Introduction

In this article I would like to share my experience over the last two and half years in investing in what is called „Net-Net“ stocks. This is a technique that has been devised by Benjamin Graham in the 1930’s to find mis-priced securities.

Graham had been a witness of markets irrationality during the bubble that was growing during the 1920’s, and had been almost ruined during the 1292 crash. He learned his lesson and wanted to invest in a very protective way, where he had little downside and big upside.

Graham found out that sometimes, some stocks could sell below their liquidation value. In other words, the market was saying that the underlying business was worth more dead than alive. One could theoretically buy the company, stop operations, reimburse all debts, liquidate assets and still make money.
But how is it possible? Aren’t market supposed to be efficient?

About efficient markets

The experience of value investors indicate that the market is not always efficient, especially in the short term. The volatility of stock prices is much higher than the volatility of their underlying business’ values. This means that in the short term, the market will tend to overreact to news, but in the long term (2-3 years) it will finally get the value of the company right. As Graham said:
„In the short term, Mr Market is a voting machine, but in the long-term it is a weighting machine.“

Graham wanted thus to take advantage of the mis-pricings that could occur in the market, especially during the irrational times and over-pessimism that followed the 1929 crisis. He figured out that for many companies, Mr Market had indeed been over-pessimist about the value of their business and offered their shares well below liquidation value.

But what was his criteria to select such companies?

 

The Net-Net method

Ben Graham would calculate the Net Working Capital (also called Net Current Asset Value, or NCAV) of a business and only buy its stock if the price was well below the NCAV (he requested at least a 30% discount to the NCAV). But what does it mean exactly?

The Net Working Capital is defined as the current assets of the company (cash, accounts receivable and inventories) minus ALL its liabilities.

NCAV = Current Assets – Current Liabilities – Long-term liabilities – other claims to the business.

 

By evaluating a company only to its Net Current Asset Value, Benjamin Graham was being very conservative in estimating the liquidation value of the company.

By only looking at current assets, Graham was only interested in assets that could be turned quickly into cash. If you subtract from current assets all the liabilities of the company and you do not take into account fixed assets (i.e Property, Factories, Real Estate and Machineries), what you are left is your Net Current Asset Value.

If you could buy the company at less than its NCAV, it means that :
– You have a very good collateral consisting in the current assets that could theoretically be quickly liquidated
You are receiving fixed assets for free: all the factories, offices, real estate and machineries of the company are given as a bonus.

As you can see, when you are buying net net stocks, what you are doing is buying assets at a discount. As the saying goes, You try to buy a dollar for fifty cents. You are much more interested in the balance sheet of the company than in its income statement (we’ll come to that later).

First criteria : Buying at a discount to NCAV: the margin of safety

Benjamin Graham was not buying businesses at their NCAV value. He wanted to buy them at an even lower price. Usually, he would wait until the price would be at least at a discount of 30% to the Net Working Capital :

Price < 0.7 * (Current Assets – Current Liabilities – Long Term Liabilities)

This discount is what he called a margin of safety, a concept very central to his approach. The role of the margin of safety is to provide a good protection to the investor against unpredicted events. If the investor had made an error in valuation or if the company had overstated the value of its assets, the market price of the shares would still be cheap enough to protect the investor against permanent losses.

Basically, the biggest the discount to the NCAV, the biggest the margin of safety and the more things can go wrong before the investor starts losing his capital. The lower the price, the less risky the stock actually is!
Indeed, if you know that a very conservative estimation of a business is $100, you have a bigger margin of safety buying it at $30 than at $50.
Actually, the bigger the margin of safety, the less we need to know about the company. We don’t try to forecast future earnings of the company, we just care about what is on the balance sheet right now.

The essence of Net-Net investing is to buy cheap assets for much less that what they are worth. By focusing on a discount to the NCAV, we are getting liquid assets for less than 70 cents on the dollar, and fixed assets for free!
From there we are just betting that the market will realize, in the two or three years to come, that the stock is mis-priced, and readjust the price of the shares towards the value of the company.

