Someone emailed me recently about net-nets. He found my old post:
Reading that email, reminded me I haven’t written about net-nets in a while.
I used to write about them a lot.
I've written a lot about net-nets and looked at them a little in Japan and a lot in the U.S. I've done some backtesting over the years, briefly wrote a net-net newsletter for GuruFocus, and have emailed ideas back and forth with many blog readers, article readers, and just individuals I know (some of who are bloggers) about net-nets. So, I think I have a pretty good idea of not just what net-nets are out there but more importantly how individuals actually do investing in them.
Net-nets can be a good choice for individual investors precisely because they’re not a good choice for money managers. Money managers don’t like net-nets. They don’t like focusing on them. You’re not constrained the way money managers are – so you can focus on net-nets.
Why Money Managers Don’t Focus on Net-Nets
Net-nets are not a good choice for money managers to focus on for four reasons:
1. It can sometimes be hard to put enough money in each idea. Though this problem is smaller than it might seem for many funds. In the U.S., we can assume any fund would be perfectly comfortable owning 4.9% of a stock for all purposes except liquidity. Liquidity shouldn’t be a concern at all for an individual investor (since this is money you don’t need now and are saving for retirement – it’s okay to lock it up for years at a time if necessary). And 20 positions is adequate diversification. Ben Graham himself suggested 10-30 for this kind of strategy. So, basically a pure net-net fund would be able to invest in companies up to its own size. In other words, if all the good opportunities in net-nets are in companies bigger than $10 million in market cap and smaller than $100 million in market cap – then a pure net-net fund should also be $10 to $100 million in size itself. A lot of money managers hope to one day manage more than $10 million to $100 million in assets. That’s not going to work well if you’re focused on net-nets. In fact, a smaller fund size – like $30 million total – is likely to work best. However, even under something as generous as a 2 and 20 type fee structure, such a fund would only generate maybe $1 million to $1.5 million a year in total fees for the people managing it. Again, this assumes good performance and a really generous fee structure. That sounds like a lot of money to make managing a fund. But, it’s capped. The strategy doesn’t scale up. So, I don’t see how you’d ever end up generating much more than $1 million to $1.5 million a year in fees no matter how successful you were. If you did end up generating more fees, it’d probably be due to having grown assets so much you’d severely hurt the future performance of the fund. So, a worldwide net-net fund with $30 million in assets is definitely doable. If done right, it should be really successful. And it could definitely produce over a million dollars in fees for a hedge fund run that way. But, it could never – if successful – be a $300 million fund generating $10 million to $15 million a year in fees. The strategy can’t scale up. This makes no difference to an individual investor. It makes a huge difference to a money manager. Most strategies money managers use could one day generate 10 times the fees they now generate if the fund is successful. A net-net strategy can’t.
2. Net-nets are illiquid. A fund would have trouble TRADING net-net stocks even if it didn't have trouble investing in them. For this reason, a pure net-net fund wouldn't want to be an open end mutual fund. It could be a closed end fund. It could be a fund with permanent capital (like that provided by an insurer) or it could be a fund like the Buffett Partnership that only allowed investors to withdraw money once a year. Buffett also didn't tell his partners what they were invested in. Graham Newman was a closed end fund. It could have been much, much bigger. In fact, Graham Newman actually traded above net asset value at times because investors put a premium on the closed end fund instead of a more typical discount. Ben Graham could have managed much more money than he chose to. His goal was not to maximize assets under management. So, net-nets were a good choice for Ben Graham. He wanted to maximize performance in percentage terms and in consistency terms. He didn’t want to maximize his own fees.
3. Net-nets don't appeal to most kind of fund shareholders. So, the actual individuals and institutions that might give a money manager capital aren't that excited by net-nets. Even if they are excited by them as a concept, they aren't excited once they see the actual stock list. So, it could be as hard or harder to attract money to this strategy as a more typical strategy and investors would definitely tend to pull their money fast if allowed to.
4. Net-nets don't actually appeal to most kinds of fund managers. Here, I think is the actual Pabrai problem. I think there were two problems. One, Pabrai likes managing a lot of money. He doesn't want to refuse people the opportunity to invest with him, doesn't want to return capital to people, etc. He wants to make a lot of money for himself and to give away a lot of money to the causes he believes in. That's fine. More assets under management also raises your profile and does other things some fund managers might want. Second, Pabrai is a very successful fund manager and often a very concentrated one. He likes having big, quick upside in some of his ideas. And that's worked well for him. The net-net approach is usually to spread your bets around - even if you wanted to concentrate in a few net-nets, it can take time to build up positions to the size you want - and they often lack catalysts. I don't think Pabrai was well suited to investing in net-nets. His approach is much closer to the Buffett partnership and Munger partnership approaches than to Ben Graham's approach.
