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How Bad Did Net-Nets Do in the Crash?

March 23, 2012 | About:
Geoff Gannon

Geoff Gannon

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

Hi Geoff,

Would you have any data how net-net investing would have fared during market declines?

I am guessing that pre-crash it would get very tough to find net-nets.

How do net-nets hold up their value during a crash?

Steve


That’s a great question. And I think the results I’m going to show you here – and some of the specific stories – will explain why I think folks who stick to the strategy in the Ben Graham: Net-Net Newsletter will eventually beat the market. And why, despite that, I think most people reading this article should check out the Buffett/Munger: Bargain Newsletter instead.

You can earn really good returns in net-nets over time. It’s not dependent on buying at a market bottom. And there are usually enough net-nets every year to provide a diversified (enough) group for someone looking to own about 12 net-nets at a time. The Ben Graham: Net-Net Newsletter picks one new stock every month. And the supply of net-nets is sufficient to make that possible. I’m not saying I have a cornucopia of wonderful businesses to choose from every month – but there are plenty of names on the list. At times there have been no more than about 30 net-nets for the newsletter to choose from.

This reinforces the idea that you probably want to hang on to your best net-nets for awhile. If you try flipping your net-nets within a year of buying them, you’d need to find a lot of new net-nets even during times when they are scarce. Reducing selectivity can increase risk. Although if you cast a wide enough net and hang on to the stocks you scoop up – through some very frightening declines – even randomly chosen net-nets will tend to work out okay.

Personally, I don’t doubt that the net-nets will work. I do doubt that investors will let their net-nets work for them. With randomly chosen net-nets, selling every time you have a decent profit in a stock will mean passing up the huge returns in a few stocks that are usually the reason why even a group of very questionable net-nets works well as a portfolio. You will get one incredible home run even in a group of very ugly net-nets simply because these stocks are so cheap that if any business really turns things around operationally – you will get very rich very fast.

But you will also have total losses.

The psychological impact of this does encourage sticking to a net-net strategy. And I think some investors will abandon a net-net strategy even if it’s working for them on a portfolio wide basis simply because they feel utterly humiliated by their big losers. It destroys their confidence.

Remember, I’ll be talking about backtests here. It’s very important to not confuse the results you could have had in the past using some strategy with the results you will get in the future.

It’s also better to focus on the overall pattern you are seeing from a backtest – the principles it teaches – rather than exactly which stocks and which slight refinements of the formula produced the best results.

Don’t over-think the backtest. Think of a backtest like a history book. You can get something out of reading a book about the panic of 1907. That doesn’t mean you now think you have a guide to exactly how to invest in every future market panic.

Same idea with any backtest. It’s a history book. Not a road map.

I’ll start with discussing the median returns since this best shows what the experience would’ve been like picking net-nets generally.

So, I just looked at a chart of the S&P 500 and picked dates that looked like the top and bottom of the market to me. I don’t know if these are the actual market top and bottom. But they are close enough for our purposes.

From Oct. 5, 2007 to March 6, 2009, the median net-net dropped 74% vs. about 58% for small stocks generally.

From March 6, 2009, to today the median net-net rose 121% vs. about 149% for small stocks generally.

So, you can see the plain vanilla median return for net-nets was worse in both periods. This does not mean a portfolio of net-nets would do worse. In fact, when I create a portfolio of random net-nets it actually outperforms small stocks substantially. I can try many different – nonsensical ways – or deciding how to sort the net-nets. It really doesn’t matter. If I pick 10 or 20 and follow that portfolio through time it will tend to beat the market even while the median net-net tends to underperform.

We can also look at the performance of all net-nets. Here we can use exact total return numbers. But don’t get hung up on those – because I’ve never met anyone who actually owned every net-net at any point in time.

From 2007 to today you’d have made about 8% a year in net-nets. That of course assumes you’d invest in just about all net-nets. Which is a very tall order. The portfolio I created to test this had about 80 net-nets in it (since 80 net-nets was about the lowest number available on the first day of any year during this time period). As you can see, like low price-to-book stocks, net-net portfolios can have poor median returns and very good overall group returns. But this depends on:

1. You actually buying a group of net-nets, not just one.

2. You holding on to them long enough.

Some net-nets return well over 1,000 percent. In fact, if you measured from the absolute market bottom – where nobody would’ve gotten stock, but let’s pretend – you have well over a dozen tenbaggers as Peter Lynch would call them among the list of net-nets. You also have bankrupt companies. But If you bought any net-nets in late 2008 or 2009 that survived until today you got very good returns. The key here is you would have to hold them for a while. Most people sell net-nets too fast. If you sold every net-net after it rose 30%, I think the portfolio would do very, very badly (but I can’t test this).

I also tested the strategy of buying only those net-nets with the highest ratio of tangible equity to total liabilities. I chose the top 13 stocks – for no reason other than it’s a diversified but small enough to be plausible group and 13 is an odd number so I can point you to an actual median performer.

