Portfolio strategies: The definitive guide to net-nets

This is hopefully the first post in a small series detailing my thoughts on a few different types of value investing strategies.  If you've been reading this blog for a while this post might not contain much new, but it's a summation of my thoughts on a subject in one place.

Net-net: A company whose market cap is less than the value of their current assets minus all of their liabilities.  Formula: (Current Assets - All Liabilities) > Market Capitalization

When a company's NCAV (the aforementioned current assets minus all liabilities) is more than a company's market value it's theoretically possible that the company could be liquidated and result in a gain for shareholders.  For an asset to be classified as current a company must have the intent to sell or use the asset in the period of a year or less.

The market is driven by emotions, fear, greed, and is rarely rational.  On the whole it gets things right over time, but in the short term anything can happen.  Some try to use this as an explanation as to why a company can sell below NCAV for any period of time.  The market is just irrational and net-nets are a sort of market fluke.

I don't believe much in life is a fluke.  Before I started this blog and met a large number of investors I would have believed in the net-net fluke theory.  But after meeting a lot of investors I've come to the conclusion that not many people view stocks the same way.  For most investors the balance sheet is a financial statement that holds almost no value.  If a company isn't generating satisfying earnings, cash flow, free cash flow or growth it doesn't matter what the balance sheet says, the company doesn't hold much value.

Net-nets exist because what the market values is different from what a subset of value investors find attractive. In my latest issue of the Oddball Stocks newsletter I discussed the idea that all value stocks have some sort of flaw.  If a stock is perfect and it's cheap then something is wrong, look harder.  A flaw might be something that many market participants find unattractive for a variety of reasons and overweight when evaluating the stock.

An investor should always try to identify why a company is selling for less than NCAV.  Once this has been identified the investor should then determine of the discount for the given flaw is appropriate.  Not all net-nets are good investments, some have gone to zero for a variety of good reasons.

Are they riskier?

For many investors net-nets are viewed as riskier investments due to their low price.  Think about this for a minute, it's a self-reinforcing notion.  Someone looks at a net-net and notices how cheap it is, and because it is cheap avoids it.  Without liquidity the stock becomes cheaper, all because it's already cheap in the first place.  Once a stock becomes undervalued it can become a self-fulfilling valuation trap.  Professional investors dump the stock for liquidity reasons, individuals dump it for lack of earnings or lack of growth, or a low price.  Companies caught in the valuation trap can languish for years before they either post numbers investors like, or become so cheap they attract interest from asset based investors.

If a net-net's assets aren't extremely specialized and the company isn't burning through their assets  then a net-net should be less risky than other stocks.  David Merkel of the Aleph Blog wrote an analogy years ago discussing two types of stability, table stability and bicycle stability.  A bike is stable as long as it's moving forward, once stopped it's extremely unstable.  A table is very stable at rest, but is hard to move.

A lot of companies have bicycle stability, as long as everything is moving the company is stable.  But if sales were to drastically shrink, or the company lose a strategic supplier operations could become unstable quickly.  Many Net-nets exhibit the type of stability found in a table.  The company might have lackluster operations, but the company has a balance sheet that can support the lackluster operations for decades without change.  As David says "..only a severe event will upend a large table."

It's important to invest in net-nets that have a table stability rather than bicycle stability.  Many net-nets are smaller and are prone to sudden business upheavals.

Fraud risk

A newer risk related to net-nets is that investors worry they're fraudulent companies.  This risk is related to the number of Chinese reverse merger companies that had both fantastic numbers, and incredibly low valuations that turned out to be fraudulent.  Outside of the Chinese companies I don't believe net-nets hold any more risk for fraud compared to other areas of the market.

In general my thoughts on fraud are this; if something looks too good to be true it probably is.  Always investigate further, and if you spot serious red flags it's not worth the risk, move on.

Profits or no profits?

One debate between those who invest and research net-nets is whether to invest in ones that are losing money, or only invest in profitable net-nets.  The research suggests that unprofitable net-nets might result in higher investment returns.  The theory is that at a money losing company management has been pushed to their limit and must either take drastic action to save the company or find an alternate outcome through a merger or sale.

It makes sense that unprofitable companies could ultimate make better investments.  But sometimes what the research says needs to be reconciled with investor psychology and emotions.  Most net-nets are average or below average companies to begin with.  Purchasing an unprofitable net-net tests even the strongest investor stomach.  An unprofitable net-net is a potentially bad company that is losing money with no end in sight.  This is a recipe for emotional disaster.

I personally prefer to purchase profitable net-nets even though I know I am sabotaging my potential returns.  The reason for this is I know emotionally I am able to hold a portfolio of net-nets through thick and thin if I know my holdings aren't destroying asset value and will be operating in three or five years.  I know myself and I know that holding a company constantly on the cusp of disaster would test my ability to hold, and I'd probably end up selling at the first opportunity I had to get out of the situation.  I'd rather implement a strategy with slightly lower returns that I know I can stick to rather than shoot for the moon with a strategy that I'm likely to abandon.

