How Jeroen Bos Picks Net Net Stocks
by Evan Bleker
Article Photo: Todd Mecklem
A lot of net net stock investors are rightfully frustrated that there isn't more written about the investment process of the outstanding deep value investor Peter Cundill. To quench their thirst, they may want to turn to Dutch investor Jeroen Bos, instead.
Peter Cundill was a legend in the investment industry, but he's not exactly a household name. Cundill was a tremendously successful investor focused on the liquidation value of firms, a strategy he felt he could "hang his hat on." Great minds rarely work in isolation, however, and gifted investors are no different.
Who Is Jeroen Bos?
Enter Jeroen Bos. Jeroen got his start in investing as a stock broker in London at Panmure Goordon & Co where he acted as a scout for Peter Cundill. Peter Cundill knew that it paid to have eyes and ears on the ground when hunting for net nets so set up a network of investors and brokers around the globe who would send him stock ideas when something interesting surfaced. Today, small investors can mirror that network by signing up for free net net stock picks via our free Net Net Hunter newsletter.
Jeroen was interested in value investing throughout the 1980s but found that the value stocks he identified really didn't work out that well. In his words, "they were cheap for a reason."
Jeroen's interest in value investing, however, really took off with the 1987 stock market crash when someone mentioned that it was probably a good idea to dive back into "The Intelligent Investor" to re-anchor to the principles of value investing and gain leverage on the market's violent swings.
Flipping through the pages of Graham's classic book, net nets immediately caught Jeroen's eye. He found the idea of purchasing a company at a price so low that he could realize a quick profit if the firm closed its doors very appealing. Adopting the strategy provided his portfolio returns with an immediate boost, and he was soon seeking out great value investors in London and the US, investors such as Peter Cundill, to learn more.
That initial success firmly cemented him in the asset-backed, liquidation value, value investing camp.
"I really always start off with the balance sheet, and if that shows me it’s cheap, then I’m immediately interested. I’ve always worked on that basis."
The success of his net net stock strategy, and Peter Cundill's fund, must have really had an effect on Jeroen as a broker. While many value investors look at earnings as a key way to value a company, Jeroen Bos firmly rejected any valuation technique that wasn't centred on the Balance Sheet. His distaste for all things earnings was so strong that he even claimed in an interview with The Manual of Ideas that investing based on Low PEs wasn't really value investing.
"Lots of people try to argue that a stock is deep value when it has a low P/E or it has a high yield; that I don’t think is really value investing; that is something different."
Quite a bold statement when legends such as Warren Buffett use earnings as their go-to metric when valuing companies. But, to anyone who has been a net net stock investor for a number of years, his enthusiasm is completely understandable.
Jeroen Bos' Trackrecord With Ben Graham Styled Net Net Stocks
How successful is Jeroen Bos as an investor? When he was interviewed by the Financial Times, it was revealed that his deep value fund had returned 65.2% versus the FTSE All-Share Index return of 21.7%. Tripling the market return over a 5 year stretch is an outstanding achievement, even for someone such as Jeroen who had been investing for 20 years.
It's also nothing new for net net stock investors. Net net stocks are outstanding investments, as long as you are managing a small pool of capital. The strategy becomes difficult to use as you approach $20 Million USD, since many net net stocks are stocks of tiny micro or nano cap firms. It's very common to find net nets in companies with market caps that range from $1 Million to $100 Million USD, for example, and much harder to find firms that qualify over the $100 Million market cap figure. Since most net nets have market caps around $20 Million USD, an investment manager can only put so much money to work before moving the stock price.
Late last month I highlighted the fact that not all net nets work out the same. In a basket of net net stocks
you're bound to have a range of returns and it's very possible to completely kill the advantage that net net stocks provide by making very obvious investment errors, such as buying Chinese reverse mergers or resource exploration firms.
When Jeroen Bos can't find something decent to buy, he sits in cash and waits. Cash has been the default go-to parking spot for large investors for quite a few decades, but cash also drags down your long term returns. Jeroen Bos' insistence on sticking to either British or Japanese markets has cost him dearly, since at times he's inevitably had to park his money in government T-Bills when he could have found decent quality net net stocks in other first world countries. Canada, the US, Europe, Australia, and other jurisdictions provide an investor with far more opportunities and ultimately a portfolio made of better net nets.
Regular readers will be well aware of my Core7 Scorecard, the NCAV checklist I use to pick net net stocks, but how exactly does Jeroen Bos make his investment decisions? As it turns out, his strategy for picking net nets very closely mirrors our strategy here at Net Net Hunter.
