It’s one thing to talk about diversification in theory. It’s another to talk practice. Today, we’ll be talking about diversification in practice. Especially how to balance diversification with selectivity In yesterday’s article, I wrote about a theoretical framework for diversifying selectively. I showed how you could use as few as three strategies in three countries and pick just three examples of that strategy – net-nets, special situations, low EV/EBITDA, etc. – in each country and manage to have a widely diversified portfolio of 27 stocks (3 * 3 * 3 = 27).
The idea there was how to stay as selective as possible – as close to the center of your circle of competence – even while you diversify widely. It’s easy to pick 27 stocks at random. It is harder to be disciplined enough to focus on just your three best strategies, your three most familiar countries, and your three favorite examples of each strategy in each country.
But that is how you build up areas of expertise.
Today, I want to talk about a situation where I had to diversify in an area – a country – where I was not an expert.
Japan.
A couple years ago, I decided the Japanese stock market – especially Japanese micro caps – looked very, very cheap. These companies often sold for less than book value. Dividend yields were frequently higher than in the U.S. (and inflation was lower). And P/E ratios – of the micro caps – were always lower.
There were a lot of stocks to choose from. I wanted to diversify. But I also wanted to be selectivite.
So let’s take a look at selectivity in action.
The key to being selective is to focus your attention on the precise spots where it is likely to do the most good. Don’t worry about things that don’t matter. And don’t worry about things you can’t control. Try to focus on the things that matter that you can control.
In investing, “know” and “control” are often closely related. I can’t control whether or not the net-nets I buy perform better or worse than other companies unless I can know – going into the position – whether one company has a stronger competitive position than another.
In the U.S., I can sometimes do this. I can always do it among businesses generally – although so can the market, so this is usually reflected (adequately handicapped) in the stock prices of the biggest and bluest chip stocks.
With net-nets – even in the U.S. – it is often harder to evaluate the competitive position of companies because it’s rocky. There are few wide moat companies among net-nets in the U.S. There are perhaps a couple. However – almost without exception – net-nets with wide moats don’t earn high returns on capital. To the extent a moat exists, it exists through something of a scorched earth situation. The fields the company controls are perhaps well defended – but they aren’t fertile. The land is marginal. The castle poorly situated. There may be a moat. But it’s not circling anything worth defending.
From time to time, I find exceptions to this rule. I count George Risk (RSKIA, Financial) an exception. When it traded around $4.50 (it’s now more like $7.50 a share) it was a net-net with a good business and a moat. There were risks – customer concentration for one – and it was no blue chip. There was no diversification of product lines, customers, geography, industry, etc. It was closely tied to U.S. construction activity.
All this means it was no blue chip. Not that it didn’t have a moat. I felt it did. And certainly not that it wasn’t a high quality business. It demonstrably was (unleveraged returns on tangible equity were around 30%). And it was a net-net. In fact, it was a net cash stock at one time.
So they do happen. But they are rare. The usual distinction with net-nets is not between companies like that – companies which may have a moat, do earn good returns on capital, etc. – but between companies that are legitimate and illegitimate businesses.
A legitimate business is – in my mind – a historically profitable one. It is likely to have positive retained earnings (there are exceptions to this rule – but it’s a good first check). It should have more years of profits (6 or more) than losses in the last 10 years. And it should be self-financing.
Compare this to an illegitimate business. The least legitimate businesses are those that – while publicly traded – have never turned a profit and can’t self finance. They may be net-nets – but they are net-nets because they have issued stock in the past and then seen their share prices drop. Retained earnings are often negative.
There are other factors to consider. Is the business old or young? Is depreciation – and other accounting – especially conservative or aggressive? Are taxes especially conservative or aggressive? And is share issuance dilutive or not.
I think a legitimate business tends towards LIFO accounting, quicker depreciation, higher taxes paid as a percentage of reported income, and lower share issuance. There are exceptions. Many big technology companies etc. would fail these tests. But we are talking about net-nets here.
