Net Net Stocks: Will Yours Wither Away to Nothing?
Buying a net net stock is a little like jumping into the deep-end and hoping your inner tube will keep you afloat.
Net Net Stocks and the Shrink Problem
When I first started investing in net net stocks I felt a little queasy. I remember looking at the companies on offer and just thinking that these businesses were a complete mess. The firms would be losing a lot of money and the stocks had often tumbled 70, 80, or 90% in price. Scanning the news stories didn’t help. Whenever something was written about the company it was usually highly critical and often predicted doom.
While I knew that Benjamin Graham’s net net stock strategy focused on an ultraconservative assessment of the firm’s assets, or the absolute minimum the firm could realize through liquidation, often the assets of these companies also seemed to be shrinking. I was highly skeptical of any of these companies' ability to maintain their net current asset value.
Apparently I’m not alone. Whenever I talk to friends or Net Net Hunter members the same question seems to come up: how can an investor be certain that the net current asset value of the company won’t wither away to nothing?
How to Avoid Asset Shrink When Selecting Benjamin Graham Net Net Stocks
The risk is always there that the company’s net current asset value will shrink dramatically. Benjamin Graham himself warned investors about the danger of shrinking assets when investing in net net stocks. So how can you protect yourself against the erosion of net current asset value when assessing a net net stock candidate?
As it turns out, there are a number of different tactics you can employ to reduce your risk.
1. Assess the Burn Rate of Your Net Net Stocks
First, you can look at what I call “Burn Rate”. You might recognize that term from My Investment Scorecard, an article that I wrote explaining my selection process in detail. Burn Rate is just a measure of how much the net current asset value of the company is shrinking. Some companies burn through current assets faster than others. Since pretty much all companies with shares trading below the represented net current asset value are facing large business problems, nearly all net net businesses will see a drain on working capital. As an investor, you can help reduce your risk by selecting firms that show the least amount of shrink.
Say you invest in a firm with a 10% Burn Rate year over year. Every year that firm uses up 10% of it’s net current asset value just sustaining the business. If you bought at a 50% discount to net current asset value then at the end of the year you would only have a 44% discount to intrinsic value left and, instead of having to rise 100% in price, your shares would have to rise 80% in price before becoming fairly valued. If you selected a stock with a 20% Burn Rate then your margin of safety would drop to 38% and your stock would have to rise 60% before it became fairly valued. As the net current asset value shrinks so does your margin of safety and your eventual payoff.
One problem with only using the company’s Burn Rate to protect your downside is that you’re looking back in time to judge what will happen in the future. While the past serves as a good rough guide to the future it can’t be relied upon absolutely.
2. Demand a large Benjamin Graham Styled Discount to Intrinsic Value
Another obvious way you can guard against a large Burn Rate is to select stocks trading at large discounts to intrinsic value. A stock with a NCAV of $100 million that is shrinking by $20 million each year will see its NCAV shrink to nothing in 5 years. If you buy the stock at an 20% discount to net current asset value then your margin of safety will be wiped out in just one year. If you increase the margin of safety to 60% -- if you buy the stock when the company is valued at $40 million -- then your margin of safety will be wiped out in 3 years, instead. That means that the company can take longer to turn its business around, find a buyer, or finally see some good news, and still allow you to profit.
While Burn Rate looks at the past, and demanding a large discount to intrinsic value requires looking at the present price-value discrepancy, you can also reduce your risk by looking at what will likely happen in the future. While relying totally on the future is a mistake, selecting firms that have a likely catalyst, a probable event on the horizon that will improve the stock price or the business, can be a good way of protecting your downside. If the favorable event actually happens then either the stock price will rise sooner or the business will improve sooner, rendering the risk of NCAV shrink null and void.
Remember our net net stock talked about above, the one with $100 million in net current assets and burning through $20 million in net current assets each year? If another firm agrees to buy the business at the end of year one for its NCAV then the company would be taken over at $80 million, giving you a 60% profit if you bought at a 50% discount to its original NCAV. With no catalyst in place, you're left in the dark as to what will actually happen to the investment over the length of your holding period. In the case of the catalyst, though, the company's burn rate becomes less of an issue.
3. Assess the Qualitative Side of Your Net Net Stocks
If you’re really good at assessing the qualitative aspects of an investment – admittedly a much harder skill to master – then you could also reduce the risk due to NCAV burn by buying firms that will obviously improve their business operations soon. A good example of this was classic Benjamin Graham investment Trans World Entertainment, which was busy trimming money losing stores and shifting its product mix to improve overall results.
It’s important to say right here that a firm does not have to have an obvious catalyst for it to work out well as an investment. Often times a buyout or improvement in the business will come out of left field, lifting the firm’s stock back up to a minimum valuation level. InfoSonics is a good example of this.
4. Take Benjamin Graham's Advice and Diversify
The key word here is most. Ultimately, not all net net stocks will work out well for an investor and some will end up losing you money. Warren Buffett, Benjamin Graham’s greatest student, mentioned that about 80% of the net net stocks he bought would work out within 3 years. That leaves about 20% drifting somewhere around his buy price or sinking to a significant loss. Obviously, if a company burns through its NCAV then it has a good chance of causing you to suffer a loss.
You can help reduce the impact that any one of these companies has on your portfolio by diversifying your holdings. I follow Joel Greenblatt’s lead and invest in 8-10 well-chosen stocks, ideally, but Benjamin Graham recommended that investors stuff their portfolios full of far more stocks than that. Any diversification will reduce the impact that any one company has on your portfolio but the right amount of diversification really comes down to personal choice. If you pump your portfolio full of firms then no company will have much of an impact on your overall results but you’ll also come closer to mirroring the overall population returns for NCAV stocks. A portfolio comprised of only 2 or 3 stocks will be impacted a tremendous amount by the fate of any one stock but also allow you to take full advantage of your stock picking skills.
It's About Risk Containment
Net net stocks can test whether you’re truly wedded to the value investment philosophy – not to mention your faith in Benjamin Graham. While there is a risk that a the net current assets of one of these deep value investments may whither away to nothing, you can actually do a lot to reduce your overall risk. In my view, at minimum, all investors should look for investment candidates with a small Burn Rate and a large margin of safety.
You can also take things a step further, though, by stacking together a larger portfolio full of companies that are likely to show a quick improvement in business results or stock price. In the end, following these steps will go a long way to reducing your overall risk, and propel your portfolio that much higher.
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