Someone who reads my blog emailed me this question:
“Do you think it's better for a small-time investor (to) buy cigar butts (Net-Nets) or to buy great companies at fair prices?"
I realize Warren Buffett started out as a Graham-style cigar butt investor but over the years has moved to excellent businesses at fair prices, where his holding period is forever assuming the company has good prospects and growth and honest management, etc.
I'm reading the book "The Snowball," and it shares that Buffett and Charlie Munger used to do a thought experiment where they would pretend they were going to be stuck on a desert island for 10 years and could only buy a single stock before leaving. Which company would they pick and have confidence that it would still be around in 10 years and would likely have higher earnings power 10 years from that day?
That approached helped them to focus on "great" businesses vs. most businesses. Do you employ this approach in your own investing?”
A lot of people ask this question. It kind of divides value investors up into groups. The truth is that the right answer depends on your own situation. What are the toughest constraints you face? Buffett’s toughest constraint over the last 40 years has been the amount of capital he had to put to work. Berkshire (BRK.A, Financial)(BRK.B, Financial) is a lot bigger today than it was in the 1970s. But even in the early 1970s – for example, when Buffett bought into the Washington Post – he had to find investment opportunities that were much bigger than what the average individual investor needed.
Most investors overstate their need for liquidity. An individual with hundreds of thousands of dollars or even millions of dollars to invest doesn’t have real constraints in terms of the sizes of the stocks he can buy. Not if he’s an investor. If he’s a trader, that’s a different story. But, I’ve bought into stocks as small as Bancinsurance (a stock that no longer trades) and George Risk (RSKIA, Financial). I owned Bancinsurance stock until it was taken private. I’ve held George Risk shares for six years. They had market caps in the $30 million or so range. Obviously, market cap depends on price.
They had smaller market caps when I bought in than they did later, but these are micro-cap stocks, and they were half or more controlled by a founding family. The float was maybe half the market cap. We are talking about floats of $10 million or less, and people weren’t exactly furiously trading these stocks. But, if you are going to hold them until they go private or for six years or whatever, there’s no liquidity problem for anyone with even a few million dollars to invest. Now, if you have tens of millions of dollars – or more – to invest (as almost all fund managers do) then it’s a different situation. So, yes, if you have tens of millions of dollars or more to invest – you’re limited in terms of the net-nets you can buy.
Even in the 1940s and 1950s, when Ben Graham was running Graham-Newman, he kept the fund smaller than he had to. He could have attracted more investors if he wanted. He didn’t want to. And part of the reason why he didn’t want to was that he didn’t have – even in those much cheaper times for stocks – enough opportunities in net-nets, arbitrage, etc., to sop up an unlimited amount of capital.
I once wrote a report about Japanese net-nets. In other countries, there are sometimes more net-nets. Sometimes there are good reasons for this (fraud, corruption, etc.). Sometimes there are a lot of unexciting, dead money type stocks – but not a lot of risks. Japan is like that. Back when I wrote that report – you could find more than a dozen net-nets that were consistently profitable. These are Ben Graham type net-nets. If Ben Graham was around today and he was managing a small amount of money, he might buy baskets of net-nets in places like Japan. I don’t think he’d be buying the net-nets you see on U.S. net-net screens.
The U.S. stock market is expensive right now. It’s been expensive for awhile. Good net-nets show up after a market has been going down or sideways for a long time. Japan is where you would want to look for net-nets not the U.S. If I was managing money in Japan, I’d buy net-nets. If I was managing money in the U.S., I wouldn’t buy net-nets. The net-nets in the U.S. often have more severe problems.
I’ve written a little about net-nets before. I don’t want to rehash everything I’ve had to say. But one thing you want to look for in net-nets is a long corporate history, a profitable past and low leverage. There are a few easy checks for this. As a rule, I’d say a net-net should have at least six or more years of profits in the last 10 years. I don’t think you want to buy any company that has lost money – I’m talking about an operating basis (EBIT) – in more years than it has made money. I also think retained earnings should be positive. You can find a “retained earnings” line on a stock’s balance sheet. It should be in every 10-K and 10-Q. It’s a silly thing to talk about.
