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Geoff Gannon
Geoff Gannon
Articles 

Pain and Patience: Net-Nets, Magic Formulas, and Micro Caps

February 13, 2012 | About:

Someone who reads my articles sent me this email:

Hello Geoff,

I followed your advice on patience, and was finally filled on (the Ben Graham Net-Net Newsletter’s September 2011 pick). Hopefully I can secure some (of this month’s pick) at some point. The strategy is not working as well as I had hoped, but I will follow your advice (2-3 year hold). Hopefully those long term results that you discussed in the last issue will materialize. Do you think that same time horizon should be followed with the Magic Formula micro cap strategy?

Best Regards,

Henry

I'm glad the patience finally paid off with you getting shares of the September pick at a lower price than the newsletter’s own model portfolio got them. One of the difficulties for the Ben Graham Net-Net Newsletter is that we make a pick on Friday night but then Monday morning comes and it might take a while for our own model portfolio to get shares. That is certainly a possible problem with this month’s pick. But it could've been a problem with two of the picks from last year (in particular). And in those cases the model portfolio got shares fairly easily. It’s always hard to tell ahead of time. There have been times in my own portfolio where a stock had averaged a few hundred shares a day in volume and then – wham – I put in an order for 10,000 shares and was filled right away.

Regarding this month’s pick, I have had to wait anywhere from 3 weeks to over a month or so for my own orders to be filled in stocks of similar size and illiquidity. But it has been worth it. For myself, I don't really compromise on price. I usually put in an order about a penny above the last trade and then just wait. For the model portfolio, we do it a little differently. And this could hurt our performance by about 5% a year or so (because we are bidding about that much higher than the last trade price in many situations).

2011 was a bad year for net-nets. Actually, that’s not a fair description. I should say the first half of 2011 was utterly awful for net-nets. The second half was pretty decent. So 2011 worked out to be a worse than usual calendar year for net-nets.

And 2011 wasn’t a good year for the Ben Graham Net-Net Newsletter generally. The price of net-nets came down rather than up throughout 2011. So far, we have done worse than the overall market. I don't think we've done worse than net-nets generally. But there is no standard benchmark to compare to. The total number of net-nets has almost tripled since we started the newsletter. This is due to price declines in near net-nets. I know of one person (Jon Heller at Cheap Stocks) who keeps track of a kind of net-net index. You may want to check out his blog. He updates the index from time to time. It'll give you an idea of what net-nets outside the newsletter are doing.

Relative to the overall market, 2011 was probably the worst year for net-nets in a decade. A lot of these stocks have just drifted lower. It is pretty much across the board. I wouldn't worry about it. I'd worry more about specific stocks blowing up because they were a bad pick. We had one of those. It didn’t exactly blow up. But we did pick a stock that is down 15% for the year. It was a very conventional pick – one of the biggest market cap stocks we picked – and probably not a good one in terms of my self-professed standards of F-Score, insider ownership, etc. I consider that one a mistake. But net-nets were hard to find through the summer months. What you should really be worried about are actual events (like bankruptcies) happening to stocks picked for the Ben Graham Net-Net Newsletter. Or steep declines in specific stocks like 30%, 50%, etc. Lower declines spread across the entire portfolio may be more of a short-term phenomenon. I would certainly treat them that way.

Like I said, Ben Graham and Walter Schloss tended to have an average holding time of 2 to 5 years for net-nets (turnover of 20% to 50% a year). And Phil Fisher – who invested in stocks very different from net-nets – thought you should hold a stock for 3 years before throwing in the towel merely because the stock price moved against you. In other words, the only reason to sell a stock in less than 3 years is because something has changed with the business not just with the stock price. I agree with that sentiment.

My biggest concern both for the Ben Graham Net-Net Newsletter's model portfolio and for the buy/sells subscribers choose to make is the trading part. Many people are not used to buying illiquid stocks. And I am concerned people will through a combination of the bid/ask spread, commissions, etc. manage to trade away 5% or even 10% a year (each and every year). It's very important not to do this. But that's why we have the model portfolio, to simulate the reality of trading these stocks yourself as realistically as possible. I hope subscribers are disciplined in this area. But that part is really up to them.