Adding this one ranking system (Tangible Equity/Total Liabilities = Highest is Best) changes some things. From Oct. 5, 2007 to March 6, 2009, the median net-net in this 13 net-net group was down 53% instead of 74%. So, if you just picked randomly from the net-nets with the strongest balance sheets – basically the lowest liabilities – you probably would’ve felt your portfolio about cut in half from the market top to bottom (2007-2009). Drop in a “strong” net-net portfolio was almost identical to the drop in the S&P 500 (the S&P 500 actually did a few percent worse from top to bottom).

If you held that strong net-net portfolio – again these are simply just the 13 net-nets with the highest ratio of tangible equity to total liabilities – from 2007 through today, the result would not have been as good as if you bought a portfolio of all net-nets.

This is something I’ve said before. But I’ll say it again. Strong net-nets don’t necessarily make for a better net-net portfolio. But they do tend to outperform the market. Over the last 10 years, a portfolio of the 13 net-nets with the strongest balance sheets (turned over each year) returned about 15% a year. Other net-net portfolios (including very weak balance sheet net-nets) would have done better. But it would’ve been a wild ride.

The nice thing about net-nets with strong balance sheets is that investors can look at the huge tangible equity compared to the tiny liabilities of the company and feel safe enough to hold their net-nets and thereby benefit from the strategy. I don’t feel this is likely with weak net-nets. I might be wrong. But I don’t know many people who’ve actually stuck with a net-net strategy other than people who pick the net-nets with especially strong balance sheets.

Regardless, strong net-nets lag the market when the bulls start running. They’ve done very little in 2010, 2011, and 2012. From 2000 through 2009 is where they outperformed. All net-nets tend to do very well immediately after the market bottoms. Remember: these are small, cheap stocks. The difference in strong and weak net-nets comes later when investors stop rewarding strong balance sheets and start buying stocks with positive year over year business trends (and stock prices). Weak net-nets are the most exposed to the business cycle. Remember, the way to get a poor ratio of tangible equity to total liabilities is to expand your business faster than you retain earnings – that’s the textbook definition of a marginal company that’ll have high earnings growth when the business cycle peaks and will file for bankruptcy when the economy busts.

Let’s talk about the strongest net-nets. They have very little exposure to the business cycle. Some of them are mostly cash – doing hardly any actual business anymore.

The annual return on a strong net-net portfolio from the market top in 2007 until today is only a little over 5% a year. But it depends on far fewer big winners. So, a strategy of selling net-nets when they appreciate 30%, 50%, 100%, 200%, etc. wouldn’t have been as costly if you stuck to the strongest net-nets. Still, I’d caution people that in actual practice most net-net investors will sell their net-nets so soon once they have a decent profit that I doubt they would really enjoy returns of about 5% from 2007 to 2012 even though those were quite possible.

To give you an idea of how silly it is to think you have to sell your net-nets the second they rise a bit in price, I checked a list of the 13 net-nets with the strongest balance sheet as of Jan. 1, 2002. So we’re talking a little over 10 years ago.

The median return among the group was a 55% gain between Jan. 1, 2002 and today. That’s a 4.4% annual return. And that’s if you held the median strong net-net for over a decade. I’ve never heard of someone holding a net-net for a decade. What did the S&P return during that time? I think it’s about 3%.

Regardless, we are talking about nothing worse than parking your money in cash.

Some clues as to why this is true.

Of the 13 net-nets with the highest ratio of tangible equity to total liabilities on Jan. 1, 2002 only 2 suffered what I’ll call catastrophic failures (a share price down 65% or more at the end of the 10 year period). Over a ten year period the number of companies that fail catastrophically is probably higher than most people think – even outside the net-net space. And the 2000s were a tough 10 years.

Anyway, 2 of the 13 net-nets ended lower by anywhere from 5% to 20% over the next 10 years. So, that’s 4 of 13 net-nets that ended up losing you money if you held them from January 2002 until today.

Actually, this would’ve been impossible. You couldn’t have held most of these 13 net-nets for the full 10 years.

Here’s the thing about net-nets. They get taken over. They liquidate. They go bankrupt. But they don’t always just keep trucking along like people fear. The great fear of stuck money is certainly real – you can make a lot more money flipping net-nets every few years than holding them for a decade. But, there’s more activity in this space than people think if you just hold the stocks long enough.

In this case, two-thirds of the net-nets delisted. Of the 13 strong balance sheet net-nets from January 2002 only 4 are still public:

1. Vascular Solutions (VASC)

2. Stamps.com (STMP)

3. National Presto (NPK)

4. Black Diamond (BDE)

Vascular Solutions, Stamps.com, and National Presto have crushed the S&P 500 over the last 10 years. Black Diamond has done maybe 8% a year or something. So, staying listed worked out okay for those four net-net over the next 10 years.

