How to Analyze Net-Nets Undergoing Change

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May 09, 2012
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Someone who reads my articles asked me a question:

Hi again Geoff,

I am very new to net-nets, so I haven't got everything thought out yet about how I view them. Or rather, I have reawakened to them, thanks to you and Oddball Stocks mostly, after being a bit more dismissive of 'lesser' businesses. It seems you use net-nets more as a quantitative screen rather than as making 100% sure the downside protection in the balance sheet is absolutely firesure. I can sympathize with this and the thing about finding stocks that are cheap on more than one metric strikes a chord with me.

I am trying to value a Swedish net-net right now (the only one I could find actually, its name is Empire). The problem is that the business as an ongoing concern is not that easy to value at all. They sold off most of it (and now sit on $25 million in inventory, $35 million in receivables, $55.8 million in cash and $47.9 million in total liabilities. The market cap is about $45 million. No non-current assets. They recently paid out $10.3 million in dividends.

They were the Scandinavian reseller of Sodastream (SODA, Financial) but Sodastream bought them out and what remains now is some other rather bland kitchen/household gadget business, some of it in their own brand and some of it as an agent for Babyliss. Basically, they sell toasters, which surely isn't the best of businesses but they have eked out profits in all years except 2009 under the current structure. The company had a wholly different profile before 2004.

Total sales last year were $375.6 million but without Sodastream proforma sales were $101.5 million, with 2-3% EBIT margins in the last two years. The Sodastream business was actually heavily contracting (saturated market with high household penetration) while the other business is growing nicely (21% year over year), and won't have the same problem of saturating markets (toasters, water boilers and shaving appliances are not 'one-off' products in the same way as a gadget which gets a buzz around it for a while, at least not in my mind).

Would you ever consider a stock like this or does the lack of operating history in its current form make you put it in the too hard pile immediately? I find that the business as such is far from worth the market cap, obviously, but they could pay out something like $40 million and still have a business worth probably about $15 million to $20 million with significant possibility on the upside, if they can continue to grow profitably. But they won't do so, obviously. They are going to try to expand faster in different ways with the help of the cash.

Would be great to hear some thoughts on this if you have the time...



Have you read "You Can Be a Stock Market Genius?"

It discusses investments that are similar in how you have to analyze them to something like this:

· Spin-offs

· One money-losing division, one money-making division

· Etc.

So, first of all, this is a tough topic. It’s often hard to analyze the actual businesses of net-nets. It’s much easier to analyze wide-moat companies. And net-nets usually don’t fall in that category.

When you add change to the mix it’s even harder. Business change of any kind is a really tough part of any investment analysis. And, yes, a net-net that was in a competitive business to start with and now is undergoing a lot of change — that can sometimes be too much to analyze.

As part of a group, you can definitely invest in businesses undergoing change. If you could find 50 companies facing a lot of change — but selling for less than their net current assets — you could have a nice portfolio. Some will blow up entirely. They’ll go to zero. But those that recover will pay off handsomely.

Right now, you’d have to be a smaller investor willing to cast a worldwide net to find anything like 50 net-nets where the big problem was business change. For investors in a few countries — Japan, Korea, etc. — there are more net-nets to pick from. Investors in those countries can keep themselves busy just focusing on net-nets.

It doesn’t sound like Sweden has a lot of net-nets. Especially if you only know of one.

I wouldn’t know. The strength of Sweden’s currency makes me less likely to invest there — I wouldn’t want to buy a Swedish stock unless I knew I wasn’t at risk of losing a lot of money when I swapped my kronas for dollars after I sold the stock. I don’t normally hedge currency risk. So, Sweden wouldn’t be the first country I’d look to invest in because I’d have to hedge there. (Here’s an illustration of the issue: The Economist’s January 2012 Big Mac Index showed a Big Mac sells for the equivalent of $5.91 in Sweden but just $4.20 in the U.S. Assuming that pattern will hold is not a risk I want to take.)

What about the idea of investing in a net-net for reasons other than the operating business?