Jeroen Bos's Net Net Stock Selection Criteria
In June 2014 Jeroen wrote a detailed article on exactly what he looks at when it comes to selecting net nets. As it turns out, a lot of the criteria that he included on his checklist is also on my Core7 Scorecard. To pick up a full copy of my Core7 Scorecard, click here.
Low Levels of Debt
Debt is a key factor when dissecting a net net stocks. Deep value stocks are usually under a lot of distress, and the ability to survive their problems is a key concern. If a company has no debt, the company's risk of bankruptcy is near nil. In Jeroen Bos' words,
"Having little or no debt will put the company in a much stronger and more stable position. It will potentially give the company the possibility to add debt, as there should be headway to do this once the path to return to profitability is re-established."
Positive Cash Flow
Positive cash flow is important to Jeroen but not a requirement on our Core7 Scorecard. Jeroen doesn't get into detail on why he requires positive cash flow but positive cash flow but a lot of net nets lose money over consecutive years.
Positive cash flow allows companies operating flexibility and makes it more likely that their net current asset value (NCAV) will stay intact. This last aspect of a positive cash flow is important for one of our key Core7 requirements. I want to make sure that the company's NCAV is rock solid or growing so that my margin of safety and profit potential remain intact.
Jeroen only invests in companies that were profitable at some point in the past, as do I. When it comes to net nets that are losing money, it's important to make sure that the company once had the ability to make money... so there's actually a business to turn around.
Investors new to net nets often make the mistake of buying firms that have been losing money for years on end, such as resource exploration firms. Firms that constantly lose money are great at destroying shareholder value.
"Avoiding companies lacking this requirement and positive cash flow will protect us from an ever-eroding margin of safety where the company may well be forced to raise further capital."
Share Price Near All-Time Lows
Forget 52 week lows, Jeroen favours net net stocks that are trading near all time lows.
"This indicates the sense of disappointment that the current share price has and that we may be reaching “capitulation level” where further bad news largely leaves the share price at current levels. Looking at this gives me some idea as to what levels the share price should be able to return to once the company hits higher profitability levels again."
John Templeton once said that the best time to buy a stock was at the point of maximum pessimism. While it's impossible to reliably tell when a stock has reached that point (people could always become more pessimistic or turn before you expect them to), by demanding a price near the stock's all time low Jeroen is engineering a shortcut to approximate this level of pessimism.
Institutional Shareholder Ownership
Are there safety in numbers? Most of the time, no. But, Jeroen Bos likes to see a number of other institutional shareholders own a chunk of the company's stock so that he knows that they can engage with the company if needed.
Jeroen also wants to see insiders with significant ownership so he knows that he has skin in the game. It pays to have managers who own major blocks of shares. This ensures that they have a major stake in the success or failure of the company. That ensures that their actions are more inline with the interests of shareholders, and this is also why I've included it on our Core7 Scorecard.
A Stable Balance Sheet
When building our Core7 Scorecard, I looked for a stable NCAV because this is the foundation of the investment. If your NCAV deteriorates... so do your investment prospects.
But, what does Jeroen look for in Balance Sheet stability?
"When checking the accounts of the company, I like to see a balance sheet that stays stable over a period of reporting years, with no frequent changes of accounting treatments or turnover in the accountants/auditors."
I would consider these red flags and have passed on companies that have turned over auditors like a dryer turns over clothes in the wash.
Three Other Key Characteristics of Great Net Net Stocks
Jeroen Bos gave a great set of characteristics that serious investors should consider when assessing a net net stock. But there are three characteristics that have such a powerful effect on returns that you should definitely incorporate them into your net net stock investing strategy.
The first is investing in companies that qualify as net nets that also have tiny Market Caps. Studies repeatedly find that the smaller the Market Cap of the companies grouped into your portfolio, the better your portfolio will likely do. The difference isn't trivial, either. You could easily find that your portfolio outperforms a net net portfolio made up of larger firms by as much as 10% a year on average. That's a tremendous boost in performance just by buying the smallest companies.
Next, focus your attention away from resource exploration or Chinese reverse mergers. I've already talked about resource exploration companies above. Chinese reverse mergers are common scams on the western markets and involve outright fabrication of financial figures to scam investors. This strategy is based on the actual published financials of the companies in question. Given that, you want to make sure that your analysis is based on substance and not outright lies.
Finally, consider looking for firms trading at very large discounts to NCAV. The larger the discount, the larger your profit potential and the further the company's NCAV can erode before your investment loses its appeal. Buying stocks with the largest discounts to NCAV will provide your portfolio with a sizeable boost in performance.
And that's really what this strategy is all about. Just like Jeroen Bos, my own portfolio returns really took off when I adopted Graham's classic net net stocks strategy. Before then my performance was, honestly, terrible. Luckily, great returns are possible if you just execute a great strategy well.
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