Net-Net Stocks Investing Strategy

Benjamin Graham, the father of value investing, especially liked the Net-Net investment strategy. The strategy is based on buying shares of companies traded at a significant discount from their net current asset value (NCAV), meaning a market value lower than the total current assets minus all liabilities.

Net-net stocks work best when the markets are down. In a bullish market, it may not the best time for net-net stocks. The last thing we would want to do is to compromise on quality, simply to follow a net-net strategy.

But before getting into all the hows, whys and whens on buying and making money with net nets, let’s review the basics first and work our way from there.

 

Understanding Net-Nets

Net-net stocks are not just cheap stocks.

Any stocks that is trading below is intrinsic value is a cheap stock. Net-net stocks are not only cheap, but are dirty, haven’t had a bath in 10 years’ types of cheap stocks.

It’s the oldest value investing technique where the stock is valued only based on its current assets.

Here’s how Graham described how to calculate the net net value.

Working capital (current assets less current liabilities) then subtract any debt not included in current liabilities.

What Graham is describing is the NCAV. You can see that he’s not talking about book value because he values intangibles and other non-current assets as zero.

 

Calculating the NCAV for Stocks

The formula to calculate NCAV is simple and the idea is to find stocks where the NCAV is higher than the market price.

NCAV = Current Assets – Total Liabilities

To get a per share value, simply divide by the number of shares outstanding.

NCAV per Share = (Current Assets – Total Liabilities) / Shares Outstanding

Graham’s criteria for buying NCAV stocks was if the stock price was 2/3 of the NCAV.

e.g. If the NCAV per share was $1.00, then Graham wanted to buy it when the stock price was at $0.666.

Past 5FY, TTM and Current NCAV is calculated in the analyzer automatically for you. You can see the trend to point out stocks that has been trading below its NCAV for years. Those may not be a streaming buy type of stock.

This stock has recently become a net-net stock. You may see that in previous financial is it trading at above its NCAV pershare and give no discount to NCAV. If the price continues to plummets and reached a 30% margin of safety, it may be an investment opportunity. But, do check on the qualitative aspect of the stock based on the checklist below.

 

Why You Would Buy a Net-Net

One main reason that investors buy net-net stocks is that NCAV acts as a solid floor for the price decline. However, it’s not every net-net stock though. A net-net has to pass a set of criteria. We will talk about this in the later part of the article.

Assuming you found a good one, your downside is protected by the liquid assets and you are buying with a huge margin of safety. If the company has other long term assets like buildings or cash overseas, that’s an included bonus if it can get unlocked.

It’s such a rare strategy where you don’t even have to know much about the industry or the future. It’s just a matter of keeping an eye on the NCAV each quarter to make sure that there is no sudden deterioration.

Problem with Net-Net stocks

Wait! Before you pull the gun and jump into the next Net-Net stock that you found, read on.

The main one is that any company trading at or below NCAV is going through some serious troubles. Definitely some scary reasons like losing major customers, production issue, having no operating business and so on.

Net-Nets are a big no no if you have the following traits:

• Don’t want volatility
• Want to hold something for as long as possible with very minimal turnover
• Don’t like buying small / micro caps
• Want to stick to mainstream ideas
• You have to look important to others
• You want to brag that you found the next hot stock

And this is perfectly fine because being comfortable with where you place your money is very important.

 

Net Net Buying Checklist – 7 Simple Rules to Follow

But if you are not limited to large caps and don’t mind net nets, here’s a brief checklist you can follow to make sure you reduce your risk as much as possible.

1. Low Cash Burn

This is one of the important point. Make sure the company has enough money to last for several years even if it keeps losing money.

Get the TTM FCF or last year numbers and divide it by how much money they have on the balance sheet. This can estimate how long the cash in the balance sheet can last. If the company having huge negative FCF and the cash balance not able to sustain it – get out!

A low cash burn is your safety net. A lot of the value is tied up in cash, so if the burn rate is high, you will be fighting against time as you see the NCAV value drop.

2. No Chinese stocks

Unless it’s Alibaba, most Chinese stocks are still very shady. Especially the smaller ones. High chance of fraud so why risk it. The idea is to buy cheap net nets that will lower risk.

Not to find ones that you think will go up by 1,000%.

3. Has a Valid Operating Business

Stay away from net nets where their business model is totally outdated as the value will erode.

A company could have a solid balance sheet, but if it’s main business is photo printing or backup data with CD’s, run away.

4. Catalyst

A catalyst isn’t necessary but it is a bonus.

If you can identify a net-net that going to turnaround or unlock its value – congratulation!

5. No Debt or Very Easily Manageable

Looking for safe net nets is key and debt is a killer for most small businesses.

When you consider that net nets are;

• struggling with their main operating business
• or losing money

the last thing you want is debt crushing them further.

6. No Insider Selling

We want to see insiders committed to saving the company, looking for ways to sell it or just extract value out of it.

Insider selling when the stock is at its lowest price point is a sign that management doesn’t care about anything other than filling up their pockets before the company rolls over dead.

7. Signs of Buybacks

The opposite of #6.

If management understands that the stock price on their company is ridiculous, they can continue to buy up shares to increase the value of each share.

 

Be Patient and Wait

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.

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. 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.