 

Second criteria : Ask for a Strong balance sheet

There is usually a reason why Net-Net companies are quoting at such low prices: either they are mediocre businesses, or they are encountering temporary issues and the market has killed the stock. In general, these stocks are very very un-sexy companies. They are the total opposite of the growing darlings of the stock market. Heck, many of them are even losing money!

Therefore, the primary concern of the investor is that his margin of safety does not get impaired in the next few years. Even if currently the business is experiencing losses or is barely breakeven, we want to make sure the balance sheet is not going to deteriorate too much in the following years.

There is no quicker way to kill a balance sheet than to be overly leveraged. Losses + High leverage = Company going belly up. We don’t want that! We want to make sure that the company can bear several years of losses without impairing too much the value of its NCAV and our margin of safety…

This is why we want to monitor two factors:
– What is the leverage of the company?
– How quickly does the company loses money? (this will be discussed in the next criteria)

The investor should therefore look for companies that are not over-leveraged; there are no universal formula for this criteria, but the one I’ve been using is as follow:
If the company uses all its cash to pay debt, I want equity to be at least 40% of total assets. In other words,

Equity > 40% * (Total assets – Cash)

This way, we keep only companies with moderate leverage and a conservative balance sheet. It allows companies to weather many years of chaotic earnings.

 

Third criteria: how much money the company is making or losing?

As we said, once he had found assets priced at a bargain, Benjamin Graham wanted to make sure his margin of safety would not get impaired. This is why at some point we need to check if the company is making money, or, if it does’t, how fast is it losing cash.
Remember, the market is super pessimistic about the company and we want to prove that the situation is not as bad as the market thought it is.

However, if companies are losing money very quickly, it is likely that the market is just simply right and the company will go under very soon.

Therefore, we want to add additional checks before buying a net-net company :

Is the company having significant sales?
There is one situation where a company burns cash very quickly : when it does not sell anything, or very little. This is the case of many pharmaceutical and/or healthcare companies, who don’t sell anything before its R&D department made a profitable discovery. In this stage they have to pay their employees plus all fixed costs, and cash is burning at max speed. That’s not a situation where our margin of safety is going to last very long. Therefore, avoid companies with too little sales!

Avoid companies where Price/Sales ratio > 5

How fast is the company burning cash?
If the company is making money, then all is good.
But if the company is making significant revenues but still loses money, then we have to estimate how long the company can lose money before our margin of safety is destroyed.
In general, capitalism works : managers have incentive to redress their companies and turn around their business so that they are at least breakeven. So if the company is still losing money, what we are betting is that given two or three years, the situation will get better for the company and the market will recognize it was over pessimistic.

Therefore, we have to ask the question: can the company lose money at the current rate for the two or three next years without our investment losing money?

Here this question has to be left to the appreciation of the investor: how will the balance sheet look in two years if the company keeps having losses at this rate? How will the NCAV look? Do we still have a margin of safety?

 

Fourth Criteria : Avoid untrustworthy companies

Economy and accounting are based on trust, which means that the investor assume that he should trusts what is stated on financial reports. If he cannot, then no investing activity can be performed soundly. In the investing community, there are unfortunately some experiences that shows that some companies like to cook the books and try to trap investors by disguising them in Net net stocks. It has been notably the case in the past of many Chinese companies listed on US exchanges.

As a result, I’d advise to avoid any Net-Net stock of companies coming from mainland China (Hong Kong, Macau and Taiwan are OK). This is really a shame because I am sure that many Chinese companies are great opportunities, but the doubt cast by the worms in the apple makes me want to be better safe than sorry.  We want first and foremost a return of capital before having a return on capital!

 

Fifth criteria : Build a basket of such securities

As an individual security, a net-net stock is never an insurance that the stock is going to perform well. We know it is _likely_ to be a satisfactory investment, but there are also chances that the stock is a _value trap_, i.e he won’t perform at all. That’s why Graham recommended to build a portfolio of many Net-Net stocks. He never knew which stocks were going to perform well, but he knew that on average, his portfolio would lead above average results.