Graham was running much more of a true hedge fund. He was looking for a way to reliably provide adequate returns to investors regardless of what the market did. Pabrai wants to compound his money as quickly as possible.
Finally, there’s the question of whether you can actually buy net-nets. Can you get the shares you want? Not in theory, in some backtest. But, in practice. Will someone actually sell you enough of the stock you want to fill up your portfolio?
I’ve found this problem to be exaggerated.
I'm not a fund manager. I'm an individual investor. I've only ever put a hundred thousand dollars into a single net-net, not a million. So, I'm not a good person to judge putting large sums to work in net-nets. However, I have actually bought very illiquid stocks. So I have some practical knowledge of the subject – buying illiquid stocks as an investor, not as a trader.
In my practical experience, historical volume hasn't proven to a good indicator of:
- The amount of stock I could buy / sell
- How quickly I could buy it / sell it
- And how much my bid/offer would affect the share price
In the most illiquid stocks I've bought: I've generally found that I could buy more shares, get those shares quickly, and do so at prices equal to or below what the stock had last traded at. This is anecdotal. But, I've always gone into illiquid stocks with a calculation that I would have a lot of my return shaved off through various frictional cots that never materialized.
The caveat here is that I'm never in a hurry to get into or out of an illiquid stock. I'll just name an exact price and wait all month. But, I've both bought and sold anywhere from an average day to an average week's worth of stock in a single trade and done so without the last trade price being changed by my trade even a penny.
I assume the reasons for this are:
1) I name a price and leave it - I don't adjust my bid or offer up or down day-to-day within any given month
2) I offer to buy or sell my entire position at once - I never look to deal in smaller amounts
If you look at the Buffett partnership, he seems to have often spent months buying a position, sometimes bought it in blocks form large sellers, etc. So, I'd caution investors to focus on:
1) The smallest net-nets
2) The highest quality net-nets
3) And especially: the most illiquid net-nets
I've had a lot of success with illiquid stocks in all sizes. In fact, from stocks in the $15 million market cap range to the $1.5 billion range (so, there I mean super illiquid by big stock standards), I've found some of my best success buying stocks with the lowest percent of freely floating stock, the least frequently traded shares, etc.
In fact, I'm not really sure whether you should want to buy a highly liquid net-net. I've said before that some stocks are cheap because of "contempt" and some stocks are cheap because of "neglect". The best net-nets are the unknown, neglected ones. Net-nets that are well known would have to be very disliked to be net-nets. Or, occasionally, they might be businesses with a ton of working capital and very low returns on that working capital - so Ingram Micro (IM) could be a net-net at times because inventory and receivables are almost all of assets and the return on assets is low. That’s a huge business that ties up almost all its equity in low-returning working capital. As a result, it sometimes qualifies as a net-net. But, big stocks like that which can slip into net-net territory are rare.
Finally, as far as your possible rules for net-net investing, I'd caution to re-balance as infrequently as you're comfortable with and especially not to sell when a stock reaches NCAV. So, for example, three rules for selling might be:
1. Only evaluate a net-net for sale every 2 years
2. Sell the net-net completely if it exceeds 100% of NCAV on the day the net-net is scheduled for you re-evaluate
3. Sell the net-net partially to the reach the targeted portfolio weighting of a normal position on the day you re-evaluate
In other words, if you want to put 5% into 20 different net-nets, you'd need to re-evaluate 2-3 net-nets a quarter. That's a reasonable amount of selling to be doing. It's not going to be that beneficial to sell net-nets really quickly. For one thing, bad momentum in the stock's price is one reason these things got cheap. So, once they start moving up - why not hold on to them for a while (since they are still very cheap even while blowing by 100% of NCAV) and save yourself the trading activity?
I really think it's not necessary to re-evaluate net-nets more than once every 2 years. I don't advocate holding net-nets for 10 years. But, I think trading them the way Ben Graham did and Warren Buffett (Trades, Portfolio) did means something much closer to a 3 year holding period on average where some might sell in 1-2 years and some might be held 5-6 years. The good returns will often be in the stocks where something happened quicker. But, the stock doesn’t know you own it. So, why sell it just because you’ve owned it for longer than you would have initially hoped to own it for?
I also think it's really important to be open to the possibility of holding net-nets beyond the 100% of NCAV level. If you sell right at 100% of NCAV, you are capping your gains at a low level and you're selling a fundamentally cheap stock (1x NCAV is still absurdly cheap for most kinds of companies) that has now started moving up in price, getting noticed by others, etc. - why do that?
So those would be my only suggestions. Illiquid stocks are a good choice and trying to get comfortable with holding net-nets for a couple years at a time is also a good idea. The one bad aspect of net-nets for value investors is that they seem to encourage these value investors to adopt more of a trader's mindset than they would have if invested solely in higher quality businesses.