So, for me, the biggest dividing line among net-nets – as businesses – tends to be on measures like:
· Time in business (longer is better)
· History of profitability (longer and more consistent is better)
· Retained earnings (positive is better)
· Share issuance (lower is better)
· Accounting (conservative is better)
· Type of business (boring is better)
· History of dividends (longer and more consistent is better)
· Communication (less promotional is better)
None of this guarantees you have found a winning net-net. All of it supports the idea you have found a true Ben Graham bargain. A Ben Graham bargain is not simply a net-net. A company that goes public – never turns a profit – and crashes and burns when its one developmental drug fails can be a net-net. It can’t be a Ben Graham bargain.
Why not?
Ben Graham liked net-nets for one reason. They were logical. Graham was a very logical thinker. And he saw a very logical reason why net-nets should work. They were public companies selling for less than a private buyer would pay for them.
Is that true of public companies that have never turned a profit, don’t have real products, a business history, etc.?
I don’t think so. I don’t think Graham would think so.
So a net-net – at least the kind of net-net I am looking for – is first and foremost a legitimate business. It may be a good or bad business. But it must be an established business. That is always the first test.
I have a second test. This one – like the first – is not meant to ensure better overall returns in the portfolio. Speculative net-nets – money losing companies – often perform at least as well as less speculative net-nets. They often give you some homeruns. They have high strikeouts rates. But net-nets are so cheap, that a homerun can easily mean returns of 200% or more even if the business never achieves very much. It just has to start out very, very cheap. And then – for a brief, blinking moment – convince a buyer (or the stock owning public) it has hope. Hope is all you need for a net-net to make money. If ever hope returns to the stock, you’ll make a lot of money. Because nothing trades as cheaply as a net-net unless it is seen as hopeless.
But I’m not interested in the best theoretical returns. I’m interested in what works in practice for me. And for me, the net-nets that work in practice – the ones I actually buy and hold long enough to turn a profit in – are established businesses (legitimate businesses as I just described them) with low leverage.
What does low leverage mean for a net-net?
There are many rules of thumb. One of my favorites is to take net current assets – this is current assets less total liabilities – and then compare that number to total liabilities.
Here’s an example. A stock trades for $3 a share. It has $20 in current assets (cash, receivables, inventory, etc.) and it has $16 in total liabilities. This is a net-net. It has $4 in net current assets (current asset minus total liabilities) against a stock price of just $3. That means it is trading for 75% of NCAV. It’s a solid net-net by price.
But is it a solid net-net by leverage?
No. It’s risky. All of the value you see in the stock is in that $4 you are getting versus the $3 you are paying. However, total liabilities are $16. So, you have NCAV of $4 versus total liabilities of $16. Yes, of course, we have already netted out those $16. But – let’s say – those total liabilities turn out to be 10% greater (not an unusual circumstance) than they are today. That would wipe out $1.60 of your $4 in value. At a 25% greater total liability, you’d end up with a worthless stock.
This is an oversimplification. A company could have that much in total liabilities but little chance it will rise over time because they aren’t working liabilities – they are related to some discontinued business or some past financial transaction or something. Likewise, operating expenses could be really low today.
Basically, though, the bigger a company is relative to its NCAV – sales, expenses, and liabilities all give you hints about this – the more likely it is to be either a home run or a strikeout. A stock with a much higher NCAV than its total liabilities (a company with an inappropriately big pile of cash, receivables, inventory, etc. relative to the business it does) may be a bad business. It’s unlikely to become an insolvent business though. By definition it has a lot of quick assets – stuff that can become cash – versus a small pile of liabilities (stuff that needs to be paid for in cash).
One of the ultimate tests of a low leverage Ben Graham bargain is simply a net cash bargain. This can be calculated in one of two ways. The most stringent is to take cash minus all liabilities. If cash is greater than all liabilities it is a low leverage company. If cash is so much greater than total liabilities that the surplus of cash over total liabilities is greater than the market cap – then it’s a low leverage Ben Graham bargain.
I understood that. I knew net-nets. But I did not know Japan. So, I focused my attention specifically on the stuff I knew. I settled on two criteria. One, the company had to have posted 10 straight years of profits. No losses in the last 10 years. Two, the company had to be – not just a net-net – but a net cash stock.
