This post was inspired by a comment and a tweet about my last post on Micropac. Two readers asked why I would even consider earnings when looking at a net-net. I look at earnings because I believe there are two types of net-nets, some that are piles of assets, others are operating businesses selling at too low of a value.
The idea behind investing in net-nets is that a business shouldn't be worth less than their net current assets (NCAV). Net current assets is defined as current assets minus all liabilities. If such a business were to liquidate investors would realize a gain beyond their initial investment.
The idea of a net-net first appeared in Graham and Dodd's 1934 edition of Security Analysis. At the time the market was littered with companies selling below NCAV, some estimate almost 40% of the market sold below NCAV at one point. Today not as many net-nets exist in the US, most are smaller cap stocks with questionable businesses. Many market historians claim net-nets don't exist anymore, or are out of reach for most investors. While the US market isn't full of net-nets a variety do exist worldwide with the biggest concentration in Japan. Japan's current market is similar to what the US was like in the 1930s. Many companies in Japan trade below NCAV, companies with solid business models, long histories of profits, and sound management. There are always a number of reasons investors try to justify why a company is selling below NCAV but whatever the reason it seems strange. Investors who are managing hundreds of millions of dollars might be precluded from investing in net-nets, but for any investor managing less than $30-40m there are plenty of opportunities globally.
Forget the financial markets and for a moment imagine a local business with one location on a sparsely travelled secondary road. The owner has run the business for years and has done ok for themselves, but the business isn't growing, and the location is in need of updates. The owner has been prudent and saves most of the excess cash and has no debt. Now imagine walking into the business and offering to purchase the entire business for less the cash and inventory and receivables. The owner would laugh you out of the place, but this is what many net-nets are like. The wallpaper needs to be replaced, the seats need new cushions, and the pictures from the 1980s need to go. Some net-nets are the equivalent of walking into the local business and offering to buy the company for less than the cash on hand. Making an offer like this would be insulting no matter how marginal the business is. Yet in the financial markets stocks trade like this every day, and even worse investors somehow trick themselves into justifying these low valuations.
The premise of Graham's original net-net investment thesis was that a reasonable company shouldn't be worth less than NCAV. He recommended investors purchase net-nets at 2/3 of their NCAV or below and sell them when they reached 1x NCAV. On the basis of this investment process alone he claimed 20% annual returns. In Security Analysis Graham discusses that a prudent net-net investor should prefer companies that are profitable and that do not exhibit an eroding NCAV.
Based on the Graham criteria it should be fairly simple to value a net-net. Take the current assets, subtract all liabilities and invest when the price is below 2/3 of NCAV. When the price eventually rises above NCAV sell the stock.
While this is a simple and sound strategy the truth is the market doesn't evaluate companies based on their asset values. This is why companies sell below book value or NCAV in the first place. The market is earnings and future focused. This isn't a new phenomenon either, Graham himself discusses it in Security Analysis.
I have explained in posts over the past few years that I separate net-nets into two categories:
Asset net-nets - These are companies with a pile of assets where the investment value resides within those assets. The goal with asset net-nets is to buy ones with businesses that aren't destroying the asset value.
Operating net-nets - These are companies that sell below NCAV but their value isn't found in their assets, but rather their operating business. An example of this type of company might be an industrial company with marginal operations and a large inventory and receivable balance.
Valuing asset net-nets is simple, calculate NCAV and buy when the price is less than 2/3 of NCAV, the same as Graham preached.
Operating net-nets are viewed differently, while these companies are selling below NCAV they do have value beyond their asset value. Net-nets of this type could be companies that fell on hard times and their earnings suffered. Or companies that are experiencing cyclical slowdowns. Eventually earnings will recover.
Because the value in an operating net-nets is found in the business not the NCAV valuing them should be done the same way one might value any other business. The NCAV in this case provides a margin of safety. If the company were to hit hard times it's reasonable to think they could liquidate and the investor would still realize a positive return. The investor isn't investing on the basis of a liquidation, they're investing with the hope that the company's results will eventually recover, or the market will warm up to the company.
Determining the best way to value a net-net means determining what the investment thesis rests on, asset value or an operating business. Of course it would be hard to go wrong simply following Graham's original strategy of buying below 2/3 NCAV and selling at 1x NCAV. The reason to view an operating net-net as more than a pile of assets is because some businesses are such, and once the market realizes this NCAV might become a distant memory as the stock rises.
I own both types of net-nets, I don't discriminate or have a favorite type. Asset net-nets are more of a sure thing in terms of safety, whereas operating net-nets seem to have more of an upside. Both are worthy additions to a value investor's portfolio.
Talk to Nate