In part one and part two of this series I looked at investing in net-nets both at market bottoms (2002,2009) and then right before a market drop (2008) and finally a relatively flat market (2010). For the first two posts I intentionally decided to leave out conclusions and commentary for brevity sake. I've now had some time to sit and look at some of the stocks and wanted to try to wrap things up.
I don't really have a grand narrative to tie this together, instead I have five observations which I think will serve net-net investors well.
1. It's not finding the winners it's avoiding the losers.
This seems obvious and it is, but it's also true. Just avoiding the three companies that lost 99% in 2008 improved returns from 28% to 46%. That's almost a 20% increase by just avoiding three companies. So how hard was it to avoid those? One CommercePlanet was unable to file quarterly statements and was under investigation by the FTC for unfair trade practices. The company also fired their auditors in 2008 only to bring in new ones who ordered a restatement of financials. Too many red flags to invest, move on. The other two didn't have any filings with the SEC or on OTCMarkets making it much harder to get information. Dark companies aren't necessarily bad, but I require a much higher margin of safety, without seeing the financials it's impossible to know if that existed.
Another big loser was Independence Resources losing 65% over the time period. The company appeared profitable but a closer look revealed the profit was a one time license sale. The company is still struggling along, but the cash from the one time sale has been quickly disappearing as losses mount. Independence Resources falls into the category of a melting ice cube.
I did some spot checks on the data and most of the big losers fell into the melting ice cube category. Of course there's a reason most of these stocks are selling for less than NCAV so warts and problems are to be expected. The discerning investor needs to be able to tell the difference in a temporary impairment of operations and a permanent problem.
I prefer to stick with companies that have either a temporary problem, or steady profits and cash flows. I realize this eliminates most net-net candidates, but I also am working to avoid losing money.
Another way to avoid losers is to avoid companies that appear to be fraudulent or have the characteristics of fraud. Currently a screen of net-nets brings back a lot of Chinese reverse merger stocks with characteristics of fraud. Avoid those if possible, if a company's results appear too good to be true, or something can't be reconciled move on. There is no reason to invest in something questionable when many perfectly good investment options exist.
2. Buy and hold for net-nets isn't ideal.
The dataset I had ran a simulation presuming an investor purchased the stock and then held without selling. This can be acceptable strategy if a net-net is actually a good business hidden by a pile of cash, or by a temporary difficultly. Sometimes if net-nets are very small companies that are completely neglected, I don't think there's any penalty to holding that sort of company long term. These sorts of investments are very rare. Of the 100 or so net-nets in the US right now I can probably count on one hand the ones with average businesses, and of those, maybe one or two is worth holding.
So what does this mean? A net-net investor needs to be nimble, these companies are called cigar butts for a reason. Take the last puff and move on. Often investors want an investment to fit their timeframe, so a holding period of one year to avoid a short term gain, or a nice steady distribution of returns. I have had two net-nets that I purchased and sold within three months because the stock had risen to NCAV, I had my puff and moved on.
I picked a few stocks at random and there were plenty of opportunities for an investor to sell with a 50% gain. One of these was Wireless Xcessories Group (WIRX). The company on 6/15/2008 was selling for less than 2/3 NCAV at $.85/sh. I counted three peaks on a chart where an investor could have sold their shares for $1.20-$1.29 up to 18mo after the initial investment.
3. A margin of safety exists.
Someone left a comment on one of the previous posts mentioning the point of a NCAV strategy is to ensure a margin of safety. I agree, but I think a distinction needs to me made; not every company selling for less than NCAV has a margin of safety. Graham made an effort to point this out as well, he showed an example of two companies one where NCAV was growing over time and one where it was shrinking. Both companies were net-nets, and Graham clearly pointed out that the company with a growing NCAV was a desirable investment while the company experiencing a shrinking NCAV was not, even though it was a net-net.
Buying for less than some multiple be it book value, NCAV or even 2/3 NCAV doesn't ensure a margin of safety it just increases the probability of one occurring. The work of the analyst is to ensure an actual margin exists. Some net-nets screen well but are terrible investments, other companies don't appear to be safe at first sight but with some digging are in reality very safe.
One of my goals on this blog is when I write about net-nets I like to highlight if there is a bonafide margin of safety, or just the illusion of safety.
4. Value works because sometimes it doesn't.
I stole that quote from Joel Greenblatt but it's true. There are plenty of time periods where a NCAV strategy might not work. Take for example the results I turned up from investing in 2010. At best the investor would have done slightly worse than the index, but at worst trailed by 4% over two years. Numbers like that are what get professionals fired. Sure over the long term the results turn out great, but what if an employer doesn't have patience?
I'm not sure if anyone read the Henry Oppenheimer study I linked to but there was a very interesting footnote on one of the pages. It said time periods in the 1950s and 1960s were studied but NCAV outperformance was spotty and not sustained. The father of net-net investing himself mentioned this as well in the 1951 and 1962 editions of Security Analysis. Graham mentions a NCAV strategy is superior but the stocks are hard if not impossible to find. One thing that benefits investors today is no one is locked into a single market. While there aren't many net-nets in Europe right now there are plenty in Japan.
The strategy might underperform for a time but one thing it hasn't done is lose money and that is essential. To me successful investing is avoiding losses, sticking to cheap businesses ensures gains at some point. Even if investing in net-nets underperforms an index for a period of time it hasn't resulted in permanent losses yet, and I doubt it ever will.
5. Diversification is essential.
I looked at a number of historical filings for the companies that appeared on these screens. The scariest part was some of the biggest melting ice cubes looked bad, but investable bad. There were a few stocks that lost 60-70% that while they were losing money had considerable cash cushions and no liabilities beyond a few accounts payable. I have a rule myself to only invest in profitable net-nets, this was a suggestion Graham made as well. Oppenheimer found that companies losing money tended to slightly outperform the profitable ones. My number one rule of investing is margin of safety, and even with a very wide berth of assets the assets aren't safe if the company is burning cash.
The point is it's easy to look at the results and say "Oh I'd avoid xyz for sure", but at the time very few would make that call. Owning a larger batch of net-nets prevents against the possibility of owning all losers. From 2008 there were more losers than winners, it's just that the gains from the winners were enough to offset the losses from the losers. This really reinforces my first point avoid companies that have a high potential of losses and the gains will worth themselves out.
Talk to Nate