Net Net Stock Value Traps
Do net net stocks always work out? No. While Benjamin Graham's net net stock strategy is a highly profitable and dependable investment strategy, still roughly 20% of selected stocks fail to work out. Let's take a look at two things which may trip up investors.
If you have been in the value investing community for a while you undoubtably have heard the term "value trap". Essentially, a value trap is a stock or security that looks like a bargain but never actually rises in price to reflect the securities full valuation. Investors can add to this situations where value drops to reflect price rather than price rising to reflect value.
One of the major mistakes that investors make when investing in net net stocks is investing in what I like to call perennial net nets. These are stocks that have been sitting as net nets for years, never really rising to reflect full net current asset value. While these stocks can fit the rest of an investor's requirements, an investor has to ask why the company's stock has been sitting at such low levels for such a long time and if the investor can expect the stock to rise to reflect NCAV within a reasonable amount of time after purchase.
Situations can arise where investors have valued a stock below its NCAV because the company has only been able to earn razer-thin levels of profit. In these situations, management has done a horrible job running the company and should be turfed. Rather than join forces to replace management, investors often just sit on the stock or exit the investment in favour of something else. In these situations, a large investor who buys control of the company can make a large profit in a short amount of time by firing management and liquidating the firm. Unfortunately, most investors don't have this luxury. Instead of liquidating, the company's stock continues to sit stagnant below NCAV as the company barely scraping along.
If a stock has been sitting as a net net for a long period of time then investors should do some qualitative research to figure out why. Just being a perennial net net stock is not enough to pass on the company but an investor should know what the issue is and if it's likely to be solved anytime soon.
One fundamental characteristic of value investing is that while investors invest based on the discrepancy between price and value, the value that the security price eventually reflects may be far different from the investor's original assessment. Price isn't the only thing that moves up and down. The value of a company can either increase or decrease depending on future events. If the company hits one or two unfortunate setbacks, its value can easily erode to reflect the original depressed price.
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One thing that classic Graham investors have to watch out for is what I call "burn rate". Unlike other writers, I don't believe investors should stay away from money losing companies. On the contrary, money losing firms can be great investments because losses can cause extreme investor pessimism, really depressing stock prices in the process. While companies that are constantly losing money may not be a good investment, investors really have to look at the company's burn rate.
The burn rate is the speed at which the company's NCAV is shrinking. Companies use cash, so if they're not producing cash through business operations then they have to obtain that cash from somewhere. Usually this means draining the company bank account. Another course of action is to reduce the amount of cash the company uses, perhaps by not replacing inventory. Whatever the case, a companys' NCAV can erode, eroding an investor's margin of safety in the process.
While no amount of burn is desirable, some amount of burn and some situations are more forgivable than others. One of the most obvious situations to avoid is where a company's NCAV is rapidly eroding. What constitutes rapid is a judgement call that an investor himself has to make. For me, a company whose NCAV is shrinking more than 15% per year has way to high of a burn rate to invest in. That rate of burn would mean that in two years over half of the investor's margin of safety has been eroded if he purchased at 50% of the NCAV. Instead of doubling his money, the best an investor could do is see a ~50% gain. If the burn rate stayed steady, an investor would only see an 11% upside in three years -- almost a complete waste of an investment.
On the other hand, if a company's current losses are due to a large one time event, an event that seems solvable within a reasonable amount of time, then an investor could pick up the stock. Investors should be careful to make sure that the stock price constitutes a large enough margin of safety, though.
Assuming a large enough margin of safety is present, companies that are steadily reducing their losses may be another good opportunity. A company that is reducing its losses is showing investors that it is in the process of fixing whatever issue it was facing. In these situations, the net income figure is moving in the right direction so -- as long as a qualitative assessment pans out -- the company should be able to eliminate its losses eventually and return to profitability. In my experience, when a money losing company trading below its NCAV returns to profitability its share price usually spikes.
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While it doesn't seem intuitive, net net stocks of money losing companies are not actually at a disadvantage as far as returns go compared to their profitable counterparts. As a group, they might actually outperform their peers. With my own portfolio, I'm focused on setting things in my favour as best I can. I'm specifically aiming to invest in the most profitable subset of NCAV stocks. At Net Net Hunter, members have access to academic studies about companies trading below their net net value and net net stock papers written by legendary investors such as Warren Buffett. These are great tools for fine-tuning a low price to NCAV investment strategy. As well, if you're searching for international NCAV stocks, our screens have over 400 net net stocks to chose from from over 7 stock markets, such as the United States, Canada, the UK, and Australia. If you're ready to make net net stocks a key part of your portfolio then sign up for full Net Net Hunter membership. Click here now!
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