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Does Net-Net Investing Depend on a 'Greater Fool?'

February 29, 2012 | About:
Geoff Gannon

Geoff Gannon

408 followers
Someone who reads my articles asked me this question:

Geoff –

I can't avoid feeling like net-net investing is predicated on selling to a greater fool. In Graham's day, he was buying institutions of a much higher quality: railroads, etc. Often his buys were overlooked by the market because they didn't pay a dividend/weren't sexy enough. Today most net nets are companies with a market cap in the million dollar range, with business models in terminal decline, and poor corporate governance. No wonder they trade for the value of their cash--odds are the company is going to piss it away! Further, these companies trade normally on the pink sheets, or over the counter, where the buyers tend to be people scavenging for net nets. Hence the necessity of the greater fool. What do you say in response to this?

Thanks,

Chris

First, I want to say there are risks in net-net investing. And there are much, much higher risks of having just a psychologically unpleasant experience in net-nets – like falling for a fraud, having a company bought out for a low price, hearing the company you own lost its major customer, and seeing a company you own fail to keep up with fashion, technology, etc. If you invest in net-nets, you will have these experiences. If you invest in net-nets long enough, you’ll probably have all those experiences and still get a good return on your entire group of net-nets. It is a maddening area to invest in. And if you can’t tolerate owning the shares of companies who blunder, constantly announce turnaround plans, etc. – it’s not the place for you.

The issue is how much these things are priced into the stock. And what your experience will be on a group of these stocks. Many times, you can have a lot of really bad things happen to a net-net and your monetary loss – as opposed to your emotional loss – will be of a small enough size that a bit of good luck in any of your other net-nets will easily make up for it. Remember, when a stock with a P/E of 40 stumbles, you tend to lose half your money right there. So misjudging a growth stock has its risks too. But you need to know what you are getting into when you buy net-nets.

I would sum up net-net investing by saying: “All your surprises will be bad ones. And you’ll probably make money anyway.”

But I’m serious about the first part. The news that comes out of net-nets is a never ending string of disappointments.

So you have to start by abandoning hope. Don’t try to visualize all the wonderful turnarounds and reversions to the mean and all that. Just don’t. Focus on how cheap and safe you think a net-net is. If, in your view, it stays cheap and safe – hold it. Once it stops being those things, sell it. When in doubt – as long as you are buying net-nets as a group – hold it. They tend to do well as a group. So holding a net-net should always be your default position regardless of the emotional toll it takes on you.

I also want to point out again that I don’t recommend net-net investing for most people. Most people would be better off reading the Buffett/Munger Bargains Newsletter rather than the Ben Graham Net-Net Newsletter. I say that even though I expect net-nets will outperform Buffett/Munger style stocks. And the reason I say it is because I think people who follow the Buffett/Munger approach will end up with more success than people who follow the Ben Graham approach. Because, frankly, most people won’t follow the Ben Graham approach the way Ben Graham and Walter Schloss did. It’s not easy. If you’re not sure if you should attempt net-net investing – trust me, you shouldn’t.

You make valid points about net-nets. I would respond by saying:

1. Back tests of net-net portfolios outperform the general market

2. Warren Buffett, Ben Graham, etc. bought over the counter stocks

3. Check the market cap on Genesee Valley Gas when Buffett bought it.

Warren Buffett (1993):

"I found a little company called Genesee Valley Gas near Rochester . It had 22,000 shares out. It was a public utility that was earning about $5 per share, and the nice thing about it was you could buy it at $5 per share."

Adjusted for inflation – that comes to just under a $1 million market cap in today’s dollars. I've never bought a stock with a market cap below $1 million. And most of the screens I use start at more than twice the market cap of what a modern day Genesee Valley Gas would be. In other words, I don’t even see stocks with a market cap below $2 million – even though Warren Buffett bought stocks like that.

If you look at the other stocks that Warren Buffett bought for his own account when he was young, they were very tiny companies.

Ben Graham kept his Graham-Newman fund small for a reason. Outside of a few times in history (like the 1930s), net-net have generally been small and illiquid companies. It takes a long time to buy them. And you do it over the counter. Often in big blocks relative to the total volume traded in a given month/year/etc.

Trading net-nets is not like trading Microsoft. And the entire stock market was pretty illiquid for the second half of Ben Graham's career. The 1930s through the 1950s were pretty illiquid markets by modern standards. And very illiquid when looking at stocks like net-nets. Buffett and Graham would not be sensitive to readers' pleas that some net-nets are just too darn illiquid.

Here is Warren Buffett talking about a stock he bought in 1958 for his partnership:

“…Commonwealth only had about 300 stockholders and probably averaged two trades or so per month.”

He bought 12% of the company. Can you imagine buying shares in a stock that averaged 2 trades a month?

Okay. Now imaging becoming the company’s second biggest shareholder. That’s an illiquid position. But that was Warren Buffett’s largest holding in 1958.

Net-Nets: A Mixed Bag

You talked about business quality and management “pissing away” the cash a company has. These are real risks in net-nets. But the truth is that business quality – and management quality – varies tremendously. Some net-nets have absolutely atrocious pasts. I tend to pick ones with decent past earning records. But not always. The Ben Graham Net-Net Newsletter also owns a couple companies that are basically cash shells. Those are the two categories we’ve tended to buy: consistently profitable net-nets and cash shells.

Here’s a barrage of facts – good and bad – that shows just how mixed a bag you get when you go shopping for net-nets. Remember, there are much more speculative net-nets out there – I probably toss out half the net-nets at any time immediately due to their historical record.

