What Are the Minimum Requirements for a Good Net-Net?

Author's Avatar
Feb 13, 2012
Someone who reads my articles sent me this email:


What are your minimum mechanical checks to invest in a net-net? For example a certain F-Score, percent of shares held by management, particular industry, etc.

Are there criteria that cause an immediate pass when looking at a net-net?



Great question. Technically, there is nothing that would eliminate a stock automatically. What I mean by that is that the Ben Graham Net-Net Newsletter has bought:

  • A net-net with a bad business but an investment portfolio worth more than its stock price
  • A net-net with no business but cash worth more than its stock price and the intent to merge, liquidate, etc. at some point
  • And net-nets with good businesses but little or no excess cash
Really, it depends on the cash situation. If a stock is a net cash bargain (cash minus total liabilities is greater than its stock price) than it could be picked even if it would fail other tests. Also, about 90% of the stocks we've picked have been what I'd call actual operating businesses. One wasn't. And another one was – but we weren’t buying the for its business – just the cash. So those are special cases.

Technically, those stocks could have really bad F-Scores, past losses, etc. because they really aren't ongoing businesses as much as cash piles. But these are the exceptions. And I'd always rather pick an operating business with a cash pile over just a cash pile anyway. A profitable, operating business is always best. Warren Buffett's recent article in Fortune reinforces this idea. A decent, productive business – yes, even if it is a net-net – is something I'd prefer to pick over just a pile of cash.

But that does bring up another exception. If I had really good reasons to believe the company had very valuable assets not stated on the books in addition to its current assets (for example: real estate, interest in another company, etc.) it could be made a Ben Graham Net-Net Newsletter pick even if it failed on most of the criteria I usually care about.

Having said that, a company should always have a Z-Score of at least 3. It should preferably have an F-Score of let's say 5. But I've picked things that were very borderline. Maybe I shouldn't have. But it's happened. So while the Z-Score is a hard and fast rule the F-Score hasn't been used that way in the past. Insider ownership is another area where I have not practiced what I preached with the newsletter in all situations. And, in fact, there was one pick that had both a low insider ownership and weak F-Score. Not surprisingly, it's one of the newsletter's worst performing picks so far. That one was probably a mistake. I should be tougher on those counts. And will try to be in the future. Unfortunately, that pick was made when there were only about one-fourth as many net-nets as today. The number of net-nets rose throughout 2011 – making the newsletter's performance poorer but my job easier. The worse net-net stocks perform, the more choices you get. The toughest time to pick net-nets is when they are doing well.

So a Z-Score of 3 is mandatory. And I will never pick a Chinese reverse merger net-net. Those two points are non-negotiable. And they both have to do with the risk of catastrophic loss. I try very hard not to pick net-nets that could go to zero.

There are some huge black marks like having negative retained earnings, public company history of less than 10 years, and being a retailer.

I am very reluctant to buy retail net-nets. Other than having a Z-Score under 3 or being a Chinese reverse merger – being a retail net-net is close to the worst thing a company can be. I’m joking of course. I just have a hard time evaluating retailers. This absolutely does not mean that retailers make bad net-nets. Nor am I saying you should avoid buying them. I’m just saying I avoid buying retail net-nets, because I’m really bad at judging retailers. See my articles on Barnes & Noble (BKS) if you need the gory proof.

For the Ben Graham Net-Net Newsletter, I don't pick stocks that aren't filing with the SEC. That's for the newsletter. For myself, I'd be open to buying a stock that stopped filing with the SEC. Some companies keep reporting balance sheets every quarter even after they "go dark". I'd be okay owning a company like that. But I don't pick them for the newsletter.

And then, again, for the newsletter we do just American companies. For myself, I'm willing to buy in other countries. I prefer U.S. companies because I understand them better. But half of my portfolio is in Japanese net-nets. So I clearly have no problem investing overseas.

So, for the Ben Graham Net-Net Newsletter the rules are basically:

1. It has to be a net-net

2. It has to be a U.S. stock

3. It has to be current in its SEC reports

Down one level from that in terms of how mandatory it is would be the Z-Score and no Chinese reverse merger stocks. To be clear, Chinese companies sometimes show up as U.S. companies due to being a reverse merger. Many people/websites treat them as U.S. stocks because they trade on U.S. exchanges. I won't touch them. And would never pick them for the net-net newsletter. Some of them are frauds. And none of them are truly U.S. companies. They shouldn’t be part of a U.S. focused newsletter.

I can't imagine a situation where I'd pick a net-net that had a Z-Score of less than 3. So that's pretty much mandatory as well.

After that, with the exception of companies that trade for less than their net cash, the Ben Graham Net-Net Newsletter normally picks:

· A non-retailer

· With positive retained earnings

· A Z-Score of 3 or higher

· An F-Score of 5 or higher

· And few or no operating losses in the last 10 years

Many of the Ben Graham Net-Net Newsletter's picks have been profitable for at least 10 straight years. The F-Scores vary more. Many fall in the 5 to 7 range. Off the top of my head, I can't remember if we've picked more than one 4 or lower F-Score stock that wasn't a net cash stock. There was at least one though.

Anyway, I'll write a full description of each stock as it exits the portfolio. So, starting around April (I think), we'll beginning selling net-nets we've held for a full year. After we sell them from the model portfolio, I'll write an article describing what the stock looked like when we picked it including things like the F-Score, past earnings history, etc. and then how the stock performed while we held it and of course what it looks like today.

Some particularly patient bargain hunters might even want to buy stocks the Ben Graham Net-Net Newsletter sells at a loss. After all, they'll be even cheaper than when we first bought them. We'll see. In some cases, it may be clear I made a mistake picking the stock in the first place. You won’t want to buy those.

And I'll try to own up to my mistakes.

It’ll be a learning experience for everyone. So, expect to see those articles on the net-nets the Ben Graham Net-Net Newsletter sells each month starting later this Spring.

Until then, premium members of GuruFocus can always read the newsletter issues as they come out. I make the pick on Friday. And we buy the stock on Monday. So you always have the weekend to think things over. And you’re never being told what stock we’ve picked after the fact. You’re always told before we buy the stock. Not after.

Talk to Geoff About Net-Nets [email protected]