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Geoff Gannon
Geoff Gannon
Articles 

How to Pick Net-Nets

February 09, 2011

I get asked a lot of questions about net-nets.

This article is my best attempt to answer those questions from a practical standpoint. It’s not about net-nets in theory. And it’s not about specific net-nets right now. It’s about how you can get started investing in net-nets.

The first rule is don’t rush out and buy 10 or 20 of them all at once. Everybody wants to do this. I understand the urge.

But trying to find 30 nets/nets all at once is like going to work on your first day as a loan officer, being handed 50 loan applications, and being told to approve 30 of them by 9 a.m. tomorrow.

Can you do it?

Sure.

Should you do it?

Not when it’s your own money at risk. First, you need to know what a creditworthy borrower looks like. You need to see more than one loan application to compare them. And you need time.

You need time alone with each application.

Because that’s really what each net-net is. It’s a loan application. All you need to do is analyze the downside risk. Just like the interest rate is baked into a loan, the annual return is baked into net-nets by their absurdly low starting price. You don’t need to analyze the upside when it comes to net-nets.

You just have to really scrutinize the downside.

My point isn’t that you can’t diversify. You can own 30 net-nets – eventually. Just not today. Not next month. Probably not even next year. Maybe you can own 12 net-nets by next year. That means you only have to approve one application a month. That’s doable.

Enough with the loan application analogy. Let’s back this up with a little evidence.

When I said you don’t need to worry about the upside in net-nets, I just mean they work so well as a group that all you have to do is avoid stepping on a landmine. If you can do that, you can beat the market buying net-nets.

When it comes to net-nets, you don’t need to generate good ideas. You just need to avoid generating bad ideas.

So, how good is your average net-net idea?

Well…

I decided to run a backtest of a simple net-net strategy from March 31st 2001 - February 7th 2011. I used stockscreen123.com to do this. If you bought 12 U.S. based net-nets each year, sold them 12 months later, and then bought a new batch of 12 net-nets each year you'd turn $100 into about $650 over 10 years. That's a 20% annual return. Over the same time period, a small-cap index did about 8% a year.

Net-nets are basically all small cap stocks. From experience, I’d say the best net-nets – in the sense of the highest quality businesses – usually have a market cap under $25 million. That doesn’t mean there aren’t some really bad net-nets with a market cap under $25 million. There are. But there are really bad net-nets with market caps over $25 million. For a company with a market cap over $25 million to become a net-net it can’t just be passively neglected. It has to be actively hated. Especially when you look at things like Chinese net-nets, the reason a company with a market cap over $25 million is a net-net is likely because some people think it’s a fraud.

Including net-nets above a $25 million market cap probably won’t improve your overall performance.

When I backtested the same strategy from 2001 – 2011 using only net-nets below a $25 million market cap for one group and only net-nets above a $25 million market cap for the other group, the under $25 million group performed better.

And while there’s no perfect measure of risk, the two groups did equally badly in terms of the average loss on their worst stock pick. Each group averaged a 53% loss on its worst stock pick of the year for those 10 years. As for the worst year for the entire portfolio, that was 2008 for both groups. And the over $25 million market cap group actually did a smidge worse than the under $25 million market cap group in 2008.

Overall, a portfolio invested in 12 net-nets with market caps over $25 million would have grown from $100 to $292.90 from 2001 to 2011. That’s an 11% annual return.

And a portfolio invested in 12 net-nets with market caps under $25 million would have grown from $100 to $658.70 from 2001 to 2011. That’s a 21% annual return.

And, finally, a portfolio invested in the group I thought would do the best – the 12 U.S. based net-nets under $25 million in market cap with the highest insider ownership – would have grown from $100 to $1,662.40 from 2001 to 2011. That’s a 32% annual return.

I don’t know if that’s the absolute best way to pick net-nets. I didn’t use that screen because I backtested my way into finding it. I used that screen because my own experience has been that net-nets with a market cap below $25 million and a lot of insider ownership are usually where you find the real bargains.

Now, I’m not saying you should specifically target net-nets below $25 million. But I am saying there’s no reason to think net-nets with a market cap above $25 million are better than net-nets with a market cap below $25 million. They aren’t. I’ve studied net-nets both large and small. The large ones are every bit as low-quality as the small ones. I’ve always found the true hidden net-net gems are around the $25 million market cap level or below. They are usually held by insiders. They are often illiquid. And they are almost always in mundane slow-growth or no-growth industries.