In chapter 15 of The Intelligent Investor, Graham wrote :

It always seemed, and still seems, ridiculously simple to say that if one can acquire a diversified group of common stocks at a price less than the applicable net current assets alone-after deducting all prior claims, and counting as zero the fixed and other assets- the results should be quite satisfactory. They were so, in our experience, for more than 30 years.

 

Variantes:

Some investors like to apply further criteria to Net-Net investing. In particular, they often want to be even more conservative when evaluating the Net Current Asset Value of the stock by discounting some items in the current assets:

– Account Receivables : are all client debtors to the company creditworthy?  By precaution we can apply a 10% to 20% discount to account receivables
– Inventories : How likely is it that the inventory can be liquidated at book value? It depends on the company : when construction materials can be liquidated close to inventory price, we cannot say the same about a retailer trying to liquidate last year’s teenagers’ fashion clothes… A discount up to 50% is often applied to inventories.

Here, a good discernment is needed from the investor.

 

When to sell?

Investors have several rules to sell their Net-Net positions:

When the position works out well

– Some sell when the price reach the NCAV, saying that the margin of safety has disappeared.
– Others wait for the stock price to reach tangible book value (adding tangible fixed assets to NCAV) because they think that the Property, Plants & Equipment should be valued as well by the market.
– Some others want to profit from the excesses of the market in the other direction, and once the price has reached NCAV in the upward direction, they „surf“ on the new upward momentum of the stock price with a trailing stop order.
– In all cases, even if the stock price has gone up (but not to its full potential), investors should sell after 3 years because of opportunity cost.

 

When it doesn’t work as well as planned

Sometimes the fundamentals of the company deteriorate quicker than expected. It is then better to sell the stock because the margin of safety evaporates…
– Instead of the price going up to the NCAV, it is the NCAV that goes down to price if the company suddenly loses a lot of money.
– Some other times, the company will become heavily leveraged: the balance sheet becomes suddenly super weak and the risk/reward ratio is not very interesting anymore.You don’t want mediocre over-leveraged companies…
– Another case is that nothing happens during two or three years… for some reason the market has kept on ignoring the stock and the opportunity cost grows bigger and bigger…

Does Net-Net investing work?

Studies Results

The theory of Net-Net investing is very appetizing, but does it work still as well as it did during Graham times? Studies tend to say so:

In an article in the November/December 1986 issue of Financial Analysts Journal, “Ben Graham’s Net Current Asset Values: A Performance Update,” Henry Oppenheimer, an Associate Professor of Finance at the State University of New York at Binghamton, examined the investment results of stocks selling at or below 66% of net current asset value during the 13-year period from December 31, 1970 through December 31, 1983.
The study assumed that all stocks meeting the investment criterion were purchased on December 31 of each year, held for one year, and replaced on December 31 of the subsequent year by stocks meeting the same criterion on that date. To create the annual net current asset portfolios, Oppenheimer screened the entire Standard & Poor’s Security Owners Guide. The entire 13-year study sample size was 645 net current asset selections from the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX) and the over-the-counter securities market. The minimum December 31 sample was 18 companies and the maximum December 31 sample was 89 companies.
The mean return from net current asset stocks for the 13-year period was 29.4% per year versus 11.5% per year for the NYSE-AMEX Index. One million dollars invested in the net current asset portfolio on December 31, 1970 would have increased to $25,497,300 by December 31, 1983. By comparison, $1,000,000 invested in the NYSE-AMEX Index would have increased to $3,729,600 on December 31, 1983.

Source : „What has worked in investing“, Tweedy, Browne

My own experience

Motivated by the various feedback on the theory as well as by the outcome of Oppenheimer’s study, I decided in 2016 to try to create a portfolio of Net-Net stocks. I focused on US and Japanese markets. Screening first manually through companies reports, I then built a tool that downloaded financial reports from the SEC database, calculated NCAV and leverage of companies, and compared it to their market capitalization. I managed to find a basket of a dozen of Net Net companies, and below are some examples…

Emerson Radio Corporation

Let’s take the example of Emerson Radio Corporation. If we examine its balance sheet, in 2016, its current assets were $58.3 million, whereas its Current Liabilities where $2.7 million. No Long-Term liabilities were present on the balance sheet.