At a good business I wouldn’t care one iota if retained earnings was positive or negative. But, a net-net is different. The companies you are looking at are public. They have tapped public capital markets at some time. People have put money into the business. If shareholders, bondholders, banks, etc. have put most of the money into the company that it finances itself with, that doesn’t prove the business is self-sustaining. A stock can be a net-net if it just goes public as a speculative dot-com or something and raises $100 million and then the stock’s market cap drops to $50 million and it still has most of that $100 million in proceeds in cash, receivables, inventory, etc. That’s not the kind of net-net in which Ben Graham was interested.
The point of the net-net approach is that you have an operating business that is worth something – it’s turning a profit – and yet it’s selling for less than it could be liquidated for. You see that in Japan sometimes. I saw that in George Risk when I originally bought it. The stock was selling for about $4.50 and had about $4.50 (maybe a little more) stashed away in mutual funds, bonds, bank deposits, etc. On top of this, I thought the company could make like 40 cents per share pretax in normal times. A business that can make 40 cents pretax could be worth as much as $4. A pile of securities with a fair value of $4.50 per share could be worth as much as $4.50. You could be paying $4.50 for something that could – theoretically – be worth as much as $8.50. That’s what you want to do with a net-net, and then it’s just an issue of waiting. Maybe the long-term return is poor because the company doesn’t do anything with the cash it has, maybe the business doesn’t grow, etc. But, at least it turns a profit each year, and it doesn’t destroy value. It’s safe.
If you can – as I did in Japan – find five to 15 of these kinds of stocks, then you’ve got a Ben Graham-type group operation going on. Except in times of real market stress – like after the dot-com bust and after the 2008 financial crisis – I couldn’t find enough decent net-nets to do a group operation in the U.S.
That doesn’t mean the net-net basket approach doesn’t work in the U.S. There has been some research and anecdotal evidence showing it does work. But, it works differently than what Graham was doing. It’s more risky, speculative, contrarian, etc. What Graham was doing was more like what I did with the Japan net-net report. You can read more about net-nets over at Oddball Stocks. Nate Tobik bought some Japanese net-nets. And he wrote about his experiences. I also think Mohnish Pabrai (Trades, Portfolio) might have bought some Japanese net-nets. I don’t think his experience was positive.
If you’re looking for Ben Graham-style net-nets, I’d look for bargains in places like Japan. It’s a lot of drudgery. It’s Walter Schloss-type work. There’s nothing wrong with it. And I think a basket of good, decent, historically profitable net-nets in places like Japan can be a good diversifier. But it’s hard to come up with a consistent supply of them. And it’s nearly impossible to focus only on net-nets in just the U.S.
The approach I’d suggest with the highest return potential is more like what Joel Greenblatt (Trades, Portfolio) describes in “You Can Be a Stock Market Genius.” You can buy into spinoffs, special situations, things like that. If you’re very disciplined and you’re willing to concentrate your bets – this is the approach that will pay off best. I wrote a newsletter that was not catalyst focused at all. But, some of the best returns were in things like Babcock & Wilcox (BW, Financial) – a spinoff into a company the market was comfortable owning and a company the market was uncomfortable owning.
Likewise, when we picked Breeze-Eastern (no longer a public company), we knew that it had underreported its normal earnings because it had been doing R&D-type work on long-term projects and then the first sales it would make on these projects were the very low gross margin original equipment while the sales it would make in later years were high gross margin replacement part sales. Everyone knew this. We read the transcripts. We tried to talk to some of the big shareholders. But it’s not like the earnings transcripts, interviews, etc., told us stuff that wasn’t obvious from the company’s own discussions.
Phil Fisher mentions this kind of thing. You’re going to get opportunities like this in small cap stocks (Breeze was probably technically a micro-cap stock although bigger than the other two I mentioned earlier). Stocks that analysts cover shouldn’t have this problem. Because earnings estimates for future years should take this kind of thing into account. A lot of these fall into the sort of “temporary problem” category. Babcock was about to break up, and it had been losing money on a speculative modular nuclear power venture that we knew would be scaled down to almost nothing or eliminated. You had a loss-making unit that was going to go away. And then you had a monopoly that was going to be split off from a business that was heavily exposed to coal. It’s the kind of stock Greenblatt would buy.
So, the “You Can Be a Stock Market Genius” approach is the one I’d suggest to individual investors who want to put in the legwork and want to maximize returns. I think a buy-and-hold approach is right for most investors. But the best approach is to study up on great businesses and then buy them when there is some kind of temporary problem. Sometimes it’s that the market doesn’t like that kind of stock. In the wake of the financial crisis, I bought IMS Health (IMS, Financial) (it’s since gone public again, but it went private in between), FICO (FICO, Financial), and Omnicom (OMC, Financial).
