Howard Marks on Net Nets: Are They the Most Important Thing?
This article on Howard Marks on net nets was written by Isaac Aydelman. Isaac is a student of economics and a former soldier. He was drawn to net net investing for their historical returns and how the strategy paired well with his personality. He manages his own personal account and is always looking for new opportunities. Net net investing was Ben Graham's strategy of choice and even helped Warren Buffett earn the best returns of his career. Get our Essential Net Net Stocks Guide to understand this strategy in detail. Click Here. Article image (Creative Commons) by Hernán Piñera, edited by Net Net Hunter.
We rarely hear about Howard Marks on net nets, despite him finding the subject important enough to get a mention in his famous book, The Most Important Thing. In a book that looks at general investing best practices, to have net net investing referred to directly carries some weight.
What exactly does Marks say about net nets? More important, should net net investors change the way they invest based on his advice?
As Marks put it, in theory, net net investing was paying less than nothing for a business and getting paid for its liquidation.
A bold claim by any stretch, but is the net net strategy that good, and what else can we learn from Howard Marks on net nets?
Who Is Howard Marks?
Howard Marks is the principal and founder of Oaktree Capital Management, one of the pioneers of “distressed” investing. Originally making a name for himself buying up the distressed bonds of bankrupt companies for pennies on the dollar, he soon transferred these ideas to stocks and developed his own deep value strategy.
His fund has generated average annual returns of 23% over the last 25 years. This significant outperformance has led him to be revered in the value investing community, often being compared to legends such as Seth Klarman and the Oracle of Omaha himself, Warren Buffett.
Now, how does this relate to net nets exactly?
Howard Marks on Net Nets (and Net Current Asset Value)
In 2011, Marks published a collection of his investment letters under the title, The Most Important Thing. While the book covered many facets of his investment philosophy, the chapter on value has Marks specifically mention the strategy of buying at a discount to net current asset value (NCAV). In his words, he saw a discount to net current asset value as:
“…you could buy all the stock, liquidate all the current assets, pay off the debts and end up with the business and cash.”.
Not only is this a brilliant summary of net net investing—similar to the way its founder, Benjamin Graham, described it—but it also shines a light on the huge margin of safety that net net investing generates.
So, if it was important enough for Marks, what exactly is net net investing?
Net Net Investing In Brief
Net net investing is the process of buying a company below its NCAV, which is a valuation method that Graham coined and remains one of the oldest valuation methods in investing. Many legends have made use of NCAV in order to consistently beat the market.
Famed for its simplicity, the formula for NCAV is as follows:
Current Assets - All Liabilities - Preferred shares = NCAV
Divide it by outstanding shares and you receive the per share NCAV, a conservative liquidation value of the business. Graham wrote that buying a basket of these so-called net nets at a discount of at least 67% provided an investor with a wide margin of safety to protect their downside, with huge upside potential if the stock reached its NCAV.
The Howard Marks Net Net Strategy
Every net net investor can learn something from Marks, whose investing framework goes hand in hand with net net investing.
The key to Marks’ investing philosophy is what he calls “second level thinking.” In his words:
“First level thinking is ‘the outlook calls for low growth and inflation—dump stocks.’
Second level thinking is ‘the outlook stinks but everyone is selling in panic—buy’…”
In essence, first level thinking is superficial, listening to the latest pundit on CNBC and investing in what sounds hot. In contrast, second level thinking requires a deeper look into things such as bad news, or looking into an obscure tiny business in another part of the world.
It is no wonder that Marks mentioned net net investing, as net net investing is basically all about second level thinking—looking beyond the markets’ exaggerated views to find diamonds in the rough.
To Invest in Net Nets Is to be a Contrarian
A common thread throughout Marks’ book is his belief in contrarianism being the key to long-term outperformance. As he put it, “Extraordinary performance comes from non-consensus forecasts.”
This makes sense—after all, following the consensus leads to consensus results, such as matching or even underperforming the market. Graham, Buffett, Walter Schloss, and other superinvestors knew that the real secret to consistent outperformance was to be a contrarian.
Nowhere is that more apparent than in net net investing, where you are looking at businesses that have been left for dead by the broad market. Marks birthed his net net strategy from buying up the bonds of bankrupt companies.
Marks believed that outperformance comes from a non-consensus view of a company’s value and to hold it until either your analysis is proved right or the market catches on to your view. It is of little surprise that this is also the key to successful net net investing, which is, in essence, betting on a reversion to the mean from an extremely depressed price point.
