This might be a strange post, maybe a sign of the times for the market we're in, I'm not sure. I've been seeing something happen that I can't fully wrap my head around, and I'm not sure what to make of it, yet it exists. I'll call the phenomenon value momentum.
Let me back up first, valuing a net-net is easy, calculate NCAV and buy below that price. At times the company might have substantial unrealized business value, if that's the case the company should be valued on an earnings basis. Another type of stock I like to buy is a two pillar stock, this is one that's selling below book value, and has earning power that supports book value.
I rarely buy stocks with poor earnings simply trading below book value, unless book value is something tangible or has strategic value. I almost never buy a stock selling below book value when book value consists almost entirely of goodwill, unless that stock falls into the next category.
A third type of cheap stock I like to buy are discounted earners. These are companies that have high returns on equity or invested capital. Sometimes these companies are heavily laden with cash, and the true business value is hidden. They might have low multiples like an EV/EBIT of 4x, or a P/E below 8x.
In this post I want to talk about net-nets which are trading at or very close to NCAV with recovering operations. The current market has a lot of net-nets where book value isn't much higher than NCAV, and if it is higher then most of book value is pure accounting fiction. An investment at a considerable discount to NCAV would be prudent and well justified. An investment at NCAV is made on shakier grounds if what lies above it is speculation. The theory behind buying net-nets is that the companies are priced for extinction, so when they don't go extinct the market will reward the stock because expectations were too pessimistic. Another word for this is mean reversion.
Try going to the local hardware store and asking the owner to buy the store for less than the cash in the registers, and have him throw in the building, inventory, and client contracts as well. It's ridiculous to even consider asking for that, yet the market gives us valuations like that all the time. People will even go out of their way to justify the valuation, with things such as: "Hardware stores are outdated", "I can buy a circular saw on Amazon, or at Home Depot cheaper", "The building was built in the 1800s, it's probably worthless", "It's located in an old part of town". Even if all of those sayings were true about the hardware store most reasonable people would agree that it should sell for something more than the cash in the register.
Some investors get caught up trying to find the competitive advantage of a net-net, my advice, stop looking, they don't have one. Others work out DCF calculations, my advice is don't waste your time. This is not to say that a good business can't sell below NCAV from time to time, it does happen, but not as often as many investors think. When it does happen question why the seemingly good company is selling so cheap. If you can understand why and the valuation is unwarranted back up the truck. A lot of net-nets are average businesses with below average valuations. You'll find companies such as, a cleaning supply store, a glove manufacturer, a barber shop product supplier, a metal stamping company, and some electronics manufacturers. Nothing exciting in terms of business potential, yet the valuations the market gives these companies is clearly wrong.
Given that most net-nets are average or poor businesses, and most should be valued on an asset basis the question arises, what to do about the near net-nets? Here's what I've observed, a company will be selling for 90% or 95% of NCAV and suddenly the company will report a great quarter, earnings go from $.10 a share to $.30 a share. The only problem is the stock is selling at $19, earning power doesn't support the valuation. Further the company's earning power will probably never support a valuation beyond NCAV. What happens in the market is vastly different though, these companies gain momentum and start to fly. I owned one that went from $6 to $13 in about six months. Unsurprisingly outlook turned negative for this company and the price fell back to $7, then they had a good quarter again and it was right back up at $11.
What I'm talking about aren't isolated incidents, I've seen a number of companies fly past NCAV into no mans land in terms of valuation. The company's valuation has become unhinged from its asset value, and earning power, yet the stock continues to rise.
My question is what should we do if anything with these value momentum stocks? This is something observable that continues to repeat, but how does one invest prudently in these companies. Once they float past NCAV and book value there is no margin of safety anymore, the price is bouncing on the whims of the market. Yet clearly there is a lot of money to be made harvesting even some of the gains as expectations shift on the company.
What's frustrating to me is there are a lot of companies selling close to NCAV, but they're too close to NCAV for me to make a comfortable investment. These companies also don't have much of a book value beyond NCAV or earning power. Yet I also know that once they have a few good quarters their price is going to rocket forward for a while before results disappoint again. I see these gains over and over, yet I can't bring myself to invest, or should I say speculate.
Has anyone else observed this?
Talk to Nate