Investing in net-nets is a really deep and pure value investing style. Net current asset value method is an investing technique first introduced by Benjamin Graham in the 1930s.
Many research studies demonstrate that the NCAV investment approach has produced clearly better-than-average results already over 80 years. Graham told himself, “I consider it a foolproof method of systematic investment – once again, not on the basis of individual results but in terms of the expectable group outcome.”
When a company's NCAV (the aforementioned current assets minus all liabilities) is more than a company's market value it's theoretically possible that the company could be liquidated and result in a gain for shareholders. In reality liquidations are extremely rare.
Different ways to use net-nets method
Although it’s easy to quantitatively define net-net stocks (current assets - total liabilities) there are many different ways to invest with this method.
The simplest way is just to screen stocks valuing under their net current asset value and buying a basket of them.
Many investors require some kind of margin of safety. For Graham it was generally buying two-thirds under the value of NCAV. Some use 75% of NCAV as their limit. The idea is to decrease downside risk if any unexpected bad information about the company (or concerning markets) is revealed.
For other investors simply NCAV valuation does not give enough downside protection. They are ready to value cash for 100% but think that receivables and inventories are more risk. For them there is the net-net working capital method. NNWC = Cash and short-term investments + (0.75 x accounts receivable) + (0.50 x total inventories) - total liabilities. This method clearly trims the list of possible investments.
And if you are very conservative you have to remember that ongoing business losses also can erode cash quickly. In other words, if a company is burning cash you should consider whether you can value it in the balance sheet 100%. Both Joel Greenblatt (Trades, Portfolio) and Seth Klarman (Trades, Portfolio) have reminded us about this problem in interviews.
Anyway all net-net stocks are dirty cheap and when analyzing net-nets you should concentrate on downside risk. As a group net-nets will work so well that it is important to avoid bad apples.
An investor should always try to identify why a company is selling for less than NCAV. Once this has been done the investor should then determine the discount for the given flaw. Not all net-nets are good investments; some have gone to zero for a variety of good reasons.
Risks with net-nets
The most common risks are fraud, rapidly eroding value and bankruptcy.
The risk of fraud is mostly related to the number of Chinese reverse merger companies that had both great numbers and incredibly low valuations that turned out to be fraudulent. Outside of the Chinese, net-net companies don't hold any more risk for fraud compared to other areas of the market.
A history of low profitability tends to produce perennial NCAV stocks. You should avoid stocks that always seem to trade below their net current asset value. Firms that constantly lose money are great at destroying shareholder value. If a company’s net current asset value is rapidly eroding, it’s a big red flag.
Companies that have been unprofitable for years can burn big holes in your pocket. You have a chance of substantial economic loss and in the worst case – bankruptcy – you may lose all the invested money.
Another danger to burn your money is buying companies that don't have existing operations.
Pharmaceutical research companies can burn their working capital without any real outcome. Also some companies sit on a bank account not doing much more. Avoid them.
We can form a quick checklist of what should be avoided:
- Chinese net-nets.
- Companies traded below NCAV for years.
- Companies that don't have existing operations.
- Selling its own shares.
- Gimmick or fraud accounting.
- Biggest net-nets.
Fine tuning net-nets
Can you get better-than-average results selecting net-nets by using additional criterion like profitability, low price-earnings (P/E) ratio or paying dividends? That is a good question. There are different studies and different answers. Henry Oppenheimer (professor of finance at State University of New York) examined the returns to Graham’s net current asset value strategy over a 13-year period. He found that net-net stocks operating at a loss outperformed the portfolios of profitable and dividend-paying net-net stocks.
The same tendency continued during the 30-year period according to Tobias E. Carlisle (updated examination of Oppenheimer’s study in his book “Deep Value”). On the other hand Victor J. Wendel (president of Wendl Financial Inc.) testified in his book “The Net Current Asset Value Approach to Stock Investing” that low P/E and dividend-paying net-nets performed better than net-net stocks on the average. Either way we have to remember investing our own money isn’t the same as examinations including all net-net stocks in the market.
Although diversification is desirable in investing in net-nets you cannot buy them all. You need to form a doable strategy to work with net-nets. As I mentioned at the beginning of this article avoiding the biggest mistakes is the most important thing. But you can also look for quality and reduce volatility, avoid some permanent losses and maybe sleep better at night.
What we are searching for?
Size of the company
We are looking for small companies – market cap under $50 million (some investors prefer under $25 million). Generally, most net-nets are underfollowed small stocks, but you should check company size. Net-net stocks of tiny companies tend to outperform the stocks of larger companies. Of course trading really tiny companies can be challenging because of illiquidity and large spread between bid and ask price.
