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Want High Net Net Stock Returns? Leave Your Emotions at the Door

January 09, 2014 | About:
Burton Malkiel

Evan Bleker

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I have a secret.

Whenever I invest in a net net stock I feel a little pang of anxiety. It doesn’t matter how optimistic I am about the investment, I still feel a little bit queasy when I look at the business.

This is what I call an investor’s gag reflex.

Plug Your Nose and Buy

Buying a net net stock can be scary. A lot of people new to these stocks feel uncomfortable buying and holding companies that are facing large problems, or have poor future prospects.

To add to the discomfort, in nearly all cases, these companies have just had a cataclysmic drop in price and it’s unclear when the price will quit dropping.

Most of the net net stock investors that I frequently talk to, and the most skilled value investors in the industry, have learned to control their gag reflex so they can invest in the most promising value stocks.

Being able to make cool rational decisions is a learned temperament that investors seeking to beat the market by a wide margin over the long term have to hone.

Still, investing in net net stocks for the first time can be scary, and holding a net net stock to maturity can be a roller-coaster of emotions. To smooth the transition I thought I’d give you a window into what owning one of these stocks is like.

Those of you who have signed up to receive free net net stock ideas each month will be well aware of my recent sale of InfoSonics (NASDAQ: IFON), a company that I’ve now held from extreme undervaluation to substantial profit twice.

InfoSonics originally made my shortlist of promising deep value investment opportunities back in 2011. I didn’t have much hope that the company would become a profitable growing business each time I purchased the stock.

Aside from some cost cutting, the only reasons I found to hold the stock was that it was extremely cheap and ranked well on my NCAV stock scorecard.

I ended up purchasing the stock in 2011 and holding on for just over a year. Let’s take a look:

IFON First Buy 2011 | Click to Enlarge

Check the Story When Fear and Doubt Set In

This chart should give readers a good idea of what holding on to a net net stock can be like.

I have heard somewhere that the average stock moves 50%, from top tick to bottom tick, in any given year.

I’m not sure how true that is, but it can be emotionally trying to hold these stocks without much in the way of news or information to justify their leaps and drops.

In the above case, when I saw the stock price slowly erode for 7 months from my initial purchase I was constantly questioning the company’s suitability as a net net stock investment.

Without much negative news, the firm’s promise as an investment hadn’t seemed to have diminished but I was constantly calling my own judgments into question.

That can be a good thing since it forces you to revisit your analysis, but investors with a weaker emotional temperament or a less secure grounding in Benjamin Graham’s value investment philosophy would feel a far stronger pull to sell.

If nothing has changed in the story and the company still fits your original well thought-out checklist then averaging down can be extremely rewarding.

The price performance of InfoSonics had a similar pattern when I held it the second time from January to December 2013:

IFON Second Buy 2013 | Click to Enlarge

Patience is Needed… a Promising Outlook Is Not

The thing about buying net net stocks is that there’s little positive reasons to own them.

Sure, there’s the great track record of NCAV stocks in general and the conservative balance sheets that most NCAV stocks have, but there’s often little on the horizon to look forward to.

Much of the time these firms are in the midst of trying to solve massive business problems. Many are turnaround companies in the truest sense of the word and it’s unclear whether management will be successful in turning the business around or not.

Not that it matters.

The great thing about net net stocks is that the price of the company is so depressed in the market, and there is so much negative sentiment built into the stock price, that any change in the overwhelmingly negative perception of investors can send the stock surging.

This is what I like to call the Dead Cat Bounce.

While a great story can boost your net net stock returns, you don’t need one for it to lead to fantastic investment profits.

But price corrections don’t happen overnight. In the two periods in which I held InfoSonics it took just over a year for the market price to rise to reflect NCAV.

When I bought shares in the company again the second time it took just under a year. I consider this timeframe fairly short but a net net stock should surge in price within 3 years.

For Paulson Capital Corp., a tiny investment/brokerage firm that Google Finance mistakenly seems to think is owned by famed investor John Paulson (Trades, Portfolio), the eventual pop in price took over 28 months:

PLCC-Buy-2011 | Click to Enlarge

Fear and Doubt Lead Me to Revisit Paulson Capital Corp.

I originally bought Paulson Capital Corp. because they seemed to be grossly undervalued on a net current asset value basis. I was right — but I didn’t spend enough time originally reflecting on the fact that the firm was a financial company.

All investors should constantly strive to improve and this is a mistake I’ve corrected in my selection process.

When I revisited my thesis near the end of 2011, I decided to be cautious.

I wasn’t exactly sure what further risks the firm faced, essentially being an investment bank, but I spent a considerable amount of time looking at the short term assets of the company.

After rechecking the firm’s fundamentals, I judged that, while not perfectly safe, there didn’t seem to be a substantial risk in holding the firm.

Put another way, I couldn’t see a reason to either buy or sell the stock after it had fallen in price so I decided to hold on to the firm until its share price reached its NCAV per share value or time (my 3 year holding cap) forced me to sell.

One thing that soon boosted my confidence in the investment was the large cash position the firm gained from selling its retail division.

While I wasn’t sure just how much the company received for the division, the size of the retail operations in relation to the firm’s total sales suggested that it was a lot.

At any rate, seeing as most takeovers occur at a price reflecting a company’s NCAV or more, I bet that the purchase price exceeded the division’s share of net current assets.

Keep a Fundamental, By-The-Numbers, Perspective and Wait

Net net stocks aren’t riskier than the average stock.

They just look ugly.

Most companies are facing huge business problems, have a questionable future, and are at the tail end of a massive drop in market price.

Investors who look past the negative points to actual business fundamentals and keeping in mind the great track record net net stocks have shown, can see surprisingly good investment results.

As Benjamin Graham wrote in the Intelligent Investor;

It always seemed, and still seems, ridiculously simple to say that if one can acquire a diversified group of stocks at a price less than the applicable net current assets alone…the results should be quite satisfactory.

Rating: 3.5/5 (4 votes)

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