I found five such stocks in Japan. Actually, a few more than that. And some folks shared other names I had missed. As it turns out, I could’ve come up with probably about 10 such stocks. I only bought five. They were the first five I found that met those two criteria.
I put equal amounts in all five stocks.
In this way, I was both selective and non-selective. I was totally non-selective when it came to specific stocks. However, I was selective when it came to the criteria for selection. I wanted legitimate businesses that were cheap and not leveraged. I was able to distill these traits into two simple, screenable criteria.
I then – manually, because I didn’t have a database to screen in Japan – applied this selective screen to Japanese stocks. To speed up my search I focused on Japan’s other exchanges. I focused on Osaka and JASDAQ rather than the main (Tokyo) exchange. I figured the kinds of stock I was hunting for – little, boring net-nets – were least likely to trade on the best known exchange.
This allowed me – in a matter of weeks – to invest in a country I hadn’t before. I was only able to do this because I used a strategy – net-net investing – I had used before. And I was only able to do it because I was selective where I could be (criteria I understood) and non-selective where I couldn’t be (the competitive position of specific Japanese businesses).
Remember, this is a subjective issue. If I was a Japanese investor, I wouldn’t have used this approach. I would’ve dug into the competitive position of specific stocks. I would have handpicked my companies. As someone who has never been to Japan and does not speak the language or know the business culture – this was impossible. So, I didn’t fool myself into wasting attention on an issue where I couldn’t add value.
Focus on the aspects of your investing where you will get the highest return on your attention.
In your local area, this is likely to be on the business itself. Scuttlebutt. In a foreign country, it’s likely to be mechanical investing – like Ben Graham did. In industries you know, it’s likely to be competitive position. In times of panic, it’s likely to be emotional fortitude.
Know where you can add value in your selection process. And know where you can’t. Then coordinate your attack so you bring the absolute maximum of effort to the very point where it is likely to do the most good in the least time. Once you have found that point focus on it to the exclusion of everything else. Push your advantage to its maximum extent.
That is selectivity in action. It’s knowing what to ignore so you can bring the most attention to the most important question for you to answer.
Talk to Geoff about Selectivity
Read Geoff’s Other Articles
The idea there was how to stay as selective as possible – as close to the center of your circle of competence – even while you diversify widely. It’s easy to pick 27 stocks at random. It is harder to be disciplined enough to focus on just your three best strategies, your three most familiar countries, and your three favorite examples of each strategy in each country.
But that is how you build up areas of expertise.
Today, I want to talk about a situation where I had to diversify in an area – a country – where I was not an expert.
Japan.
A couple years ago, I decided the Japanese stock market – especially Japanese micro caps – looked very, very cheap. These companies often sold for less than book value. Dividend yields were frequently higher than in the U.S. (and inflation was lower). And P/E ratios – of the micro caps – were always lower.
There were a lot of stocks to choose from. I wanted to diversify. But I also wanted to be selectivite.
So let’s take a look at selectivity in action.
The key to being selective is to focus your attention on the precise spots where it is likely to do the most good. Don’t worry about things that don’t matter. And don’t worry about things you can’t control. Try to focus on the things that matter that you can control.
In investing, “know” and “control” are often closely related. I can’t control whether or not the net-nets I buy perform better or worse than other companies unless I can know – going into the position – whether one company has a stronger competitive position than another.
In the U.S., I can sometimes do this. I can always do it among businesses generally – although so can the market, so this is usually reflected (adequately handicapped) in the stock prices of the biggest and bluest chip stocks.
With net-nets – even in the U.S. – it is often harder to evaluate the competitive position of companies because it’s rocky. There are few wide moat companies among net-nets in the U.S. There are perhaps a couple. However – almost without exception – net-nets with wide moats don’t earn high returns on capital. To the extent a moat exists, it exists through something of a scorched earth situation. The fields the company controls are perhaps well defended – but they aren’t fertile. The land is marginal. The castle poorly situated. There may be a moat. But it’s not circling anything worth defending.