Okay. So, what kind of net-nets end up in the newsletter…

The Ben Graham Net-Net Newsletter’s model portfolio holds 11 stocks right now. Five of those 11 stocks had at least 10 straight years of operating profits when we bought them. Some have had longer streaks than that.

· One company had 25 straight years of operating profits.

· Another had 18 straight years of profits.

· Another paid dividends in 13 of the last 14 years.

One of the companies was the target of a hostile takeover offer (which I didn’t take very seriously) before we invested in it. Another had a competitor buy a big block of its shares – also unfriendly – after we picked the stock for the newsletter.

I don’t mean to overhype these stocks. There are very good reasons why stocks with those kinds of perfectly decent past records end up on the discount rack:

· The company with 25 straight years of profits is facing a changed industry environment and may very well post a loss this year.

· The one with 18 straight years of profits lost a key supplier.

· The company that paid dividends in 13 of the last 14 years is heavily dependent on a single customer.

Others face technological risks. One was involved in a federal government spending scandal before we bought the stock.

You get the picture.

These are mostly companies that either had problems in their past or are perceived to face big, unsolvable problems in the near future. Sometimes the past problems will go way. Sometimes the market’s perception of future problems is overdone.

At the moment – and I’m awful at predicting the future, so take this with a bucket of salt – there are two net-nets we own who lost key suppliers (in both cases nobody would recognize the name of the net-net but everybody would recognize the name of the supplier).

In one case, they seem to be getting along without this supplier much better than I ever could’ve anticipated. And they’ve exceeded my gloomy expectations as to what would happen after they lost a relationship that had lasted for decades. In the other case, the jury is still out, but I think it could fundamentally change their business in a very negative way. Previously, they had been earning good returns on capital – about 10% on assets (after taxes and before leverage, so most companies would turn that into something like a 15% ROE) while growing year after year.

I suspect those days are over. And losses may be ahead. To be fair though, they still stack up very well against their publicly traded peers in terms of margins, returns on capital, etc. So we’ll see if they maintain a superior competitive position. It could happen. But the idea that these companies were always lousy businesses, or that their managements were always going to “piss away” the cash, is not true in many cases. Parts of it are true in some cases.

A lot of companies – not just net-nets – don’t pay dividends, buy back stock when they should, and do dumb acquisitions from time to time. Some of our picks aren’t good capital allocators. Others are. A lot are very conservative with their cash. They let more cash sit idle than a blue chip stock ever would.

A few of our picks actually outperformed the S&P 500 over the 15 years before we made the pick. So, if long-term stock price success is the best gauge of how a company compounds wealth – some of these companies had a fine history of doing that.

Others didn’t. These stocks have very different backgrounds. It’s the place they are in now – the doghouse – that is the one thing uniting them.

But there are stocks picked in past issues of the Ben Graham Net-Net Newsletter that have compounded their sstock price and book value around 8% to 10% a year for the last 15 years. That’s fine when compared to stocks of all sizes. And remember, all theses stocks are trading at a very low valuation when I pick them. They have to have lower market caps than net current assets. So compounding the stock price for almost 10% a year for 15 years when your end point is below NCAV probably means you increased intrinsic value by 10% or higher. That’s an acceptable long-term record at a lot of companies.

These are just some indications that not all net-nets are awful businesses with awful managers in awful industries. But most net-nets either qualify as one of those things – or are perceived to be on the wrong side of history. T

There’s always a good reason for net-nets to be trading the way they are. And many times it seems pretty logical. It’s often hard to quantify whether the real problem a company faces should actually shave quite that much off the company’s stock price. And as a group, the answer is almost always that a legitimately bad possible future is having too great an influence over the stock price.

Net-nets that have been historically good businesses tend to be facing cyclical or even technological headwinds. It’s not uncommon for them to have just lost a key customer or be at risk of losing a key customer.

Generally, I’d rather bet on companies facing those circumstance who delivered decent earnings in the past rather than bet on companies who have no history of profitability. But you pay for a decent history. Usually, the trend is negative whenever I add a net-net to the Ben Graham Net-Net Newsletter.

As for the idea of a greater fool – I think that’s completely backwards. Swank (SNKI) was a net-net before it got an offer to buy the stock for $10 per share (a more than 100% premium) from a leather goods company. Lakeland (LAKE) was a net-net before Ansell bought 10% of the company’s stock. These are just recent examples of cases where someone other than other investors are willing to pay for these companies.

And, of course, you often have very high insider ownership at the net-nets we buy. Not always. But often. So, you have a constant state of stock ownership by insiders and occasional instances of stock purchases and outright acquisitions by competitors and other control buyers.

I think a lot of your points make sense. The part about “a greater fool” does not. In fact, I always try to stress to people that you shouldn’t assume you will get a good return in a net-net through share price appreciation caused by a change in investor attitudes. Instead, you may have to wait a while and then be bought out by management, a competitor, etc. Or see some other type of extraordinary event that drives your performance. You should count on “a greater fool” less than when dealing in other kinds of stocks. Often, there isn’t much interest in these stocks from people who can only own small pieces of them. Buying the whole company may be more attractive.

That was the point behind buying net-nets for Ben Graham. A stock trading for less than its net current asset value is selling for less than it’s worth to a private owner.

Ask Geoff a Question about Net-Nets

Check out the Ben Graham Net-Net Newsletter

Check out the Buffett/Munger Bargains Newsletter

About the author:

Geoff Gannon
Geoff Gannon


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