Today, I’m talking about my personal favorite newsletter – the Ben Graham Net-Net Newsletter. This is a hard newsletter to write. Impossibly hard at times. There are only so many net-nets to choose from – today there are 96 American net-nets by my count – and the Ben Graham Net-Net Newsletter’s model portfolio already has 11 net-nets in it. Last month’s pick isn’t in the model portfolio yet – net-nets can be extremely illiquid so some orders go unfilled – but that’s still one more stock I can’t pick for the March issue. Assuming every past pick still qualifies as a net-net – this isn’t quite true, but it’s pretty close – that means there are only 84 possible picks for next month’s issue of the Ben Graham Net-Net Newsletter.
Now you’re probably thinking that picking one stock from 84 possible choices sounds pretty easy. In reality, it’s pretty tough. There are a few net-nets on that list that aren’t eligible for the Ben Graham Net-Net Newsletter’s model portfolio because they no longer report to the SEC. This is a self-imposed requirement. I made it a rule that stocks have to be reporting to the SEC to be eligible, because otherwise subscribers might not know where to find the company’s financial data, business description, etc. There actually are companies that don’t report to the SEC but do voluntarily provide all that stuff. But you can’t find them on EDGAR.
The list of viable candidates is further narrowed by my personal peccadilloes. I am not a fan of retailers. Or at least not a good judge of their investment merit. And the net-net list often includes quite a few retailers.
After all, inventory is a current asset. And who holds more inventory than a retailer?
Retail net-nets often have some of the biggest upside of any net-nets. Just see Jon Heller’s post on his original Cheap Stocks 21 Net/Net Index. One retailer – The Finish Line (FINL) – returned 500% in fewer than three years. That pushed up the performance of the whole index. Although Jon used a market cap based weighting system – typical for indexes – which usually short changes net-net performance. Big net-nets get the biggest weighting. And traditionally big net-nets have been poor performers.
To be fair, the poor performance of big net-nets is not due specifically to their bigness. Rather, it is evidence of a larger phenomenon. Almost any quantitative or qualitative assessment you make of a group of net-nets will show you that the biggest net-nets are not the names on the list in the best shape. For example, using the F-Score will tend to reveal big net-nets to be turnarounds that haven’t turned yet. Also, insider ownership tends to be low at big net-nets. And as I’ve mentioned before the ratio of insider ownership to institutional ownership is actually one of the best predictors of the future stock market performance of a net-net.
If insiders don’t own the stock and fund managers do – it’s probably a dog. If the reverse is true – it’s probably unknown. It might be a bargain. It might not. But it’s usually cheap – at least in part – because it is underfollowed. Big net-nets are usually cheap because they are known but hated. Of course, “known” is a relative term here. The vast majority of the names on any net-net list will be utterly unfamiliar to most investors.
So how do I pick one stock from a list of close to 100 net-nets?
First of all, sometimes I’ve had far fewer than 100 net-nets to choose from. When making the selection for one past issue, I only had 30 or so candidates to choose from. At the market’s lowest and most tumultuous I once had more than four times that amount to choose from. So the number of net-nets varies an insane amount over the course of a year.
It’s important to note that the median price-to-NCAV (Net Current Asset Value) of a list of net-nets tends to be on the high side. As a result, if every net-net rose 20% at once, it would shorten the list by much more than 20%. A lot of stocks rise above the net-net line and fall below it pretty much in tandem.
This is purely due to investor sentiment. It’s not because net-nets themselves are especially correlated. In fact, if you’re into Beta – I’m not, but bear with me – you can find a nice mix of high-beta and low-beta names in net-net land.
In fact, because a human – me – is picking the stocks that go into the Ben Graham Net-Net Newsletter’s model portfolio the Betas we see are probably not representative of net-nets generally. And because the model portfolio uses (a small amount) of my own actual money – the Betas tend to be very, very low.
Any portfolio constructed by me will tend to have an abnormally low Beta. This is simply a result of what kinds of stocks I’m willing to buy. I don’t actually look at a stock’s Beta.
Anyway, these are the Betas Google Finance gives for each of the 11 stocks in the Ben Graham Net-Net Newsletter’s model portfolio:
I bolded the two picks with a Beta greater than 1. As you can see, there are actually as many stocks in there with a negative Beta – they tend to move in the opposite direction of the overall stock market – as there are stocks with a Beta greater than 1. The two picks with a Beta over 1 are worth mentioning.
One is the August 2011 pick. This is a well-known net-net. If you read blogs dedicated to net-nets like:
· Cheap Stocks
· Whopper Investments
· Oddball Stocks
You’ve read about this particular net-net. In fact, if you’ve ever read a “mainstream” article about net-nets at one of the big finance websites – chances are they mentioned this stock.
It’s the Ben Graham Net-Net Newsletter’s worst performer to date.
