Net-Net Investing: A Deep Value Strategy

 

Net-nets are a cornerstone concept in the realm of deep value investing, pioneered by Benjamin Graham, the father of value investing. This strategy involves identifying stocks trading below their net current asset value (NCAV), providing investors with opportunities to purchase shares at a significant discount to their intrinsic value. The term “net-net” refers to a company whose market capitalization is less than its net current asset value. NCAV is calculated by subtracting total liabilities from current assets. To qualify as a net-net, the stock must be trading at a price less than its NCAV per share. This means the company is valued by the market at less than the liquidation value of its current assets, providing a margin of safety for investors.

 

Historical Context and Rationale

Benjamin Graham introduced the net-net concept in his seminal work, “Security Analysis,” published in 1934. He argued that buying stocks at such a deep discount minimized downside risk and provided substantial upside potential. Graham’s strategy was built on the premise that financial markets are not always efficient and often misprice securities, particularly those facing temporary difficulties or neglect.

The rationale behind net-net investing lies in its conservative nature. By focusing on the most liquid part of the balance sheet (current assets), investors reduce exposure to long-term uncertainties and operational risks. This approach is especially potent during market downturns or in distressed industries where sentiment is overly pessimistic, leading to potential bargains.

 

Benefits of Net-Net Investing

  • Margin of Safety: Net-nets offer a significant margin of safety, as the company’s current assets alone are worth more than the market price. This cushion protects against downside risk, especially if the current assets are of high quality, like cash or short-term investments.
 
  • Limited Downside: Since these stocks are already trading at a depressed value, the potential for further significant decline is limited, assuming the company’s financial situation doesn’t deteriorate drastically. Even if the market value of the company declines, the net-net investor can lean on the fact that the company can, in theory, be liquidated at a far higher valuation.
 
  • Potential for High Returns: When the market eventually recognizes the true value of these companies, there can be substantial upside, leading to outsized returns.
 
  • Diversification: Net-net investors typically spread their investments across a broad range of such stocks, mitigating the risk associated with any single company’s poor performance.
 
  • Uncorrelated to the market: While it is true that net-nets are most common during market downturns, most of the time, these stocks are usually somewhat uncorrelated to the broad market. Net-net investing, as with any special situation investing, might therefore be a good strategy during times when value is hard to find elsewhere.
 

Challenges with net-nets

 

  • Scant Availability: True net-nets are rare, especially in modern markets where financial data is quickly integrated into analytical software and made available to all market participants. Net-nets often appear during economic downturns or in specific sectors experiencing significant distress, and therefore it might not be a sustainable long-term strategy.
 
  • Quality of Assets: Not all current assets are created equal. Accounts receivable may be doubtful, and inventories might not be easily liquidated. In some cases, inventories might even be worth less than zero, and the company has to pay somebody to haul the stuff away. Hence, due diligence is crucial to assess the quality of the current assets. A superior net-net is one where short-term assets mostly consists of cash and other liquid assets such as short-term investments.
 
  • Management and Operational Risks: Companies trading as net-nets often face significant operational challenges, poor management, or declining industries. Sometimes all of the above. When you invest in a net-net, you have to be confident that things will get better, or at least revert to a more normal state. Otherwise, the company might turn out to be a melting ice cube, a value trap in other words.
 
  • Market Sentiment: Net-nets can be subject to extreme market pessimism, making it difficult to predict when or if the market will recognize their true value. Since most investors are not hedge fund managers with the ability to join the board and make actual changes within the company, investors usually have to rely on the market to recognize the value of their investments. Compare this to the investor who invests in companies that generate distributable cash flows every year. He will not have to worry about the market valuation of the company, since he will earn a return based on the underlying performance of the company.
 

 

Net-nets in modern markets

 

While net-nets remain a viable strategy, modern investors often complement this approach with other valuation techniques and qualitative assessments. Technological advancements and increased access to financial data have made it easier to identify potential net-nets, but also mean the market is quicker to correct mispricing.

Net-nets are definitely hard to find on the large, more “efficient” stock markets. If you are actively looking for net-nets, you are more likely to find them on smaller markets, or on foreign stock markets where most analysts aren’t searching. In my experience, Japan has been a good place to find high quality net-nets for some time, but it is a marketplace that is relatively hard to enter as a novice investor, and information might be hard to come by. This, of course, can also be used to your advantage.

And remember that not all net-nets are created equal. There are net-nets that consistently lose money and make bad investments, where inventory values might be worth close to nothing, and where management seems completely oblivious to the fact that they are destroying shareholder value. And then there are the net-nets that consistently make money over time, where short term assets are of high quality, and where the low valuation isn’t necessarily deserved.

 

Conclusion

 

Net-net investing, though challenging, remains a testament to Benjamin Graham’s legacy, emphasizing deep value and conservative principles. For the astute investor, net-nets offer a unique opportunity to achieve significant returns while mitigating risk. However, success in this domain requires thorough research, patience, and a keen understanding of the underlying business fundamentals.

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