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How to Detect Fake Net-Nets
Posted by: Mark Lin (IP Logged)
Date: December 5, 2012 09:56AM

It is common for classical Benjamin Graham-style value investors to buy stocks trading for less than net current asset value. However, not all net-nets are not real undervaluation cases, if you take the time to dig deeper.

A few caveats apply: In relation, the valuation of the key components of the net current asset value such as short-term investments, accounts receivables and inventories.

Investors should learn to differentiate between bank deposits and other short-term investments such as stocks, bonds, hybrid securities and structured products. These investments are typically mark-to-market with huge volatility in their prices and values.

Accounts receivables are near-cash in nature as long as they do not become bad debts, i.e. customers default on payment. If a large percentage of accounts receivables is concentrated with a few customers, the risk of non-payment on the receivables is higher. In addition, if the customers themselves have weak balance sheets and poor profitability, the accounts receivables should be discounted further. Investors should also assess the collectability risk of accounts receivables for the company in terms of the trend in account receivable days, the credit payment terms for customers, the credit strength of major customers, the adequacy of current provisions for bad debts and the potential for further write-downs on the receivables. Receivables overdue for a period exceeding the average receivable days of a company is at high risk of write-down. A trend analysis could be done to examine the trend of receivable days and the proportion of receivables overdue for more than 90 days.

Under normal conditions, the costs and selling prices of inventories are relatively stable. In reality, rising raw material costs, changing customer preferences and lack of bargaining power with suppliers & customers could lead to overstocking, loss-making finished products and eventually write-downs on inventories. The marketability of various types of inventory differs. While most inventories can be sold at or close to book value, consumer electronics such as smartphones and high-end apparel can quickly be obsolete and sell for significantly less than cost. Also, certain types of inventories may suffer from lack of market depth. Specialized inventories such semiconductor testing equipment and fresh produce may not find sufficient buyers for a realization of value within a specific period of time.

Previously, I also wrote about Radioshack Corp (RSH) as a "fake net-net," as it has significant off-balance sheet liabilities in the form of operating leases and purchase obligations which exceed its current assets in value.

Stocks Discussed: RSH,
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