IMS Health was a health care stock when Obamacare was coming. It also had some headline risk related to politicians attacking the use of anonymized data. FICO is credit scoring. It makes money based on the number of times its customers make use of the product. When banks, insurers and other financial institutions aren’t looking to approve new credit applications, they don’t need FICO scores. As for Omnicom, advertising takes a big hit in a recession. It falls first and harder than the overall economy and then it recovers faster and stronger than the overall economy. These are sort of temporary problem stocks. Some would say they are more along the Richard Pzena (Trades, Portfolio) – normalized earnings – approach. Good examples of stocks that could fall into this category now are Hunter Douglas (XAMS:HDG) (trades in Amsterdam, but is mostly an American company) and Frost (CFR, Financial).
Hunter Douglas sells shades and curtains. It does better when more people are moving into and redecorating their homes. Frost is a Texas based bank. It has a lot of low cost checking and savings deposits. It uses these deposits to make loans to businesses in Texas and to buy municipal bonds in Texas. A low federal funds rate depresses the yield on loans to businesses and yields on bonds. The Fed has less influence over the rate Frost pays for its deposits. Frost earns a lot less in a low interest rate environment than it does in a high interest rate environment.
What is Frost? It’s not a net-net. Is it a Greenblatt “You Can Be a Stock Market Genius” type stock? Is it a Pzena normalized earnings type stock? A Buffett-type stock? I certainly think Buffett would buy a bank like Frost if he wasn’t instead in the business of owning shares in giant banks like Wells Fargo (WFC, Financial). Wells Fargo is a better lender and cross-seller than Frost. Frost is equal to or better than Wells in almost every other way though. And Wells is limited by having about as many deposits nationwide as it will ever be allowed to have. Frost can grow for decades if it wants to. Texas will also grow probably twice as fast (or more) than the U.S. economy. It’s the kind of bank Buffett would buy if that’s the size of opportunity he was looking at.
But Buffett bought Wells during a crisis. California loan losses were real bad when he bought into Wells about 26 years ago. Frost isn’t in any sort of crisis. It’s just faced low interest rates for the last seven years. I’m probably fooling myself when I think it’s the kind of stock Buffett would buy. He’s more selective than that. He often holds his fire until a stock is cheap because of temporary problems.
Yes. I do think about the question: “What’s the one stock I would buy if I went to a desert island for the next 10 years?” The first question I ask is always: “Would I be comfortable owning this business forever?” Most of the mistakes I’ve made in the past have been cases where I bought into a stock – like Barnes & Noble (BKS) – that I was only willing to hold for a few years even if everything went well. I’d be comfortable owning a stock like Frost for 10 years even if I was on a desert island. That doesn’t mean it’s the best stock. Just the one I’d be comfortable owning. The other big bank in Texas – Prosperity (PB) – probably has a better management team than Frost. It has a great corporate record. It could certainly outperform Frost. And it’s much more interest rate neutral. So, it’s not a speculation on the Fed the same way Frost is.
If Prosperity announced it was changing both its CEO and chief financial officer, I’d want to sell the stock immediately. This is like when Quan and I were writing the newsletter and we were discussing DreamWorks Animation (since taken private). One of the questions we asked was: “What if Jeffrey Katzenberg was hit by a bus tomorrow?” We both agreed on the answer. We’d never even consider DreamWorks in that situation. DreamWorks was never a desert island stock, and Prosperity isn’t a desert island stock. I don’t think I own any stock that’s as much of a desert island stock as things like the Washington Post (in the 1970s) and Coca-Cola (KO, Financial) (in the 1980s and 1990s) were for Buffett. I sold Babcock’s nuclear reactor (submarines and aircraft carriers) spinoff, BWX Technologies (BWXT). But that would be a desert island stock.
The U.S. isn’t going to abandon the nuclear triad. It isn’t going to do away with carrier groups. And the only place it can get the parts it needs for those ships is from Babcock. So, BWX Technologies – at the right price – would be a desert island stock. Frost is probably the closest thing to a desert island stock I own right now. I’m less of a desert island investor than Buffett.
Disclosure: Long Frost and George Risk.
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