From time to time, I find exceptions to this rule. I count George Risk (RSKIA, Financial) an exception. When it traded around $4.50 (it’s now more like $7.50 a share) it was a net-net with a good business and a moat. There were risks – customer concentration for one – and it was no blue chip. There was no diversification of product lines, customers, geography, industry, etc. It was closely tied to U.S. construction activity.
All this means it was no blue chip. Not that it didn’t have a moat. I felt it did. And certainly not that it wasn’t a high quality business. It demonstrably was (unleveraged returns on tangible equity were around 30%). And it was a net-net. In fact, it was a net cash stock at one time.
So they do happen. But they are rare. The usual distinction with net-nets is not between companies like that – companies which may have a moat, do earn good returns on capital, etc. – but between companies that are legitimate and illegitimate businesses.
A legitimate business is – in my mind – a historically profitable one. It is likely to have positive retained earnings (there are exceptions to this rule – but it’s a good first check). It should have more years of profits (6 or more) than losses in the last 10 years. And it should be self-financing.
Compare this to an illegitimate business. The least legitimate businesses are those that – while publicly traded – have never turned a profit and can’t self finance. They may be net-nets – but they are net-nets because they have issued stock in the past and then seen their share prices drop. Retained earnings are often negative.
There are other factors to consider. Is the business old or young? Is depreciation – and other accounting – especially conservative or aggressive? Are taxes especially conservative or aggressive? And is share issuance dilutive or not.
I think a legitimate business tends towards LIFO accounting, quicker depreciation, higher taxes paid as a percentage of reported income, and lower share issuance. There are exceptions. Many big technology companies etc. would fail these tests. But we are talking about net-nets here.
So, for me, the biggest dividing line among net-nets – as businesses – tends to be on measures like:
· Time in business (longer is better)
· History of profitability (longer and more consistent is better)
· Retained earnings (positive is better)
· Share issuance (lower is better)
· Accounting (conservative is better)
· Type of business (boring is better)
· History of dividends (longer and more consistent is better)
· Communication (less promotional is better)
None of this guarantees you have found a winning net-net. All of it supports the idea you have found a true Ben Graham bargain. A Ben Graham bargain is not simply a net-net. A company that goes public – never turns a profit – and crashes and burns when its one developmental drug fails can be a net-net. It can’t be a Ben Graham bargain.
Why not?
Ben Graham liked net-nets for one reason. They were logical. Graham was a very logical thinker. And he saw a very logical reason why net-nets should work. They were public companies selling for less than a private buyer would pay for them.
Is that true of public companies that have never turned a profit, don’t have real products, a business history, etc.?
I don’t think so. I don’t think Graham would think so.
So a net-net – at least the kind of net-net I am looking for – is first and foremost a legitimate business. It may be a good or bad business. But it must be an established business. That is always the first test.
I have a second test. This one – like the first – is not meant to ensure better overall returns in the portfolio. Speculative net-nets – money losing companies – often perform at least as well as less speculative net-nets. They often give you some homeruns. They have high strikeouts rates. But net-nets are so cheap, that a homerun can easily mean returns of 200% or more even if the business never achieves very much. It just has to start out very, very cheap. And then – for a brief, blinking moment – convince a buyer (or the stock owning public) it has hope. Hope is all you need for a net-net to make money. If ever hope returns to the stock, you’ll make a lot of money. Because nothing trades as cheaply as a net-net unless it is seen as hopeless.
But I’m not interested in the best theoretical returns. I’m interested in what works in practice for me. And for me, the net-nets that work in practice – the ones I actually buy and hold long enough to turn a profit in – are established businesses (legitimate businesses as I just described them) with low leverage.
What does low leverage mean for a net-net?
There are many rules of thumb. One of my favorites is to take net current assets – this is current assets less total liabilities – and then compare that number to total liabilities.
Here’s an example. A stock trades for $3 a share. It has $20 in current assets (cash, receivables, inventory, etc.) and it has $16 in total liabilities. This is a net-net. It has $4 in net current assets (current asset minus total liabilities) against a stock price of just $3. That means it is trading for 75% of NCAV. It’s a solid net-net by price.
