics like the F-Score. I would not try to apply much human judgment beyond ranking the whole universe of net-nets according to numbers I thought indicated quality when bought as a group. I'd then buy say the top fourth (25%) of the entire group.
As for why we settled on a total portfolio size of 13 stocks for the Ben Graham Net-Net Newsletter – that’s because picking more than one stock a month is against my nature. And finding things to say about net-nets beyond the stats is pretty difficult even for just one stock. The cheapness and risks in most net-nets are pretty obvious compared to something like big cap stocks. It's right there in the balance sheet, earnings record, and insider ownership.
If you buy net-nets, you're going to spend a lot of time owning family controlled businesses. In fact, one of the best ways to sort net-nets in back tests – and in my own experience of seeing which net-nets I owned worked and didn't work – is simply dividing a stock's insider ownership by its institutional ownership.
As a rule, the more stock owned by insiders versus institutions the better a stock will do. The less stock owned by insiders relative to institutions, the worse a stock will do.
One of the worst features for any net-net is high institutional ownership. It is close to the strongest predictor of bad returns you can find in net-net land.
This will shock you. But it's true. I mentioned a back test of 13 randomly selected net-nets a year that are turned over for new net-nets each year returned about 21% a year since 2001. If instead of randomly selecting those net-nets you picked the 13 net-nets with the highest insider ownership to institutional ownership ratio, the annual return would be 40% a year. If you picked the 13 net-nets each year with the lowest insider ownership to institutional ownership ratio, the annual return would be just 10% a year.
It's very hard to find any single metric to sort net-nets by that brings their returns down as low as 10% a year. And keep in mind that's before trading costs. That doesn't take illiquidity into account. When you consider the high costs associated with that sort of trading – and the work involved – it’s clear that buying the most institutionally owned net-nets isn't worth it at all.
On the other hand, a portfolio of the highest insider ownership to institutional ownership net-nets actually has much lower turnover than other net-net portfolios. Obviously, ownership changes slowly. Especially insider ownership in companies where it is high. So trading costs would be lower than in a normal net-net portfolio because turnover would be lower.
In my experience, people gravitate toward the net-nets that will actually perform worst as a group. They dislike family ownership. And they like institutional ownership.
By the way, this isn't something that works only in short-term oriented net-net portfolios. If you look historically at stocks that were net-nets but went on to have good 10 and 15 year returns, you find a lot of insider dominated companies. I don't have good data on this – I don't have a way of screening for net-nets more than 10 years in the past – but I see it all the time. And you'll notice that some stocks picked in the Ben Graham Net-Net Newsletter actually had decent records – sometimes better than the stock market – over the last 10 to 15 years.
Again, these tend to be controlled companies.
Finally, as Walter Schloss said about the net-nets he bought:
“They were mostly secondary companies; they were never the top grade companies. And they tended to be ignored by the public because they didn’t have any sex appeal, there wasn’t any growth – there was always trouble with them. You were buying trouble when you bought these companies, but you were buying them cheap. Of course, when you got them too cheap, they maybe ended up going down the tubes. So you try to be a little careful. But people don’t like to buy things that are going down.”
And perhaps more importantly for our topic:
“When Ben was operating in the 1930s and 1940s, there were a lot of companies selling below their net working capital. Ben liked these stocks because they were obviously selling for less than they were worth but in most cases, one couldn’t get control of them and so, since they weren’t very profitable, no one wanted them. Most of the companies were controlled by the founders or their relatives and since the 30s was a poor period for business, the stocks remained depressed."
I have very few definitive answers about any individual net-net. These are not perfect stocks. They’ve got problems I can only talk about it as part of a group operation. I think the group of 13 net-nets picked for the Ben Graham Net-Net Newsletter will perform well over time. I don’t know about individual picks.
But I will say a few things about net-net investing. I know some people who dabble in it. And usually their returns are not anywhere near as good as just randomly buying net-nets.
I'm not exactly sure why. But I have my suspicions.
Two things stand out as almost always true of bad net-net investors:
1. They have an aversion to controlled companies.
2. They sell too soon.
Studies of net-nets that bother looking out 3 to 5 years, generally show market beating returns even that far out. But some people are reluctant to commit to a full year of ownership before reconsidering. I think that's silly. If you do everything you can to choose a stock wisely – especially a statistically cheap but ugly, ugly stock like a net-net – revisiting your decision more than once a year is not an optimal strategy. It's counterproductive. It's better to focus on a stock intensely for a while when making a decision and then putting it out of your mind entirely for the next year. Then repeat. But it shouldn't be done more than once a year. I've never met anyone who is expert in making money on the good decisions they make between the day they buy a net-net and 365 days later. It's just a question of buying the right ones and having the stomach to hold them.
Then there’s the whole family control thing. Insiders scare people. Families scare people. Control scares people. It’s a risk. But companies with well-meaning insiders go bankrupt all the time. If a net-net isn’t financially sound – the most honest CEO in the world won’t make it worth buying.
Talk to Geoff About “Uninvestable” Net-Nets email@example.com