Overweight real estate?

A signature feature of many net-nets, and value companies in general are significant real estate holdings.  At times these real estate holdings can be extremely valuable, and sometimes a source of hidden value.  I have owned many companies where management sold an undervalued real estate holding that resulted in a bonanza for shareholders.

Land can be valuable, if you own the only empty plot in Midtown Manhattan you're sitting on a fortune.  But those cases are rare.  More likely for a net-net is a company owns a plot of land in Altoona, PA or Eaton, OH where land is in ample supply.  For readers who live on the coasts and and are under the impression that the US is overpopulated I'd encourage you to drive across the country.  The United States is a vastly empty place with a few tiny hubs of human activity.  Anyone who's driven across South Dakota, Iowa, Ohio, or Montana would agree.  There is so much empty land it's almost incredible.  In many small towns there is no premium to land.  To build a new facility outside of the city limits would cost as much as getting an existing facility up to code.

Unless a company has a unique real estate holding I don't give a company's real estate much weight.  At times some real estate can be resold for book value, but that's only in certain circumstances.

The curse of real estate is that to sell incurs a high transaction cost and takes a long time.  It's hard to unload a lot of real estate quickly at market rates.  If a seller tries to liquidate their real estate holdings quickly it's likely they'll only realize fire sale values.

Inventory, inventory, inventory

The biggest concern I hear investors voicing about net-nets is that many of them have high levels of inventory and that makes investors uncomfortable.  The problem with inventory is investors think about how quickly it could be liquidated, which I believe is the wrong attitude.

If a company is operating and isn't writing down their inventory it's a sign that the inventory has some value in the market place.  As long as the net-net continues to operate, and isn't constantly writing down inventory it should be valued at something reasonably close to fair value.  The caveat to this is if the company is losing money.  If a company is losing money this means they are unable to sell their goods for more than their cost.  A company that's losing money might merit a discount to the value of their inventory.  Or a discount might be merited if the company has stated that some of their inventory is collecting dust in the back of a warehouse somewhere.

Of all the net-nets that trade in the market only a few will ever progress to a liquidation.  Liquidations are extremely rare.  They're costly, and take a long time.  When Graham first discussed net-nets in Security Analysis he spends a lot of time discussing how a net-net could potentially be liquidated for more than their market value.  He goes through a lengthly analysis of how certain accounts should be discounted to take into account liquidation values.  Many investors seem to get hung up on the prospect of a company liquidating and what accounts receivable, inventory or the real estate should theoretically be marked down to in a liquidation.  Almost no net-nets ever liquidate, and I think fixating on a theoretically liquidation is wasted mental energy.  If a company declares a liquidation it's time to focus on their liquidation value, but until then it's wasted energy.  Graham's point in my view was to emphasize the absurdity of the value these companies were trading with.

Are they bad companies?

Many investors are looking for companies that return 15% a year no matter the market and will make shareholders rich no matter the price purchased at.  These are not net-nets.  It's not uncommon to find a net-net earning a few percent on equity.  Some net-net require a magnifying glass to see their return on equity, it's there, but it's just that small.

A lot of net-nets are under utilizing both their assets and intellectual capital.  Under a different management team, or under different market conditions these companies can earn significant returns.  The reason many of these companies are selling so cheaply is because the management team, or market conditions are not ideal.  Market conditions can always change, and a company that has been left for dead can find itself in an ideal environment and losses can turn to gains.

Keep in mind when you're evaluating net-nets that you're not trying to find a great business at an average price that you can buy and hold, but rather you're investing in an average company at a bargain price.

Think of a net-net investor as someone who's buying reprint paintings at TJ Maxx for $20 and reselling them online for $40.  The Buffett buy and hold value investor is looking for a Van Gogh that they can buy at any price and resell at some point in the future for more.  They know because they own a rare Van Gogh that the painting will always be worth more in the future compared to today's price.  The person buying paintings at TJ Maxx makes their money at the purchase.

Their role in a portfolio?

Net-nets should play a strong supporting role in any value investor portfolio.  A supporting role means that a portfolio isn't concentrated in them entirely, but they're also not so small of a position that they don't have a meaningful impact on the portfolio's returns.

The reason investors shouldn't concentrate in net-nets is because as the market rises higher there are fewer and fewer opportunities to invest in.  At multiple points in the past there have been less than a half dozen net-nets in the US.  When there are few net-nets the quality plummets, it wouldn't be wise to have a portfolio concentrated in three money losing companies selling obsolete products.

