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How to Avoid Investing in Perpetual Net-Nets aka Value Traps

July 29, 2013 | About:
Definition of a Perpetual Net-Net

A net-net that remains a net-net, i.e. the stock price has never traded above its net current asset value

Avoid Loss-Making Net-NetsLosses give stocks a double whammy. Losses deplete retained earnings and eat into book value. Furthermore, loss-making stocks attract negative sentiment and in turn affect the P/B and P/NCAV valuation multiples accorded by the market.

Avoid Net-Nets Which Do Not Grow Their Book ValueIf net-nets grow their book values, investors can earn decent returns, as long as stock prices grow at least in tandem with net asset value growth. We are positive on net-nets which grow their book value by growing their earnings, or through a mark-to-market process where their assets are restored to close to their intrinsic values on the books.



Avoid Net-Nets Which Do Not Pay Dividends
The stock market can stay irrational longer than investors can stay solvent. Dividends serve many purposes. Besides providing net-net investors with incentives to wait for the market to return to efficiency, they provide evidence of real cash, one of the key components of many net-nets. Moreover, huge dividend payouts by certain stocks are reasons for their net-net status, with dividends debited against retained earnings, thereby reducing book value.

Avoid Fraudulent StocksIf the books are cooked, value of assets and earnings are not dependable, so the net-net case hardly holds water. Granted that most investors are not forensic experts, or for that matter have that level of information to make a judgment, the Beneish M-Score and James Montier's C-Score are examples of indicators which provide another level of security for investors.

About the author:

Mark Lin
Mark is a private value investor and runs the Cheapskate Investing website which borrows from the wisdom of value investing giants, using a systematic quantitative screening approach to filter the global stock markets for cheap cigar-butts and wide-moat compounders. He is also a regular contributor to various value investing communities.

Visit Mark Lin's Website


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