High F-Score and Z-Score
Particularly F-score but also Z-Score work well with net-nets. F-Score tells you how financially strong and healthy these bargain stocks are, and it is just what you need to know. Z-Score tells you how distressed a company is and the risk of bankruptcy. Important information to know.
Remember however that net-nets are always really cheap stocks with some kind of financial difficulties, distress and risk. You should also get to know financial statements (SEC filings) and annual reports.
Adequate past earnings, retained earnings or paying dividends
If you get any signals that a net-net stock turns profitable, first it means decrease of risk and second there could be a big upside potential. Retained earnings tell you much about the quality of net-nets. They can help you avoid some perennial money losers.
Graham recommended dividend-paying net-nets. Times have changed, but sustainable payment of dividends is still a sign of strength although dividend-paying stocks trading below liquidation value can be difficult to find (Japan is an exception).
Insider ownership and company is buying back stocks
It’s important to know that company owners or management are supping from the same bowl.
It’s appropriate to require insiders collectively to own at least 1% of a company’s stock. Every time a net-net company buys its own stock it increases the value of shareholders. It also shows a strong confidence in its own future.
Low price to net current asset value and increasing net current asset value
The lower the price to NCAV the better the returns will be as an average. Graham looked to purchase net-nets that were valued at a discount to their net current asset value by 33% or more. It’s a widely known truth that net-nets can, although cheap, still quickly lose value. The lower the price to NCAV the bigger is your margin of safety and downside protection. If a company’s NCAV is, on the other hand, increasing, it’s a good sign. A company is working in the right direction and balance sheet is getting stronger.
Selling net-nets
One of the oldest methods is buying at the discount to NCAV and selling when the stock price reached NCAV. This method worked a long time ago and maybe it’s still profitable, but I doubt that it is the best possible. Generally, I imagine that the biggest mistake of many investors is to sell net-nets too early.
The two main reasons for it are (1) when the price of the stock rises rapidly investors are in a hurry to collect profits and (2) when the value of the stock decreases or stays flat for many months, investors get bored and lose their faith. Usually you make a mistake both ways.
When the price of the net-net's stock rises rapidly, even over NCAV level, you should remember that it has been initially dirty cheap and when something positive comes out the upside possibility can be enormous. Don’t cut the future of three-, five- or even 10-bagger stocks too early. Analyze what has happened and how the fundamentals have changed and draw your own conclusions. Based on your new analysis is the stock undervalued or overvalued?
The same applies when the stock value decreases or stays flat for many months. If you have chosen stock according to the right criteria (remember this is the most important thing in net-nets investing) you should keep it at least one year. The only exception is if you made a clear mistake when purchased.
Three years should be enough to see what happens. Often something like five years is the maximum time to keep them in your portfolio. You don’t have to look at your net-net portfolio every day, but you should re-evaluate your holdings every six months or at least every year.
Want to learn more about net-nets?
Books
Of course first you better read the most important books from Graham, the father of value investing who developed the net-net investing method.
- "Security Analysis."
- "The Intelligent Investor."
There are also other interesting and useful books on this theme.
- "Deep Value" by Tobias E. Carlisle.
- "Deep Value Investing" by Jeroen Bos.
- "The Net Current Asset Value Approach to Stock Investing" by Victor J. Wendel.
Not so much about net-net investing techniques but a great story about Peter Cundill, one of the masters of this style.
- "There’s Always Something to Do" by Christopher Risso-Gill.
Other quality investing books that contain relevant information about this topic.
- "Value Investing" by Greenwald, Kahn, Sonkin and van Biema.
- "Quantitative Value" by Wesley R. Gray and Tobias E. Carlisle.
- "The Manual of Ideas" by John Mihaljevic.
- "The Value Investors" by Ronald W. Chan.
From the Internet you can find a lot of information. Some useful tips:
- Net Net Hunter (all about net-net investing and great checklist).
- Old School Value (a lot of value investing information, also net nets).
- Oddball Stocks (great articles – not only net-nets).
- Cheap Stocks (already name will tell you all).
- Greenbackd (writer of “Deep Value” and “Quantitative Value”).
- ValueInvestingBlog.net (net-nets and micro caps).
- DVI (net-nets investor from Germany).
- Geoff Gannon’s articles in GuruFocus (great deep analysis about net-net investing and other educational articles).
You can find other interesting resources searching the Internet.
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