A net-net position should be diversified as well.  There's no sense trying to pick the 'best' net-net.  No one knows which companies will strike gold, and which ones will strike out.  It's better to spread a portfolio's best across a variety of net-nets.  Even though these companies trade below NCAV that's no guarantee against any of them eventually going bust, they have been known to do that at times.

Can a bank or financial company be a net-net?

For a reason unknown to myself financial companies are usually lumped into a "too hard pile" for 90% of the market.  Investors would rather ignore financials over spending a little time learning the specialized industry.  Because of this financials are always excluded from lists of net-nets and deep value stocks.

It's possible to have a bank or a financial services company trading below liquidation value.  There are specific liquidation value calculations for banks and insurance companies that differ from the standard net-net formula.  While the formula is different the idea is the same.  At a certain point investing in a company that's trading for less than liquidation value makes sense because the worst case scenario is better than the current one.

Why don't more investors invest in them?

I think most investors avoid net-nets because they're too simple and too boring.  Juan Matienzo discusses this during his interview with the Manual of Ideas.  Too many investors view net-nets as simplistic and investments for value investing beginners.  A lot of investors want to be like Buffett finding great companies with moats and durable advantages.  In their quest to own these great companies they avoid simple areas of the market that offer great returns.

My portfolio isn't build to impress anyone.  I don't find my value in the stocks I own.  My portfolio serves one purpose, to generate returns on my capital.  If I do that via net-nets or via great companies with moats I don't care.  I want to invest in whatever will give me the greatest safe returns.  Too many investors are trying to impress their peers with fancy shareholder letters, or by discussing their investments at cocktail parties.  Your friends might be impressed that you hold all the value stocks du jour, but they'll be more impressed by your returns if you hold net-nets.

A second reason many investors don't invest in net-nets is because a lot of them are too small.  Many of these stocks are considered uninvestable by Wall Street.  It's hard for a fund managing $500m to build $50m worth of positions in net-net stocks, especially if the market is higher.  If a fund were to look globally it's possible they'd find enough opportunities, but managing the large number of investments could time consuming.  Only at the market bottom does one find enough large net-nets that a large fund could build a position.

When to sell

The time to sell a net-net is when the stock pops near fair value.  These are not buy and hold investments, they are buy and sell quick investments.  Sell when you are given the first opportunity, a second opportunity might not exist.

16 comments:

  1. Hi Nate,
    Could you add more color on the research report that suggests that unprofitable net-nets might result in higher investment returns...
    Thanks

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    Replies
    1. I'd also would love to hear Nate's comments on the research, one of which is this paper by Tobias Carlisle: http://www.scribd.com/fullscreen/120327973?access_key=key-v87koheb7bxg1r8rob5&allow_share=true&escape=false&view_mode=scroll

      Thanks.

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    2. Yes, that's the report I was talking about. There's another one on net-nets that I have that shows that buying all net-nets at 2/3 of NCAV and selling at NCAV results in similar returns to the money losing net-net strategy.

      In the post I addressed why I stay away from these, which is the emotional aspect. Now it's probably true that I should dedicate a portion of my portfolio to just 2/3 net-nets and do it mechanically or something. I find it easier to hold a stock if I know the company will be around in the future because asset value isn't disappearing.

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  2. Hi Nate,
    Thanks for you wonderful blog.

    I have a question regarding the net-net stocks, what is the spread between the NCAV and MKT Cap that you will consider to invest in ?
    For example, RELL - NCAV of 163M vs MKT Cap of 142 which give us 13% NCAV.
    This is not something that offer a big return to investor, but still - a net net.

    Thanks,
    Baruch

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    Replies
    1. This is a good question, and the answer is that it depends. It depends on what the rest of book value is comprised of. If a company has almost no value beyond NCAV it'd be prudent to buy with a bigger discount. If a company has a lot of potential value (possible earnings, other non-current assets) NCAV purchasing with a smaller discount could be alright.

      Thanks

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  3. Nate,
    I would love to hear more about your thoughts on banks or a financial services company trading below liquidation value. From your previous posts it seems you use book value as an estimate of a banks liquidation value... Is this fair? What do you think about insurance companies?

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    Replies
    1. Don,

      The formula I have for a bank's liquidation value includes a number of discounts to things like loans, loan loss reserves, OREO and securitization residuals. The formula makes sense on paper, but in essence it's really just dictating that a bank's liquidation value isn't 100% of book value.

      As you said I tend to work off of book value as a liquidation value for banks. This is two fold, right now banks are well capitalized and they've dumped their bad assets, so their balance sheets are good. Secondly the market is doing well, we don't see banks being sold off for 60% of BV with the acquirer doubting the value of what they've purchased.

      Banks are only liquidated in very rare circumstances. If a bank isn't profitable and is liquidated the FDIC takes care of it and shareholders are completely wiped out. In this market if the bank has any value it's easier to find an acquirer rather than go through lengthy liquidation proceedings.