But is it a solid net-net by leverage?
No. It’s risky. All of the value you see in the stock is in that $4 you are getting versus the $3 you are paying. However, total liabilities are $16. So, you have NCAV of $4 versus total liabilities of $16. Yes, of course, we have already netted out those $16. But – let’s say – those total liabilities turn out to be 10% greater (not an unusual circumstance) than they are today. That would wipe out $1.60 of your $4 in value. At a 25% greater total liability, you’d end up with a worthless stock.
This is an oversimplification. A company could have that much in total liabilities but little chance it will rise over time because they aren’t working liabilities – they are related to some discontinued business or some past financial transaction or something. Likewise, operating expenses could be really low today.
Basically, though, the bigger a company is relative to its NCAV – sales, expenses, and liabilities all give you hints about this – the more likely it is to be either a home run or a strikeout. A stock with a much higher NCAV than its total liabilities (a company with an inappropriately big pile of cash, receivables, inventory, etc. relative to the business it does) may be a bad business. It’s unlikely to become an insolvent business though. By definition it has a lot of quick assets – stuff that can become cash – versus a small pile of liabilities (stuff that needs to be paid for in cash).
One of the ultimate tests of a low leverage Ben Graham bargain is simply a net cash bargain. This can be calculated in one of two ways. The most stringent is to take cash minus all liabilities. If cash is greater than all liabilities it is a low leverage company. If cash is so much greater than total liabilities that the surplus of cash over total liabilities is greater than the market cap – then it’s a low leverage Ben Graham bargain.
I understood that. I knew net-nets. But I did not know Japan. So, I focused my attention specifically on the stuff I knew. I settled on two criteria. One, the company had to have posted 10 straight years of profits. No losses in the last 10 years. Two, the company had to be – not just a net-net – but a net cash stock.
I found five such stocks in Japan. Actually, a few more than that. And some folks shared other names I had missed. As it turns out, I could’ve come up with probably about 10 such stocks. I only bought five. They were the first five I found that met those two criteria.
I put equal amounts in all five stocks.
In this way, I was both selective and non-selective. I was totally non-selective when it came to specific stocks. However, I was selective when it came to the criteria for selection. I wanted legitimate businesses that were cheap and not leveraged. I was able to distill these traits into two simple, screenable criteria.
I then – manually, because I didn’t have a database to screen in Japan – applied this selective screen to Japanese stocks. To speed up my search I focused on Japan’s other exchanges. I focused on Osaka and JASDAQ rather than the main (Tokyo) exchange. I figured the kinds of stock I was hunting for – little, boring net-nets – were least likely to trade on the best known exchange.
This allowed me – in a matter of weeks – to invest in a country I hadn’t before. I was only able to do this because I used a strategy – net-net investing – I had used before. And I was only able to do it because I was selective where I could be (criteria I understood) and non-selective where I couldn’t be (the competitive position of specific Japanese businesses).
Remember, this is a subjective issue. If I was a Japanese investor, I wouldn’t have used this approach. I would’ve dug into the competitive position of specific stocks. I would have handpicked my companies. As someone who has never been to Japan and does not speak the language or know the business culture – this was impossible. So, I didn’t fool myself into wasting attention on an issue where I couldn’t add value.
Focus on the aspects of your investing where you will get the highest return on your attention.
In your local area, this is likely to be on the business itself. Scuttlebutt. In a foreign country, it’s likely to be mechanical investing – like Ben Graham did. In industries you know, it’s likely to be competitive position. In times of panic, it’s likely to be emotional fortitude.
Know where you can add value in your selection process. And know where you can’t. Then coordinate your attack so you bring the absolute maximum of effort to the very point where it is likely to do the most good in the least time. Once you have found that point focus on it to the exclusion of everything else. Push your advantage to its maximum extent.
That is selectivity in action. It’s knowing what to ignore so you can bring the most attention to the most important question for you to answer.
Talk to Geoff about Selectivity
Read Geoff’s Other Articles