Unfortunately, I saw the Ben Graham Net-Net Newsletter’s February pick traded recently at what had been the ask price before we published our issue. Hopefully, it was not a subscriber who put in that order. But, basically, somebody agreed to trade at the ask price rather than getting any movement from the other side. That's sad to see. And I really do hope it was not someone who read the issue I wrote. Because I didn't write to pay the ask price. I did everything I could to stress the importance of being patient and demanding when it came to price. I even put that part in front of the actual discussion of the stock. But I know that part is very, very hard for people. Especially if you are new to net-net investing. If you are used to buying blue chip stocks the idea of bidding for a stock instead of just getting your shares – it’s a foreign concept. And it’s something the Ben Graham Net-Net Newsletter has to teach. Otherwise, subscribers will not have the success Ben Graham did.

As you know, I don't write the micro cap magic formula newsletter. I think 2-3 years of holding a stock is a good idea. For many strategies any holding period of 2 years all the way up to 5 years will still get good results if the underlying strategy is as solid as net-nets. Magic formula stocks are a little trickier. Personally, they are not my favorites. But there is no doubt the strategy works. The problem – and I think this is also the secret to why the magic formula keeps working – is that It is very easy to pick bad ones. Joel Greenblatt has written about this a bit. People who chose their own magic formula stocks often did much worse than an automated list chosen for them. That scares people away from using the approach.

By the way, this is a big risk with all stocks. Net-nets chosen by a computer do very well. It’s hard for a human to improve on those results. And easy for a human to mess them up.

This risk of human error is at least as big a problem for Magic Formula stocks. Maybe even bigger.

There's a reason for this. Magic formula stocks are the opposite of something like high F-Score stocks. Rather than having a range of positive outcomes they have big positive and big negative outcomes with the scale of positive outcomes more than making up for the frequency of negative outcomes. They're like low price-to-book stocks that way. If you’ve read Piotroski’s F-Score article you know what I’m talking about. And if you haven’t read it – what are you waiting for? (You can just Google “piotroski f score” and the professor’s Chicago Booth School paper should be one of the top results. Read it.)

So the problem with magic formula stocks is making sure they are safe. It's also the problem with net-nets. But I work very hard on that part.

Here's what I can say. If you picked the right magic formula stock from the start, and especially if you picked a safe stock – 3 years is a very good choice in terms of holding period. I think it's the holding period I'd recommend myself. But if you ever realize there's something seriously wrong not just with the stock but with the actual business you picked – you need to sell it fast. That's true of all holding periods. Once you realize you have an unsafe stock in your portfolio you need to cut it right away – regardless of how big a loss you'd take.

While as long as you have a safe stock you can afford to hold it. If it's part of a solid strategy like net-nets, magic formula, etc. you should hold a safe stock for about 3 years as long as the business isn't impaired. By that I mean you see a real risk of catastrophic loss. When you see that in any portfolio – when you perceive a real risk of catastrophic loss – that’s when you sell no matter how long you've held the stock or how big your loss will be. It's best to sell anything where you fear losses could be huge (50%+) under some scenarios. That's one reason why picking things like bank stocks is hard. There's often a big upside/big downside situation that may have good probabilities but still have a real risk of catastrophic loss.

I try to avoid things like that in my own portfolio. And always try to do it with net-nets. That is my biggest concern in writing the Ben Graham Net-Net Newsletter. The question is always how can I keep the level of catastrophic risk as low as possible while building a portfolio built solely from net-nets. That's the biggest concern both with magic formula stocks and net-nets. If you feel uneasy about the risk of catastrophic loss due to permanent impairment of the business – you should sell. Don't worry about the holding period. Just get out.

This can be due to bankruptcy risk, technology change, fraud, etc. But if the risk is real – sell now. Otherwise, if you picked the right stock in the first place I'd be willing to hold it for 3 years before I threw in the towel.

Warren Buffett saw the price of stocks like The Washington Post (WPO) go against him for about that long. And eventually he made 30% a year over his first decade in that stock. So, waiting 1 year or even 3 years because you believe in the business but the stock price doesn't show it yet is fine.

But it’s never fine to keep holding a stock if you realize there's a risk you didn't see at first. Or if the risk to the business has really changed since you bought it. It's rare for that to happen so fast outside of a few super fast changing industries. But it can happen. If you see catastrophic risk – sell. Otherwise, hold for 3 years. That advice is sound both for net-nets and magic formula stocks.

And it’s especially sound for micro caps.

Micro cap stocks are the worst stocks to sell in a hurry.

Talk to Geoff About Net-Nets and Patience [email protected]

About the author:

Geoff Gannon



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