Net-Net Investments: Buyer Beware

Benjamin Graham, commonly thought to be the father of value investing, utilized a simple tool to identify cheap stocks. He looked for companies that were trading at less than two-thirds of their net current asset value. The net current asset value, as Graham defined it, is calculated as the cash on the books plus 75% of the value of the accounts receivables value plus 50% of the inventory value plus 1-50% of the long-term asset value (depending on liquidity, etc.) minus all of the liabilities. A simpler way to calculate the net current asset value is to simply subtract the current assets from the total liabilities. It really doesn't matter which one you choose since the two methods will typically lead you to a very similar valuation.

These criteria represent the essence of Graham and his brand of value investing. He liked looking at liquid, tangible assets when valuing a company rather than uncertain future earnings. However, times have changed since Graham first advocated this investing methodology. The universe of these "net-net" stocks, as they are sometimes called, has shrunken considerably and now consists primarily of tiny companies laden with financial, managerial, and/or legal issues. It is very likely that you will not recognize any names on the list of net-nets. Nonetheless, you may come across one or two diamonds in the rough that will provide outstanding returns.

Inventory Quality

I have found that one of the most common issues with these net-nets is that the inventory on their books is either extremely difficult to sell, expensive to store, obsolete, or some combination of these things. Plenty of homebuilders have fallen into this category over the past couple of years and remain there to this day. They have massive amounts of materials in their warehouses with which to build new houses, but demand has slowed to a trickle. As such, the inventory is really worth next to nothing as it cannot be turned into cash and costs quite a bit to store.

Negative Earnings = Burning Cash

Another common issue is not the amount of the net current assets, but rather the permanency of those assets. Many of the net-nets have lots of cash on their balance sheets, yet they have terrible businesses that consistently lose money. They have negative earnings and negative cash flows which quickly deplete the cash on their books.

The Debt Problem

Another issue that sometimes burdens these net-nets is a high level of debt. While heavily indebted companies are always worrisome, net-nets are particularly sensitive to high debt levels as they are typically small companies with unstable earnings. Furthermore, hefty interest expenses can do a lot of damage to cash balances.

Low and No Volume

The fact that these small net-nets are completely ignored by Wall Street is both a blessing and a curse. It is a blessing in that a nonexistent analyst following allows for huge price inefficiencies. However, this is worth nothing if the price does not eventually rise to its true value. For the very small companies that comprise most of the list of net-nets, it is unlikely that they will grow into larger companies that will eventually be recognized by institutional investors. More frequently you will see value realized by a company being bought out or deciding to go private. Additionally, since there is such low trading volume, there may not be an opportunity to buy stock at the current price due to a huge bid-ask spread.

Not All Bad

Although research on this topic is far from extensive, there have been some studies that show that buying a diversified basket of these net-net stocks will indeed outperform the market. Additionally, there is some proof that Warren Buffett bought some of these net-nets, or what he called "cigar butts," for his investment partnership during his early career. Although it is rare that you will find a good net-net investment opportunity, they do pop up from time to time and can be extremely lucrative. The key is to look for a company with an understandable business, positive earnings, manageable inventory, low debt, and some kind of catalyst that will drive the price up to its true value. This is a lot to ask for, and you may have to wait as long as a few years to find such an opportunity. But when they come, which they seemingly always do, make sure you are ready.

Price to Free Cash Flow: A Useful Valuation Tool

When considering a quick valuation method, most people will turn to the price to earnings ratio or the price to book ratio. However, earnings can be manipulated easily and book value is far from the best true measure of value. Instead, I believe that comparing the price to the free cash flow (what's left over for shareholders after normal expenses used to keep the business running) is just as simple to calculate, but much more useful in identifying cheap stocks.

There was an intriguing back test done last year by Peter George Psaras to see if stocks with low price to free cash flow ratios truly outperformed the overall market. He did this by creating a hypothetical portfolio in which at the beginning of each year from 1950 to 2007, he "purchased" an equal weighting of the companies in the Dow Jones Industrial Average that had a price to free cash flow ratio of under 15, and then sold them at the end of the year. The results were startling. This portfolio outperformed the Dow for 53 of 58 years and had an average gain of 23% versus 8% for the Dow. A $10,000 investment in this hypothetical portfolio in 1950 would have been worth $974,617,645 by 2007, or 1434 times more than what the Dow would have returned.

Not only does this show the power of this particular tool, but it is a testament to simplicity when choosing an investment philosophy. It would take no time at all to manage this portfolio, yet it has yielded results that professional money managers would kill for.

Don't Mimic Buffett

Warren Buffett's words and actions attract the attention of the masses and sway world markets. He cannot even hint at what he is considering buying as investors would flock to the stock and push up the price. Every quarter the revised holdings of Berkshire Hathaway are anticipated by thousands. Normally, any new positions receive a boost just from his endorsement alone. People tend to believe that if they follow Warren Buffett's investment moves and buy into stocks when he does, then they will be able to share in his impressive returns.

What people tend to forget is that the pond of investments from which Buffett can fish from is significantly smaller than that of the average investor. Berkshire Hathaway is one of the largest corporations in the world with tens of billions of dollars to deploy. It therefore is limited to investing exclusively in large cap stocks in order to maintain a decent return on its capital. Buffett simply does not have the time or resources to swallow up and keep track of thousands of little companies to recreate the fantastic returns he enjoyed decades ago.

Most of us are in a completely different situation than Buffett, so why do we insist on copying his every move? We are not constrained by such large sums of money (lucky us) and therefore have a massive universe of stocks to choose from. Buffett said the following in 2007: "Were I working with a very small sum...I'd be doing almost entirely different things than I do...You can earn very high returns with small amounts of money." As he stated in 1998, he advises to instead "look for small securities in your area of competence where you can understand the business and occasionally find little arbitrage situations or little wrinkles here and there in the market" when dealing with small sums of money. With this strategy, he guaranteed that he could compound $1 million at 50% per year.

There is a paper written by Gerald Martin and John Puthenpurackal called "Imitation is the Sincerest Form of Flattery: Warren Buffett and Berkshire Hathaway" in which they study 261 of Berkshire investments from 1980 to 2003. Now, Berkshire was already somewhat large during this period, but nowhere near its current size. During this period, Martin and Puthenpurackal identified 59 of these 261 stocks as arbitrage investments with an average holding period of under six months compared to an overall average of about 32 months. These arbitrage opportunities produced an astounding average annualized return of 81%, dwarfing the overall average of 39%. I would guess that if you looked at his investment activity from the 1950's and 1960's when he had a considerably smaller sum to invest, the returns from arbitrage investments would have been even more impressive.

While I believe that the growth of the investment management industry and the ubiquity of information that we have at our fingertips has shrunken the number of arbitrage opportunities and other "market wrinkles," I by no means think that they are gone. In addition, we don't have to leaf through thousands of pages of Moody's manuals to find an opportunity like Buffett did; there are many free online stock screeners that can help us hone in more easily, and there are many more publicly traded companies nowadays to choose from.

Now, I must give a small dose of reality, and another reason why we should not mimic Buffett's moves: we are not Warren Buffett. As I wrote earlier about him, Buffett is a genius and probably knows more about investing than anybody on the planet. As such, it would be unwise to dive into arbitrage or deep value opportunities without having a firm knowledge of the target's financial situation and business.

Lastly, I have to say that while I don't think copying his specific investments is wise, I do believe we should absolutely emulate Warren Buffett's investing principles. The vast majority of his investments throughout his career have been long-term stakes in well run, highly profitable companies trading at a discount to their intrinsic value. These opportunities are more plentiful and ultimately more profitable for the average investor.