Marks believed that being a contrarian was a means to profit from inefficient markets, which he had plenty to say about that we shall discuss below.
Net Nets in the Somewhat-Efficient Market Hypothesis
The efficient market hypothesis is the belief that markets factor in all known information and create the fairest price for the company at any one time.
However, value investing—and especially net net investing—proves that markets are not efficient. Investors are still able to buy businesses that are selling at absurd discounts due to panicked sellers and an overly pessimistic market.
But, it was not all binary for Marks. He believed that parts of the market were more efficient than others. In his book, he lists off criteria for efficiently priced securities. If we use a favourite technique of Charlie Munger—inverting—we can derive what Marks believes are criteria for inefficiently priced companies. What we will see is that there is plenty of overlap between this list and the typical net net.
According to Marks, inefficiently priced securities are often:
- Not well-known names, and thus not followed. The opposite of Tesla or IBM.
- Somewhat controversial. Imagine a business that has lost 70% of its price in a year, or an out-of-favour industry.
- Are not clear on the surface. Think about a company whose earnings have collapsed, yet digging into their filings reveals that the collapse is due to a temporary factor.
- Information on the business is not distributed widely and evenly. Think about foreign companies in markets like Japan, where the language barrier on its own creates an information inefficiency.
- Things other investors can’t or won’t invest in (the largest inefficiencies). Think of microcaps that are so small that it simply isn't worth an institutional investor's time to research.
Noticing a pattern here?
All of these criteria are found in net nets, and it also links back to Marks’ view on “second level thinking,” Many of the inefficiencies aren’t screaming in your face; you need to dig around for them. Most importantly, as we will see, when you are betting against the consensus, you have to be prepared to take some short-term losses for massive long-term gains. Net Net Hunter members know this well.
Howard Marks On Net Net Price Declines
Unsurprisingly, Marks does not believe in market timing, but he’s a big believer in averaging down.
Of businesses at a deep discount like net nets, Marks stated:
“Value investors score their biggest gains when they buy an underpriced asset averaged down unfailingly and have their analysis proved out.
“Thus there are two essentials for profits in a declining market: a view on intrinsic value, and to hold that view strongly enough to be able to hang on to buy, even as price decline suggests that you are wrong. Finally: you have to be right.”
There is a lot to unpack here in terms of net net investing strategy.
The first is clear cut: averaging down is much better than trying to time market rebounds. If your analysis leads you to like a company at 60, you should like it at 50, and love it at 40.
Next, you have to believe in your analysis of the company enough to hold it during a decline. That is why the net net strategy is so attractive for valuing a business compared to discounted cash flow (DCF), for example. With DCF, you are making a lot of assumptions 5-15 years in the future, a long time for any business. Meanwhile, with NCAV, you are looking at the current assets the business holds today and how they relate to the company’s outstanding liabilities. There is no predicting or assuming; it's right there on the balance sheet.
Finally, Marks makes an important point. At the end of the day, you have to be right about the fair value of the company and be sure enough to stick to that conviction. One thing that helps net net investors stick to the strategy is the spectacular performance history of net net investing.
In the end, we should greet market declines with open arms as they provide us with amazing buying opportunities and a chance to lower our average cost basis in our current positions. To sum up, I’ll defer to Marks again:
“Buy when they hate ‘em, sell when they love ‘em!”
Wrapping Up Howard Marks’ Net Net Strategy
Marks was a qualitative value investor. At Net Net Hunter, we also value the qualitative factors in an analysis by keeping our eyes peeled for future catalysts and other factors. Marks believed that the most important thing in investing was intrinsic value and whether that intrinsic value provided the necessary margin of safety to justify the risk.
We have seen how Marks respected Graham’s valuation method, giving it a shoutout near the beginning of his book. It's no coincidence that Marks’ view meshes so well with net net investing. After all, investing at a discount to NCAV was created in order to provide a large margin of safety when investing in the beaten down companies traditionally seen as “risky.” However, was it Marks’ belief on net nets that there is no risk involved?
“Even a net net can be doomed if the company's assets are squandered on money losing operations or unwise acquisitions.”
Marks rightly observes that every margin of safety can erode, even the large one afforded by net net investing. This is part of the reason why we look so closely at the burn rate of businesses—the decline in NCAV of a company over time.
In the end, Marks’ fund is far too large to realistically invest in the net nets he adores, but that doesn't mean we can’t take Marks’ net net ideas and apply them to our own investing. I want to close with a small gem that I believe encapsulates the mindset of a net net investor:
“There are few assets so bad that they can't be a good investment when bought cheap enough”
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