The idea behind investing in net-nets is an investor has the ability to buy a company for less than working capital. The idea is to buy the company for a discount to the asset value and wait until the market recognizes the undervaluation and sell when the stock reaches its asset value.
I have a simple rule I try to use when selling:
1) Sell when the price of the issue is at or above NCAV
2) If operations improve evaluate the company on a cheapness basis compared to other cheap stocks in the portfolio. If the operations are not cheap compared to existing holdings or potential holdings sell.
Why did I buy?
I think there are usually two reasons to buy a net-net; the first is that the assets are being undervalued, the second is the business is undervalued and the assets provide a downside.
It's very important to know the reason on why the stock was purchased. If it was purely an asset purchase then evaluate selling on an asset basis. For a stock purchased with the net-net value as a downside protection for a cheap business evaluate selling based on the cheapness of operations.
What if the business improves?
I think the biggest impediment to selling a net-net for most investors is what to do if/when the business results begin to improve. During the time spent waiting for the market to recognize the value of the cigar butt management works to turn operations around. Eventually the company begins to post respectable earnings and solid free cash flow. The stock begins to climb and the investor begins focusing on the earnings growth story instead of the asset value realization.
This scenario is where the second portion of my rule comes into effect. If I find myself looking at the operations of the company verses the asset value I need to refine my focus. I will evaluate the company on an operations basis alone and compare the cheapness and quality of operations against other holdings in my portfolio and potential holdings. If the company doesn't meet my criteria for being cheap I need to sell the holding.
A few examples
I recently went through this exercise Dainichi which I highlighted on the blog here and here. When I first posted the stock was trading at ¥632, I purchased it for around that price. I recently noticed that the price was in the ¥800 range and above, it prompted me to take a look at Dainichi again. When I purchased the stock I evaluated the NCAV to be ¥828.
So what did I do when I noticed the rise above my estimated NCAV? I re-evaluated my thesis, I took a look at the updated filings for Dainichi to determine if there was any new information out that could materially change the thesis, and there actually was. The company consumed a lot of its cash and receivables to build up inventory in the most recent period thus lowering the NCAV calculation. To me this was a no brainer, the NCAV value had dropped and the price was above my target. I ended up selling for ¥844 a share. It was tough, the stock drifted higher eventually reaching ¥873, but I can't call the top exactly, my thesis had been met, it was time to sell.
SGI was one of the first net-net's I invested in a few years ago. Before I discovered the joys of net-net investing I was more of a good company at a cheap price type of person (I still invest a lot of my money this way). When I first took a look at their balance sheet I added and re-added the assets and subtracting the liabilities convinced I had made some sort of mistake, but I hadn't, the company was trading for less than working capital.
I purchased the stock around $5 a share and at the time the company had about $7 in working capital. I held the stock for a while and eventually it started to rise quickly passing $7 a share. The results of the business were pretty poor and I didn't understand why the stock jumped so I sold. At times I kicked myself because the stock ran up to $12 about three months after I sold, and eventually hit $22 a year and a half after my sale. But I had no confidence in the SGI business, I was purely buying assets cheap and I kept my discipline by selling when the asset value was realized.
I wrote about George Risk here, this was a net-net stock that I purchased below NCAV but I liked the operating value of the business. I guess you could say I purchased George Risk on an operating basis with the NCAV as downside protection. I knew this when I purchased, and worked up my valuation based on what the business should be valued at from an operating stand point. I still hold George Risk even as has traded above NCAV, I consider the stock to still be cheap.
This is another stock I profiled on the blog, my first post actually. I bought PC Connection on the same basis as George Risk, that the business was cheap and the NCAV provided downside protection. I purchased PC Connection for $6.91 last September and it's currently trading at $8.91 well above NCAV, but on a operating basis still cheap.
One thing I haven't mentioned at all in this post is tax considerations, I didn't mention it because I don't consider them as much as others. In the case of Dainichi I held the stock for about three months resulting in a short term gain. The reason I don't focus on taxes is because tax considerations can muddle an investment thesis. If I had held Dainichi for the long term gain I would have been holding a stock that was trading well above a diminished NCAV. I would also be holding on a speculative basis to avoid a possible tax hit, it's not worth it in my opinion.
Disclosure: Long George Risk, PC Connection