These are stocks that are boring investors to death.

If instead of picking just 12 essentially random net-nets, you picked the 12 best net-nets by their F-Score, your $100 in 2001 would turn into $1,000 by 2011.

That's an annual return of 25% a year. So the F-Score doesn’t seem to work as well as insider ownership. I’m not sure if I would have predicted that.

But I do know it’s a good idea to focus on net-nets with high F-Scores and high insider ownership. That’s not just some backtesting talking. That’s a lot of experience with net-nets that weren’t heavily owned by insiders or weren’t real solid in terms of their F-Score. Big mistake.

Why does picking net-nets based on insider ownership work so well?

While it’s hard to screen for insider buying in a perfect way, I did try to check this in the backtesting. I was unable to come up with any form of insider buying screen that outperformed a pure insider holding screen. In other words, if you’re going to hold a net-net for a year or more, you’re better off picking a net-net where insiders already own a lot of stock than picking a net-net where insiders are buying more of the stock right now.

Insider buying has a certain allure to it. Folks in the know are buying more, that’s got to be a sign of something. And maybe it is. But I’ve always found – and the backtests I did confirm this – that insider ownership is at least as good a sign as insider buying when it comes to net-nets.

I think I know why ranking net-nets by insider ownership works so well.

There are 3 big risks with net-nets:

- Fraud

- Bankruptcy

- Share Dilution

Why would someone who owns the majority of a company commit a fraud? Why would they risk bankruptcy? And why would they allow their majority ownership position to be diluted through stock issued at rock bottom prices?

Normally, they wouldn’t.

Although I do worry about fraud in insider owned Chinese net-nets.

Buying net-nets is such a good strategy it makes no sense to go looking for trouble. All you have to do is find net-nets that aren't frauds and you will make money. So why bother with Chinese net-nets at all?

You shouldn’t.

I couldn’t backtest a strategy of buying just Chinese net-nets because they are such a new phenomenon. Before 2007, there were almost no Chinese net-nets. Since 2007, there are often up to a dozen Chines net-nets. Some of them have had great returns. But part of the problem with looking at net-nets is how they perform in different market environments. And we have no performance data on how Chinese net-nets performed in the relatively “normal” stock market years before 2007. We only have a very short record of their performance around the time of the 2008 crash and the subsequent recovery. Both of these episodes have been once in a lifetime events. Market moves of this magnitude happen a couple times a century in the United States. So we have no record of Chinese net-nets before about 2007 and we have no record of Chinese net-nets from normal years.

That’s the problem.

If you want a diversified net-net portfolio, it’s easiest to create one after a stock market crash.

The number of net-nets tends to decline as a bull market ages. I don’t have numbers to back that up. It’s just my best guess from experience. Basically, bull markets make net-nets disappear. The Great Depression was very helpful to Ben Graham, because the aftermath left him with net-nets for years and years.

It took a long time to have a consistently rising stock market after 1929. There were great years. But there were also bad years. As I mentioned in an earlier article, Ben Graham was only able to find A&P stock selling below its net current assets – despite a terrific earnings record – because of the economic aftershock of 1938. Even in the 1930s, it took a second downturn to scare people back into offering up a wide variety of net-nets. Investors were already inching back toward normalcy before 1938. Within 10 years of the ’29 crash, people were already feeling good enough to stop stocks from selling below their net current assets. A second scare – the 1938 recession – frightened investors into letting A&P sell at a ridiculous valuation despite being America’s biggest retailer.

These aren’t exhaustive net-net backtests. They aren’t scientific. And they certainly aren’t optimized.

I didn't fiddle with the backtest to find the perfect combination of number of positions, holding period, or sorting mechanism. I just said: let's do our best to have the computer ape a strategy any dumb human could follow.

Start in January and choose a net-net to put 8.33% of your portfolio into (1/12 = 8.33%). Add another in February. Another in March. Another in April. Keep adding until next January. Then, if there's a better net-net than last year's January pick, sell your old holding and buy the new one. Repeat.

Don’t just sell net-nets when they hit their net current asset value. A lot of people do this. And I’m not saying it’s wrong. But there isn’t much logic to it. I’ve looked at Ben Graham’s portfolio. He didn’t turn his stocks over very fast. These were sleepy stocks. And yet I notice a lot of people trade net-nets pretty furiously.