What about the net-nets that delisted?

So 9 of the 13 net-nets are no longer with us. Two of them failed catastrophically (there was an 85% loser and a 100% loser). They were Airspan Networks and Cosine Communications. They both still trade over the counter. But my best information based on their market cap, etc. is that they really are essentially total losses relative to what their prices were in 2002. Two other stocks were delisted with losses of a little under 5% to a little under 20%.

So, four of the nine stocks that were delisted were delisted with losses. Five of the nine stocks that were delisted were delisted with gains. They range from 15% higher than the price paid in January 2002 to almost 14 times the price paid on January 2001.

The 14 bagger was CyberSource.

VISA paid $2 billion for CyberSource in 2010. It had a market cap under $60 million when it was a net-net in January 2002.

You could’ve bought the stock for $1.76 in January 2002. It was sold to Visa for $26 a share in April 2010. That’s a compound return of 39% a year.

CyberSource was the best performer among the 13 most solid net-nets in January 2002.

As you can see from the timing of buyouts, etc., you probably would’ve ended up with about 70% of your net-net portfolio being turned over without your consent during the next 10 years anyway. So, stuff happens to net-nets whether you want it to or not.

Your obvious next question is what about the cheapest – rather than the safest – net-nets.

Okay, here’s a look at the 13 stocks with the lowest price to net current assets on Jan. 1, 2002:

· 8 of the 13 cheapest net-nets would delist within 10 years.

· 4 of the 13 cheapest net-nets lost money for investors who held them for 10 years.

· National Presto and Black Diamond made both lists (they were among the cheapest net-nets and the safest net-nets).

· 2 of the 13 net-nets were bought out for at least 3 times the prices they traded at in January 2002.

Cutter & Buck was sold to a Swedish company in 2007. MCK Communications merged with Verso in 2003 (in a complicated deal). Verso went bankrupt in 2008. I know MCK shareholders also got special dividends as part of the deal. The final cash payout to MCK shareholders – before the Verso merger – was actually bigger than the market cap of MKC in January 2002. So, even if you took shares of Verso in the exchange, kept them, and held them until the Verso bankruptcy – there was no way you could have lost money in MKC as long as you bought the stock when it was a net-net in January 2002.

Okay. Now, for the real horror stories. Let’s say you bought the 13 net-nets with the worst balance sheets on March 6 2008 and held them for exactly one year. Theoretically, this is a test of the greatest net-net nightmare imaginable. Instead of picking your net-nets randomly, you picked the 13 net-nets with the lowest tangible equity and the highest total liabilities. And instead of buying your net-nets over time and holding them for the long run – you bought them just before the worst financial panic in almost a hundred years. And you sold them at the very worst moment: March 6, 2009.

What would that have looked like?

For every $100 you put into the 13 net-nets with the worst balance sheets on March 6, 2008 – you’d have ended up with just $30 the following year. So, at the market’s bottom in March 2009, you would have lost 70% of your investment. This is versus about a 50% loss in small stocks generally.

What if you had held those super weak balance sheet net-nets through until today?

Here’s where my suggestion to stick to strong balance sheet net-nets comes into play.

Only five of the weakest net-nets bought in March 2008 now sell for higher prices. And of the eight losers, the smallest drop is 38%. Six of the 13 net-nets with the worst balance sheets in March 2008 ended up being delisted down more than 90% from their March 2008 prices. Basically, they went bankrupt. That’s right, the bankruptcy rate was 46% for this group.

How about the list of 13 net-nets with the highest ratio of tangible equity to total liabilities on March 6, 2008. Their bankruptcy rate was 0%. No net-net with one of the 13 strongest balance sheets in March 2008 lost more than 78% of its value. Nine of the 13 are still listed. The median stock is down 11%. That compares to the median stock in the weakest balance sheet group being down 76%.

It’s that difference between going through a banking crisis that knocks your average net-net down 11% or 76% that makes me think investors will have more success sticking with a portfolio built around the net-nets with the strongest balance sheets.

Those are usually the net-nets I pick for the Ben Graham: Net-Net Newsletter.

These strong balance sheet net-nets are not always favorite stock picks for readers. Usually, people prefer a company with a sizable operating business rather than something that’s closer to a cash shell.

But a pile of cash is better than a bad business.

The key to net-net investing is sticking to it. A strategy people won’t follow isn’t going to do them any good. And buying weak balance sheet net-nets – on the hopes their operating business will get better – is a tough strategy to stick to. After a few years where you have the occasional 100% loser – you stop following the strategy no matter how well your overall portfolio does.

Read Geoff’s Other Articles

Ask Geoff a Question about Net-Nets

Check out the Buffett/Munger: Bargain Newsletter

Check out the Ben Graham: Net-Net Newsletter

About the author:

Geoff Gannon
Geoff Gannon


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