Net Net Stocks: Why Does This Strategy Work So Well?
Why do net net stocks work out so well?
I was sitting behind the computer desk in our home office years ago busily skimming listings of journal articles trying to find studies looking at Benjamin Graham's low price to NCAV investment strategy. The more I looked, the more amazed -- and baffled -- I felt.
Every study looking at Graham's ancient strategy showed huge outperformance over the market index year over year. It wasn't even just most studies, or the studies of authors who were clearly entrenched in the value investment camp, either. Every single study that talked about net net stocks showed the same tremendous performance.
What baffled me was that despite 100 years of backtests, and use in practice by outstanding investors such as Warren Buffett, Walter Schloss, Seth Klarman, and Peter Cundill, nobody was really paying attention to the strategy. Of course, I have my hunches now as to why so many investors pass up what's obviously one of the best -- if not the best -- investment strategies open to them.
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But I don't want to talk about that right now. What I want to talk about is the reasons I see for the huge results this strategy offers investors.
A lot of studies have come out and tried to use contemporary financial theories to explain the great returns of net net portfolios only to find that the data points away from their original hunches. Neither risk in terms of volatility nor the high return characteristics of microcap stocks can explain these outstanding returns. Instead of just one or two factors, I think that there are at least 6 very compelling reasons for the outperformance investors see.
Two background assumptions that any value investor works with are that a company's business value and value in the market will converge in the long run but that in the short run prices and value can be out of sync. At times, the spread between the two can be very very large.
Of course, to value a company you have to measure value using some set standard, whether it's value as compared to other firms in the industry (relative value), discounted future cash flow (DCF), price to earning (PE), or price to book (PB). In essence, there are many ways to value a firm, and even a strong subjective aspect to valuation, but one thing is certain -- price to net current asset value is about as conservative of an intrinsic valuation measure as you can get.
Take a look at what happened to relative value during the late 1990s, and early 2000s. You could buy a "cheap" internet company that would lose 95% of its value over the next two years. Sure it might have been relatively undervalued at the time but, when internet stocks tanked, knowing that they narrowly missed losing 98 or 99% of their money would have been cold comfort to an investor.
The same goes for any other valuation method -- think you have a bullet prove PE valuation? PEs float with general market levels. Think you are getting a great deal on the real estate value of some company? That value can erode if real estate values are inflated like they were when I bought Sears.
By contrast, net current asset value is an much more dependable value, especially in this day in age. Even if a firm liquidates and the company gets less than the stated book value for its current assets, since net net stock investors pay no attention to long term assets, those assets can come in to perk up the overall, realized, valuation.
Liabilities Are The Root of All Bankruptcies
Tweedy Browne has shown that companies with debt-to-equity ratios less than 20% can outperform other firms by a wide margin. When a company is debt-heavy, or has razor thin margins of safety on its balance sheet, then it can run into serious problems. A company has to be able to pay its bills or it will cease to exists as a company.
To qualify as a net net stock, a firm has to have enough current assets to cover all of its liabilities, not just its debt or it's current liabilities. This means, essentially, that the company should be so rich in current assets that it could liquidate to pay off creditors and have enough left over afterwards to dish out cash to investors. While a company trading as a net net stock may not be able to continue as a business, liabilities do not usually pose an investment risk to a NCAV investor.
Compare this to a low PE stock. For any low PE stock it is possible for the company to carry a large debt load that it has to pay interest on. It's also possible for a low PE company to own much less in current assets than it owes in current liabilities. That means that investors could face a situation where the earnings collapse resulting in bankruptcy and the company's common shares becoming practically worthless. This just can't happen with net net stocks. In that sense, buying net net stocks can be a much safer investment strategy.
Heads I Win, Tails I Win
What the following two paragraphs should tell you is that these companies are priced so low that the odds of making large profits are really stacked in the investor's favour.
If you are buying at a decent margin of safety, at a low enough price when compared to a company's value, then if the company decides to shut its doors, you'll be paid a cash distribution. This cash distribution is typically much more than you paid for the net net stock in the first place. While there are risks in any investment strategy, the chance of an eventual large profit is disproportionately in the investor's favour.
I'm probably one of the few investors that actually hopes the companies he's invested in will have to close their doors. One of the biggest annoyances when it comes to net net stock investing is waiting for something to happen. Sure, most net net stocks workout within 2 years but it can be incredibly boring watching your net net stock squiggle around near your buy price for a year or two. Since I invest below a conservative estimate of a company's liquidation value, if one of my holdings decides to liquidate then I realize my estimated profit much faster.
3 More Reasons
These are just three reasons why net net stocks outperform the market and the vast majority of other investment styles over the long term. There are definitely more so check out the followup post right now.
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