      I think the same could be said for insurance companies.

      Nate

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  4. Hi Nate,

    I'm a new follower on your blog and I just want to say first that I thoroughly impressed by the level of thought and effort you put into your posts. I particularly like this one.

    I am a value investor who is terrified of net-nets, so perhaps I can shine some light on why guys like me are so apprehensive about investing in them. First off, I run a very concentrated portfolio of maybe 10-12 stocks maximum. I believe running such a concentrated portfolio precludes investing in net-nets. Due to the largely binary outcome of net-nets, I think investing in them only makes sense if you spread your capital across a lot of them; I simply cannot afford a blow-up, which is a very real possibility with a net-net. Of course, you did touch upon that very topic in your post. Something else that bothers me about net-nets, and this is also something you mentioned, is the short time horizon for exiting them. Almost every net-net I've seen is a cash-burning business with a highly questionable value proposition or precarious competitive position. Admittedly, most great investments have some sort of ugly quality that scares off investors (which in turn is what makes the investment a bargain), I believe that time is a very brutal enemy of net-nets and I'd rather not have to watch my stocks like a hawk every day looking for the nearest exit.

    I think superior investment performance can be obtained not just through hitting grand slams, but by avoiding big [permanent] losses of capital. And net-nets, on an individual basis, are just too prone to blow ups. I totally agree with your overall post though; net-nets definitely make sense in a large, diversified portfolio.

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  5. Hi Nate,

    Your post got me thinking about the "root causes" of companies essentially going bankrupt or "eternally declining" stock prices. I'm sure you have more clear view about these causes than I do, so I was hoping you could shed some light on the matter. Certainly leverage is one of the root causes of trouble. Just curious cause I think (open to hearing opposite views) identifying these would spare investors from much pain. Many times you can read about different things but they simply don't seem to be the essential things, the base, as it could perhaps be called. Things that truly are the drivers, things at which you end up when you start walking back the chain from different things.

    Thanks for your insights!

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  6. Yeah I think that the dislike for net-nets is pretty unbelievable given the statistical evidence.

    If the business is below NCAV you can essentially buy the business for free.

    Even Phil Fisher appreciated net-nets (I think that's what he was referring to in this article):
    http://www.rbcpa.com/What_we_can_learn.html

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  7. Hi Nate,

    What you say it is not totaly true :

    "Unless a company has a unique real estate holding I don't give a company's real estate much weight. At times some real estate can be resold for book value, but that's only in certain circumstances."

    When you bought a business at book value, but... land are booked at historical value (for 20 years for example) and buildings amortized (for 20 years too), if the company decide to sell theses assets, that's mean you are going to do lots of cash !!

    We started a net-net portfolio experience in 2008 and included an approach with hidden real estate assets. The performance is today +660,77% (bank accounts avalaible).

    You can have a look here : http://blog.daubasses.com/category/portefeuille-2/ (french blog).

    Always nice to read you.
    Thanks.

    Franck

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  8. I've done plenty of asset-based investing.

    I also stick (mostly) to profitable companies, and I think there is a very sound reason to this (and its not entirely psychological). If you invest in a company that is destroying value, then you are entirely dependent on the market offering you a favorable exit at a reasonable time. This makes me very uncomfortable and feels a bit like gambling.

    I prefer investments where my money has some time value. If Time is the friend of the great business, then I prefer Time to be at least an acquaintance to a NCAV or other really cheap business. After all, I could get locked into the stock for years, and the difference between a company that is creating a few % in value per year vs one that is destroying a few % a year is HUGE over a several year period.

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  9. Much thanks for this, Nate! Looking forward to the other posts in the series.

    Cheers!

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  10. I have a question about net-net investing.

    When I run a screen for net-nets, the P/E ratios of the companies that are listed vary from 4-100. Now, with other investment techniques, would low P/E net-nets make for better investments, considering the qualitative aspects are the same?

    In any case, would any of the valuation/financial ratios affect one's choice of net-nets? Especially, if there are not a lot of net-nets to choose from?

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  11. Sams ---

    Search for 'Piotroski Score' to see a list of criteria an accounting professor made for screening low Price/Book stocks.

    I don't think there's anything magical about his list, but its a good example of a checklist approach.

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  12. The best time to look for net-nets is after a major market dump. In 2002 and 2009, there were numerous stocks trading for less than cash minus all liabilities. You could pay off all liabilities, have cash left over, with inventories and receivables as gravy.

    Many of the few net-nets that remain today are fallen biotechs. These companies raised a lot of money, then had their main drug fail in trials. These companies generally have little or no revenue and basically exist to develop drugs. I've found management and BoD's of these companies determined to spend every last cent and even raise more in secondaries. I wouldn't touch them with a ten foot pole.

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