You don’t really have to. It gets distracting to watch net-nets constantly. And it doesn’t make tax sense to sell a net-net before one year is up. Plus, unless you’re very careful about which broker you choose, buying micro cap stocks – which is what net-nets are – can get very expensive. I see no reason to ever sell a net-net within one year of buying it. The more diversified you are, the more true that statement becomes.

Pay a lot of attention when you first pick a net-net. Then forget it for a year. Your time is better spent finding a new, equally good net-net than debating yourself on some choice you already made.

The level of attention you give your stocks is determined by the amount of time you have divided by the number of decisions you have to make. Your buying decisions are determined by the number of positions in your portfolio times the portfolio turnover rate. It’s one thing to own 5 net-nets and turn them over twice a year. You would have to be real selective about which 5 net-nets to own, since a 100% loss in one of them would cost you 20% of your portfolio. But at least you’d only have to make 10 decisions a year. If you owned 10 net-nets and turned them over twice a year you’d have to make 20 decisions a year.

Decisions are where risk comes from. Deciding wrong is the real danger. For most investors, I don’t see how making more than 1 decision a month can possibly be safe. You just don’t have enough time to consider the decision before you make it.

So, that’s why I picked a backtest using a portfolio of just 12 net-nets. I think that’s as far as you can stretch a human’s attention before it snaps.

That doesn’t mean you can’t own more than 12 stocks. You can. But the more stocks you own, the less you should turn over your portfolio. In other words, if you want to hold stocks for 5 years each – feel free to own 30 of them. That actually takes less attention than picking a stock every month.

Now, a 30 stock portfolio may not be optimized from a return perspective. But a 30 stock portfolio with a 20% turnover rate is actually very good from a risk taking perspective. You can spend a lot of time worrying about each stock before you buy it. And you’ve spread the risk around.

But I don’t get the sense most people are widely diversifying among net-nets while simultaneously taking enough time to make each decision. They seem to be selling net-nets pretty fast. That only forces you to make more decisions faster. And that’s risky.

From the emails I’ve gotten from people about net-nets, I get the impression they don’t hold a stock for years. In fact, most people seem to be holding their net-nets for well under 1 year.

It’s true that Ben Graham – and Walter Schloss – held 100 stocks at a time. But they didn’t spread their portfolio over those hundred stocks evenly. Ben Graham’s median position size was more than 1%.

If you have a portfolio with a median position size of 1.5% and you have less than 40% portfolio turnover, you’re really mimicking the decision making requirements of about a 25 stock portfolio instead of a 100 stock portfolio. That’s assuming the guy with the 25 stock portfolio is turning over his entire portfolio every year.

There’s no doubt Ben Graham was widely diversified. But Ben Graham didn’t make quite as many decisions as you might think. Stocks stayed in his portfolio for a long time.

Now, if you really could find 100 net-nets year after year – and you could buy and sell them in a cost effective way – I’d have no problem suggesting you do exactly that. But I’ve never been able to do that. There are often no more than a couple dozen candidates.

Right now, there might be 50 net-nets if you count literally every single stock that passes a pure net-net screen. I’d say about 10 of those 50 net-nets are actually false positives. They’re not true net-nets – computer and website and screeners just think they are. If you went over them with your own human eyes you’d find the math doesn’t add up for about 10 of those 50 net-nets. That leaves probably 40 true net-nets.

That sounds like a lot.

But you’ll find a lot of stocks on that list that Ben Graham would never buy.

The backtest I did is far from perfect.

I noticed a small number of Chinese net-nets did slip in. This seemed to be caused by recent reverse mergers. But I can’t be sure.

Regardless, stockscreen123.com was able to eliminate the vast majority of Chinese net-nets when I told it to.

In the backtest, I had to do a once yearly selling of the entire portfolio and buying of a new one. From a purely human standpoint, you are psychologically much better prepared to replace one net-net a month and pay no attention to each individual net-net you own until it comes up again in next year’s rotation.

And stockscreen123 doesn't really use the F-Score as far as I can tell. It uses a 50% book value/50% F-Score combination. But that’s the closest approximation I could find.

Low price-to-book doesn’t do much when screening for net-nets. Obviously, net-nets are all low price-to-book stocks. All of the companies in the net-net universe are crazy cheap. That's not the issue. Even at a stock price of 99% of net current assets, a stock is deeply undervalued if it’s a viable business.