Yeah. I’ve done that.

You want to be careful to pick on reason or the other though. It’s kind of like how people can get themselves into trouble with a convertible security. Is it a good income producing security? Yes. With a conversion opportunity — yes. Perfect. That’s a good investment. But, is it a so-so fixed income investment with this conversion supposedly making it a really attractive combination...

That might work. But you have to be honest with yourself. Why are you buying this thing? Four almost-good-enough reasons may not be as good as one obviously great reason.

Ideally, I like buying perfectly decent businesses when they sell below their net current assets. I think that’s the best approach in the long run. I think it’s something I can stick to.

But, yes, I’d be willing to buy something just because I think it’s safe and I know it’s selling for less than it could be liquidated for.

In fact, I’ve bought stocks with no real operating business left. We have one such stock in the Ben Graham: Net-Net Newsletter’s model portfolio right now. I won’t say the name. But it’s just a cash pile (with maybe some value in future tax savings). Anyway, you’ve read about this kind of stock — and quite possibly this exact stock — at a lot of blogs. No operating business. But it’s selling for less than it could be liquidated for.

That works. The in-between situations are tricky. I’d like to know a stock is clearly good enough to invest in comfortably on an operating business valuation or a liquidation valuation. I don’t want to justify the investment by thinking I’ve found a stock that’s just good enough when you look at both of those facts. Because chances are the liquidation value will end up being frittered away if the operating business turns out much worse than you expected.

Managers rarely rush to evacuate excess capital from a sinking ship. Usually, they’re still there trying to save the wreck.

So I’d be careful about situations that look like a mixed opportunity — half supported by a decent liquidation value and half supported by an operating business.

What about pure liquidations?

I have invested in liquidations. And actually I’ve had tremendous success in that very narrow category (I’ve made less than one such investment a year — maybe I’ve participated in about one liquidation every two years). For example, I bought a company that was basically just a cash pile (it sold its operating business) and was majority owned by Carl Icahn . After a few months, he bought out the remaining shareholders. No surprise. Worked fine. The annualized return was obviously terrific. Any time you get bought out within a few months the annualized number looks great.

I also owned stock in a business that was a poor performer — its product was made obsolete by cell phone cameras — that chose to liquidate. That worked fine too. Took a while. But it worked fine on both an absolute and relative (to the market) basis. And the nice thing about liquidations is they tend not to move with the rest of your portfolio. They work on their own timetable. A nice kind of diversifying plus.

There are a couple other examples. But that’s a good taste of some of what I’ve invested in outside the normal range of businesses that are still doing today pretty much what they did last year and the year before.

There is nothing wrong with investing in a corporation undergoing a lot of change. In fact, generally, it’s far, far better to invest in a corporation that’s undergoing a lot of change than in a business undergoing a lot of change. You should be able to figure out what a business is worth in just about any corporate structure — financed in just about any way.

A business undergoing a lot of change is harder to figure out. It’s a more fundamental problem to solve. Usually too fundamental. Changing customer habits are the worst. It can be nearly impossible to predict future earnings in situations where you know future customer habits will differ from past habits. That’s because customer habits are so basic, so fundamental to everything a business does that a change of habit can ripple through all the financial statements in a way that makes the future completely unlike the past.

Okay. Let’s look at the company you asked about.

First of all, I have to admit I didn’t even know what Sodastream was before reading your email.

I would watch a situation like this. I’m not sure I’d consider investing in it unless I had a clearer idea of whether it would pay out money or intended to reinvest it all.

If you could get a rump business for very little because a lot of your purchase price will be returned to you in cash over the next year or so — that would be great.

But that doesn’t seem to be what you are describing.

If they really intend to reinvest this capital it would be hard to analyze.

From what you said, I think you have history from around 2004 or 2005 to today. So, maybe we are talking about seven or eight years or something. Correct me if I’m wrong.

And the remaining part of the business was profitable in six or seven of those seven or eight years — all but one.

