Friday, February 1, 2013

Value momentum, speculating on recovering net-nets

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  People will even go out of their way to justify the valuation, with things such as: "Hardware stores are outdated", "I can buy a circular saw on Amazon, or at Home Depot cheaper", "The building was built in the 1800s, it's probably worthless", "It's located in an old part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

11 comments:

  1. Nate,

    Here is my view: a margin of safety isn't just a way to give us profit when the business reverses to mean (i.e. Bought at 33% discount of NACV, when the value gap closes, you reap a 50% return). But it is also an insurance against our mistakes, mistakes in the valuation and mistakes in understanding the situation. When a mediocre business is trading close to NACV, it doesn't offer such margin of safety, unless there is something else in the business to compensate for that. It doesn't mean it's not investable. But the speculative component becomes the dominating factor.

    I suppose it also depends on how concentrate your portfolio is. In my case, I'd rather swing the bat when the odds is overwhelmingly in my favour. If so, the opportunity cost is high for me to accept a net-net trading at NACV.

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    1. I agree, it's really insurance against errors, a smaller discount means less unknowables, and more assurance that the business will mean revert soon.

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  2. I just had a pretty decent 30% return on HLYS, a company that was losing money selling a fad product. Their only thing was they had all of their NCAV in Cash and were burning 10 cents a share per year. In that rate, they had another 20 years to burn all cash unless they did something stupid like buying another company.

    Interestingly, the stock most of the time would sail close to their NCAV and once an year, it will for no reason go as low as 40% of NCAV. Past year it went that low during the Libya unrest. I just waited for those times and bought some shares. The company finally they got sold very close to NCAV recently.

    A few things I learnt in this was that Net-Nets can't be bought unless you get at least 20-30% discount. All Net-Nets if they make money or not, will at a random time go 30-40% less than Book Value for reasons most of us can't understand. The less the Margin of Safety on Net-Nets, it is very difficult to make any money on them.

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    1. Congrats on HLYS. I looked at HLYS a couple of times in the past. Couldn't get myself to buy it.

      Both of my young kids are permanently wearing their shoes though. One thing I can say is their shoes are really well made, surviving my kids' abuse, better than Nike or Adidas.

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  3. Yes, I have seen some situations like that as well. A company trading at a small discount to NCAV posts a good quarter and the stock price jumps 20% the next day. I still don't like investing in them though and I think that is mainly because of the opportunity cost involved.

    If market sentiment sours and all stocks drop like crazy you will be invested in a mediocre net-net that has all of a sudden become a lot cheaper. Chances are that at that moment there are many other, higher quality net-nets available. If you don't have much cash available at that moment you have paid a big price for investing in that stock.

    I do think that if an investor takes a basket approach and buys a bunch of these he will do well though.

    What I have also observed and is somewhat related to what you describe is tax loss selling. I have seen some cheap micro caps post a disappointing quarter late in the year and the stock will just get killed because it dropped to a low for the year and tax loss sellers dump it. A recent example might be Servotronics (SVT) in November 2012. I didn't buy it unfortunately.

    I think it is very profitable to buy in a situation where you suspect tax loss selling plays a role. It is different from the situation you described because with SVT, at the low price there was a decent discount to NCAV. It is similar in the sense that momentum (selling pressure) plays a role. After the new year the situation changes and the selling pressure lessens. There's a good chance that the stock will recover quickly and significantly.

    This year I will try to make one or two small buys late in the year to try and take advantage of this.

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    1. I know someone who does something similar. They noticed that a lot of cheap stocks will swing wildly around IV in a year. They keep a watch list and when the stock drops 30-40% on no news they buy, then they sell when it shoots past IV.

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    1. How would I do that? I don't have access to anything I could backrest with that I know of. If you have the tools I'd love to know the results.

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  5. Have you backtested this? (i.e. can you rule out observation bias?)

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  6. Hey Nate - I really consider this as a subset of the usual value investing phenomenon. I often joke that: i) most people will only buy a share AFTER it's up 50-100%, and ii) I'm often thinking of selling when other people are finally thinking of buying! Why the stock begins rallying is often a mystery - maybe more people noticed how cheap it is (probably not), there are takeover rumours, earnings jumped, a catalyst has attracted attention, who knows..!? It's v unpredictable, and you may never figure out why - all good reasons for portfolio diversification.

    Should you continue to ride stocks like this? Hard to answer - the 'easy' answer is to continue holding with a stop loss, maybe you'll milk another 50%+, while only risking (say) 10%. Yeah, easy in theory, but the smaller/less well-known the stock, the more likely you can wake up in the morning with the stock down 30%, and you kick yourself for being so greedy. You also lose track of what the potential upside might be, so it becomes increasingly difficult to figure out whether it would be better to sell your holding for a new high-potential buy.

    If you can identify the reason for the stock rally, that will definitely assist in making a decision. Honestly, I usually just sell - I always have 100%+ potential buys on hand, so they generally look more attractive. However, look at my Trinity Biotech $TRIB writeups/comments - it's clearly reached my fair value, but I believe there could be attractive further upside as more & more growth investors pile in.

    Cheers, Wexboy

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  7. One thing you need to be careful of on NCAV is the actual value of the current assets.

    An example is bankruptcy, from my experience in bankruptcies, despite the first lien lender only lending on 85% of AR and 65% of inventory, they usually end up under water in a bankruptcy. This is because, the cost of liquidating inventory and collecting AR is time consuming and costly.

    If a company currently trades for $10/share and has $3/sh in AR and $10/sh in inventory with no liabilities, but only generates $0.10 / share in earnings per year, is it a good buy? Essentially my read would be that selling the inventory is costly and to run the business they are only able to generate a low income and so despite being below NCAV, it is not a good buy. Companies that have very low margins are good examples of this issue.



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