The Bucket Approach to investing in Net Net Stocks

I was talking with one of our members the other day over email when he brought up a really good point - he couldn't understand why some investors opt for the fundamental analysis route when putting together a net net portfolio when a much more passive buy and hold strategy seems to work much better.

As value investors, bottom up analysis is thought to be critical when selecting a company's stock for purchase. I'm not saying this is a bad thing - far from it - but it's important to recognize that you don't actually have to do deep fundamental analysis to do well with value stocks. Other approaches can - and do! - work exceptionally well.

Three Ways to Select Great Net Net Stocks

When investing in net net stocks value investors have three general paths open to them:

1. The Bottom Up Approach - This is the classic value investor approach. The investor does all his homework, thoroughly checking the company and the competition to see if it makes sense to invest. The investor analyses any major problem that the company might be going through, as well as the skill (or honesty) of management. He looks at trends in same store sales, inventory turns, and cash flow to see if the company is viable going forward. Often hidden assets come into play or some other perk to justifies the purchase.

2. The Half-Analysis Approach - This is my approach to picking net net stocks. A half-analysis approach basically means reading the most recent 10K and the current year's 10Qs to get a good understanding of the company's situation while also screening out firms that don't meet some other core criteria. Core criteria are those that are associated with out-performance. For example, if low-price-to-NCAV stocks with no debt out perform their debt-laden peers then the investor will look at how much debt the company has and the debt that the company has carried in preceding years. The investor would then screen out companies that carry too much debt. There are a lot of factors that an investor can chose to optimize his portfolio's performance but it takes a systematic scientific approach to identify them. That's why Net Net Hunter has an area dedicated to research papers published on Net Net Stock performance.

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3. The Bucket Approach - The bucket approach is essentially what every study on net net stocks sets up to test. A basket of net net stocks are put together and the results measured. No fundamental analysis is done beyond the absolute most basic screen to see if the stocks actually are low-price-to-NCAV stocks or not. If they are, they're lumped into a basic portfolio and held for a period of time at which point the portfolio is sold and the results recorded. More sophisticated bucket tests lump all net net stocks with a specific identifiable characteristic into a portfolio which is compared against a baseline portfolio: the S&P500, NASDAQ, TSX, a more general net net stock portfolio, etc. Nearly all the characteristics used in investment approach #2 come from bucket tests but investment approach #2 utilizes much more in depth fundamental analysis than a strict bucket investment approach does. Returns for buckets of net nets seldom fall into the low 20% range.

Which Path to Take?

It seems obvious that investors should opt for investment approach #1, doesn't it? I mean, if the bucket tests shows as great of returns as they do then applying a rigorous process of fundamental analysis should lead to returns really taking off. I'm not at all sure it works that way, though. In my eyes, fundamental analysis is only good if it helps screen out companies based on some proven fatal flaw. This is the debt situation that I described above. Looking for attractive investments, on the other hand, seems like a waste of time because of how well ugly net nets do. In general, you can't really tell just by looking at a net net how well the stock will perform 1, 3, or 5 years out.

This is partly because of how net net stocks come to reflect full valuation. In my portfolios, I've found that net net stocks tend to either fix their own business problems, spike on rumors, get acquired, or liquidate. In fact, many of the companies that I've owned have been acquired before they're able to solve their own business problems. These companies often provide the best returns and they're never the companies that I suspect will be acquired. Liquidations, admittedly, almost never happen but would provide the purchaser a good return if the stock was bought for cheap enough. NCAV is supposed to be a good guess at actual real-world liquidation value, after all. At other times, a blip of good news in the press will send the stock price shooting skywards, often reflecting the company's net current asset value. The stock of InfoSonics Corp (NASDAQ: IFON) is a good example of one of these companies. Essentially, nothing really meaningful changed but a bit of good news sent the shares soaring and I was able to cash out for for a price reflecting the company's NCAV. Take a look:

Screen Shot 2013-09-10 at 9.05.40 PM

(In case you're wondering, no, the bit of good news is not indicated with the letter "A". The good news happened April 2012 as seen by the price spike.)

I'm not suggesting that anybody invest based on likely investor overreaction but it does go to show how a little good news can affect the stock prices of net net companies.

Net net stocks are ugly. That's just one of the realities of opting for a net net stock strategy. Usually companies are not sold as cheap as this if things are going well for them. These companies are typically suffering major problems and the future looks bleak. Still, somehow despite how dark the future looks, the vast majority of net net stocks work out well. If an investor spends too much time digging through financial statements in an attempt to do a thorough and rigorous fundamental analysis then he will likely pass on a good number of companies that would otherwise make up a solid net net stock portfolio. Remember that the base rate is the bucket approach so opting not to invest in a large number of net net stocks means opting not to invest in stocks that will ultimately perform really well.

My Advice

If it's a mistake to opt for investment approach #1, that still leaves two more general ways to construct a net net stock portfolio. Selecting which method is right for you really comes down to personal preference. If you don't have much time to put into investing then the bucket approach might suit you well. By investing in a bucket of net net stocks you should be able to do exceptionally well over the long term - at least enough to make your neighbors extremely jealous. If you have a little bit more time to put into putting a portfolio together then I still think that you're best off stacking the odds in your favor by screening out companies that are poor takeover candidates or have handicapped themselves with debt. Essentially, I still think that my investment scorecard is a solid way to screen out less than ideal candidates, and that means going back to investment approach #2.

So.... Why?

Getting back to the original question, I'm not exactly sure why value investors insist on performing rigorous fundamental analysis on net net stocks. Maybe it comes back to the man-with-a-hammer syndrome: if you're skilled at performing rigorous fundamental analysis on a company, why not use it?