Sunday, June 27, 2010

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.

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