 

Therefore, its Net Current Asset Value was 58.3-2.7 = $55.6 million.
Its leverage was really reasonable, as obviously there were no debt and equity was more than 5 times Assets minus cash. The company was slightly losing money : $1 million for the 2016 exercise. At this rate and with such a strong balance sheet, the company could weather many more years of losses before going belly up and it was likely that management would try to redress the business. With around 22 million shares outstanding, the NCAV was worth $2.47 per share. But the share price was $0.65 in July 2016! That meant a margin of safety of more than 70% on the Net Current Asset value of the company. I decided to open a position in my portfolio.

Two years later, the stock is now quoting at $1.48, so it seemed that the market slowly realized that the stock was undervalued and adjusted accordingly, even if the company kept on losing money in between!

Over two years, my position returned on average 50% per year. But not all my positions were equally satisfactory; let’s see below statistics on my Net-Net stocks.

Portfolio Statistics :

TABLE 1 – Net-Net Stocks Portfolio
Company Price Bought Price Sold or Current Price Performance %
Rubicon Technology (RBCN) 5.8 USD 9.18 USD 58%
Emerson Radio (MSN) 0.65 USD 1.48 USD 127%
Gigamedia Ltd (GIGM) 2.5 USD 2.92 USD 16.8%
Richardson Electronics (RELL) 5.25 USD 9.4 USD 79%
Gravity Corps (GRVY) 4.32 USD 11.6 USD 168%
Velcan SA (ALVEL) 10.64 EUR 11.28 EUR 6%
Zwahlen and Mayr (ZWM) 178 CHF 252 CHF 41.6%
Sears Hometown and Outlet Stores (SHOS) 3.1 USD 3.15 USD 1%
Sanshin Electronics (TYO:8150) 906 JPY 1842 JPY 103%
Nippon Antenna (TYO:6930) 537 JPY 772 JPY 43%
Nichiwa Sangyo (TYO:2055) 196 JPY 289 JPY 47%
Asia Pacific Wire Cable (APWC) 1.75 USD 2.65 USD 51%
Deswell Industries (DSWL) 1.8 USD 3.46 USD 92%

 

You’ll notice that these are all unknown and unsexy companies… Heck, I even bought a chicken feed business! (Nichiwa Sangyo…)
But the average performance of my Net Net stocks over the two years period is 64% (or 28% annualized). Over the same period, the S&P500 returned 38%, so the Net-Net portfolio realized 26% excess performance over the S&P500, which is quite satisfactory.

Another interesting point is that, after two years, no position lost money .Some had adverse volatility at the beginning, but we have not observed a permanent loss of capital. This was due to our big margins of safety! These positions had little to lose and quite a good upside.The margin of safety played its role…

 

Yes, but…

These results are certainly appetizing. But let’s not fall into being excessively enthusiastic! There are a set of comments that deserve to be made:

  • This is only my experience, over a quite short period; it would have been interesting to be able to test it over a longer time span
  • July 2016 to July 2018 was a strong bull market. As goes the saying, „Never confuse brilliance with a bull market…“
  • These kind of occasions seem to be more and more rare on the market, to the point that I currently cannot find any more Net Net on the US market for instance. Net-Net are a very good investing tool, but they do not seem to be always available, hence the importance to have other tools at hand
  • These companies are all microcaps (less than $100 million capitalization), which is very good for a small portfolio, but absolutely not practical for a bigger one.
  • Finally, as Buffett said, „Time is the friend of wonderful businesses and the enemy of mediocre ones…“ We are clearly in the field of super-mediocre companies, so time is our enemy: the performance is super good over two years, but what about the third year? The fourth? It’s clear that these particular companies won’t perform as well since they are all closer to their intrinsic value. If other opportunities stop coming, time is clearly running against us…

 

Net-Net Stocks are a wonderful tool for the value investor. But they are only a tool! When they are available on the market, it should be a no-brainer for the investor to pick a basket of such securities. However, when the market becomes expensive and such securities become rarer and rarer, he will certainly need other tools to invest wisely…

 

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