Actually, it’s pretty easy to see why. While the company is decently well known – you’ve seen the brand but it’s an utterly forgettable one – it fails most tests of what makes a good net-net.
The August pick was obviously made in August. What you probably don’t realize is what the net-net situation was like in August. That’s my only defense for why I let this particular pick get into the portfolio. Basically:
· It’s big (for a net-net)
· It had a lot of cash
· It was really, really hard to find decent net-nets last summer
In fact, the market tanked right around the time I made that pick. So, it got much easier to find net-nets after that.
What was wrong with the August pick?
First of all, it could still work out. Any net-net could perform wonderfully or horribly. There are very, very few net-nets I have enough confidence to bet on as a single stock. The Ben Graham Net-Net Newsletter is run – like Ben Graham would’ve run it – as a group operation.
Having said that, the August pick was clearly a mistake. Not because it’s down since the Ben Graham Net-Net Newsletter bought it – the July 2011 pick is down too but it was a fine choice – but because it went against several of the things that make for a good net-net.
What makes for a good net-net?
· High insider ownership / Low institutional ownership
· High F-Score
· Consistent Earnings
· Simple Business
· Decent Return on Equity
· Decent Long-Term Prospects
Comparing the August and July 2011 picks is night and day. Remember, these were both net-nets when the Ben Graham Net-Net Newsletter bought them. In fact, they are both still net-nets today.
|July 2011 Pick||August 2011 Pick|
|10-Year Average ROE||12%||1%|
|Profitable Years||9 out of 10||5 out of 10|
|Dividend Paying Years||9 out of 10||6 out of 10|
It’s hard to see how I could have picked those stocks back-to-back. The July 2011 pick – which is around one-tenth the size of the August 2011 pick – is clearly the superior business.
Both companies have an extra risk factor. The August 2011 pick has a very large technology risk. The July 2011 pick has zero technology risk. But it has a huge customer concentration risk. Overall, I would not consider the July 2011 pick to be any riskier than the August 2011 pick.
The Ben Graham Net-Net Newsletter can afford to make a couple picks like the mistake I made in August 2011. But it’s important to remember how easy it is to overlook some very obvious points. The August 2011 pick was clearly a much worse business than most of those I’ve chosen for the Ben Graham Net-Net Newsletter. Yet, it remains one of the favorite stocks of people who email me.
At the time the Ben Graham Net-Net Newsletter picked the August 2011 pick, it was trading at a tiny premium to its cash. Basically, the stock had about 90 cents in cash for every $1 of its stock price.
That makes up for a lot of sins.
Even a pretty bad company may end up being worth more than the cash it has accumulated.
Still, in yesterday’s article about the Buffett/Munger Bargains Newsletter, I mentioned the idea of calculating a stock’s intrinsic value using:
4. Interest Rates
I’ll talk more about this approach in future articles. But, for now, I ran the formula for the Ben Graham Net-Net Newsletter’s July 2011 and August 2011 picks. Even though the August 2011 pick has fallen from where we picked it – my favorite intrinsic value formula shows it’s actually still 8% overvalued. This is largely the result of its awful earning power. Meanwhile, the formula shows the July 2011 pick is worth 30% more than where it now trades.
For me, this reinforces the importance of applying common sense business analysis to net-nets. Even when you are buying a net-net, the idea is to get the best business for the lowest price. Sometimes that means buying a company for close to its net cash. Sometimes that means buying a company with less cash but more earning power.
In this particular comparison it’s pretty clear to me that the better choice was buying a company with less cash and more earning power.
Of course, not every stock I pick for the Ben Graham Net-Net Newsletter can be equally good. Some have to be better than others.
But it’s important to focus on why I make the mistakes I do. In this case, I think my mistake was caused by a false sense of security from:
1. A big market cap
2. A recognizable name
3. And a lot of net cash – but not enough to cover the entire stock price
That last point is critical. Obviously, if a stock has more net cash per share than its stock price the only question is whether the operating business is a net plus or a net minus. As long as the operating business adds some positive value – the stock is cheap.
In this case, though, cash accounted for less than 90% of the company’s stock price. Which means there was no margin of safety from the cash alone. So, the stock was only worth buying if the operating business added some real value. In the case of the Ben Graham Net-Net Newsletter’s August 2011 pick – I think that’s an open question. Basically – when we bought it – the stock was 90% investment and 10% speculation. It might have been a very good speculation. In fact, I’d say the odds favored a positive outcome for this stock when we bought it. And the Ben Graham Net-Net Newsletter still might end up making money on the stock.
We’ll sell it in September 2012.
I’ll report back to you then.
And, yes, I’ll reveal the stock’s name at that point.
Ask Geoff a Question about the Ben Graham Net-Net Newsletter
Check out the Ben Graham Net-Net Newsletter
Check out the Buffett/Munger Bargains Newsletter