Yes. I usually prefer — in fact, require — at least 10 years of history before investing in any company for any reason other than its cash.

I like to have 15 to 20 years of history whenever possible. It’s often possible with U.S. companies, because EDGAR goes back to around 1996 or so. If a company’s been public that long, you can get the data.

Combine this seven or eight years of history with 2% or 3% operating margins — and I’d be very hesitant. To me, I’m not sure how I could ever value that company on an earnings basis. It seems like all I could do is look at liquidation value.

But I would definitely follow the company. They have excess working capital. That’s always interesting. You want to be the first person to really understand what is going on if they make an announcement about any distribution, liquidation, acquisition, etc., because of the position they are in. It’s definitely a stock that could be mispriced. Stocks going through these kinds of changes can be oddly valued by the market. People just don’t know what to do with them.

Just because it’s not a decent, consistent business doesn’t mean you can’t invest in it.

I picked GTSI (GTSI, Financial) for the Ben Graham: Net-Net Newsletter.

And that is not a good business. It lost money in about half of the last 10 years. It had no history of earning more than about 6% on equity over time. It was a truly terrible business.

But it was selling for less than its cash and receivables and it had a stake in another company that was obviously worth something.

So, you can include a stock like that as part of a group. I would not have bought it as my only net-net investment. But I had no problem adding it to a newsletter that has picked over a dozen net-nets. As part of a group like that, I think it’s a fine addition — because it really is selling for less than you could liquidate it for.

With Empire, it sounds like management’s plans are the key. So I would follow the stock. And I’d pay attention to who is running the company, what they are saying, and what’s going on there.

If they end up owning things you can easily value, it may make a good investment at some point.

Corporate change alone is not a problem. I’d be very happy following a John Malone company through all sorts of corporate changes. Because I can usually figure out what the businesses are worth it’s just the structure and changes in what the corporation holds that’s tricky.

You get the idea. Change itself is not the problem. A short corporate history in a certain form is not a problem.

But a business that isn’t super easy to predict the results of — there’s no moat, there is lots of price competition, etc. — where the company is going to increase investment pretty rapidly...

That can be too hard to figure out.

If they end up expanding with some products that you can’t evaluate — it’ll be a pass for you. But it’s worth following. Overcapitalized companies undergoing change are good stocks to follow.

Especially if they are in your home country. Many of my best investments were in my home state of New Jersey when I lived there. Some were pretty local. It helps to follow companies that are maybe a little more obscure.

My best results have been in stocks that were both very simple and very obscure.

I can guarantee you that worldwide there are fewer investors looking at Swedish stocks than U.S. stocks. So you have an advantage there. Use it.

I never like to see someone in a country with a stock market that’s not so well known worldwide spending too much of their time analyzing U.S. stocks, UK stocks, Japanese stocks, huge companies, etc.

You actually have an advantage. The companies I know best are American companies. And American companies show up on everybody’s screens. So if it’s just a matter of being a net-net, below tangible book value, low P/E, high dividend yield, etc. — something really quantitatively conspicuous like that — well, everybody’s at least had a chance to glance at that company if it’s in the U.S.

This is less likely in most of the rest of the world.

So follow companies like this one. Even if you never actually end up buying Empire you’ll get a good idea of what net-net investing is like. Not as good an idea as owning a net-net — that’s quite a different experience. More people are abstractly interested in the idea of net-nets than actually end up practicing net-net investing on a regular basis. That’s because of how frustrating these stocks — and their managements can sometimes be.

You won’t experience that as viscerally when you don’t own the stock. But it helps to watch a lot of net-nets you don’t own. They will test your patience.

Personally, in this case, I wouldn’t know how to evaluate additional investment in some related business of theirs until I actually start seeing the results. So, I don’t think I could buy a stock like Empire today. If they were going to pay the money out as a dividend, that would be different. And if they were going to buy an existing business I could research, that would be different. But rapidly growing the existing business — with only a limited history of less than a decade (and really thin margins) to go on is probably too tough for me to wrap my head around.

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