The question with net-nets is viability. That means bankruptcy risk, financial deterioration risk, and fraud risk. And that's about it. Net-nets do fine if they can just stay solvent and honest. It’s not like their sales have to increase next year for their stock price to increase.

So, I'd suggest looking for net-nets:

- In the U.S.

- With positive retained earnings

- A Z-Score greater than 3

- One of the highest F-Scores among the current crop of net-nets

- And one of the highest insider ownership percentages among the current crop of net-nets

Reverse those criteria, and you have a list of possible net-net disasters. You should avoid net-nets that:

- Are foreign

- Have negative retained earnings

- A Z-Score less than 3

- One of the lowest F-Scores among the current crop of net-nets

- And one of the lowest insider ownership percentages among the current crop of net-nets

There's no doubt you will occasionally lose a lot of money on one net-net if you diversify as widely as 12 of them. Honestly, there aren’t always 12 good net-nets.

If you want a "magic formula" for net-nets just do this:

- Rank all known net-nets by F-Score

- Rank all known net-nets by insider ownership

Add the two ranks together. Pick the net-nets with the highest combination of F-Score and insider ownership.

If you're letting a computer pick for you, that formula may be fine. However, if you're doing the picking yourself you are adding a dangerous human element which you need to combat by checking for domestic companies with positive retained earnings and an adequate Z-Score.

I’ve noticed most net-nets people talk to me about in emails fail those 3 tests. I’m not sure why people are attracted to Chinese net-nets, or net-nets that have lost money over their entire business history, or net-nets that are at risk of becoming insolvent in the next year or two. Sometimes, I think it’s because these net-nets seem to have more upside potential. But you don’t need upside potential when picking net-nets. You just need downside protection.

My point isn't to lay down absolute rules for buying net-nets. It's to emphasize the fact that all you have to do with net-nets is avoid big mistakes. You don't have to pick winners among net-nets. You just have to avoid companies that are either scams or soon to be bankrupt.

Unfortunately, the emails I get from readers tell me that some people are interested in exactly those net-nets where there’s a real risk of fraud or bankruptcy.

Don’t bother analyzing those stocks. Don’t worry about close calls. Borderline cases aren’t worth the trouble. You don’t have to figure out if a certain net-net is or isn’t about to go bankrupt. You don’t have to figure out if a certain net-net is or isn’t a fraud.

You just have to find a few net-nets where you know the answer.

And go ahead and hold the good net-nets a bit longer than most people do. The backtest I ran looked at a 1-year holding period because that was the longest holding period stockscreen123.com uses. Ben Graham suggested holding net-nets for up to 2 years before selling them.

I think most people can afford to wait 1 year after buying a net-net before selling it as long as they take the effort to make sure it’s a net-net they wouldn’t mind having to own for a 12 months. That’s the key. Less time spent worrying about selling net-nets and more time spent worrying about buying net-nets will improve your performance.

This is especially important when you consider how high broker commissions and taxes can be on net-nets. Some brokers charge more for buying these kinds of stocks – small, under $5, OTC, etc. – so you probably want to change brokers if you plan on investing in net-nets.

I’m a big proponent of always holding net-nets for a full year. I think it makes no sense to add concerns about selling to your list of things to worry about. Finding good, safe net-nets is hard enough in a bull market. If you can eliminate the sell decision – make it totally automatic – why not do that?

Just focus on buying net-nets. That’s where the risk is.

Really, net-nets are the perfect place to just take a list of stocks and read the 10-Q like a credit analyst.

Ask yourself: would you be willing to lend money to this company?

If the answer is “no”, don’t buy the stock.

If the answer is “yes”, buy the stock.

Picking net-nets is just a matter of looking for risk and avoiding it. With net-nets, the reward takes care of itself.

So don’t worry about reward. Just focus on risk.

And make fewer, better decisions.

For some folks that means being less diversified. For other folks, it means holding each net-net for a longer time period. Either way works. Just ask yourself which would make you more uncomfortable: being forced to own fewer net-nets, or being forced to own each net-net for longer.

Then pick the lesser evil.

The time you spend trading net-nets and re-analyzing net-nets you already own is time that would be better spent analyzing new net-nets for potential risks.

That’s really all there is to investing in net-nets. You just keep working your way through a list of super cheap stocks hoping to find a few low risk applicants.

Follow Geoff at Gannon On Investing

Editor: Check out GuruFocus Net-Net Screener

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Geoff Gannon



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