How to Destroy Your Net Net Stock Portfolio

Are you tired of building wealth?

Would you rather watch your money burn?

One of Canada's leading newspapers came out in 2013 with a list of net net stocks that it expected would produce amazing returns.

Author Robert Tattersall, co-founder of the Saxon family of mutual funds, looked back in time and put together a basket of net nets trading on the Canadian markets at the start of 2012. His strategy was simple: a basket of Canadian net nets, 21 to be exact, trading at no more than a 20% premium to NCAV, with no additional filtering.

Over 2012 the stocks would have performed very well, recording an 18% gain versus the TSX's 4% return. That result is on par with the returns of net net stocks generally.

Over 2013, however, returns began to sour. Rather than the market crushing performance of the previous year, Tattersall's basket of net nets actually underperformed the market, returning just 2% compared to the market's 7.2% return. 

What Went Wrong?

Part of the problem was the holding period. Net nets show their best yearly performance as a group over a 1 year holding period but then perform worse the longer you hold onto the stocks. Over a two year period, a net net stock's CAGR drops in a meaningful way. Over a 3 year holding period, results are even lower. Returns decrease step by step until in year 5 a lot of the advantage of owning a basket of net net stocks is destroyed. If you want to run a net net stock portfolio, annual rebalancing is a must.

But holding period length is not the only thing potential net net stock investors should keep in mind, and it wouldn't have been responsible for the large drop in performance his portfolio saw. There is a fair amount of variance in portfolio returns, after all. But, astute readers will notice two other fatal flaws.

It's no secret that net nets perform spectacularly when you stick to the strategy over a long period of time. Not all net nets perform the same. I crafted my Core7 Scorecard to help identify the net nets that have a better chance of outperforming net nets in general and help avoid firms that will disappoint. While it's impossible to avoid every firm that will produce a loss or ensure that all the highest returning net nets are in your portfolio, it does a good job of stacking the odds in your favour.

One of the key requirements in my scorecard is avoiding Chinese net nets and resource exploration companies. China has become famous in the West for its spectacular growth, but it's also developed a bit of a reputation for offering up western market listed firms that are nothing more than frauds. These companies over-inflate their Balance Sheet figures, record assets they don't actually have, and even tally up growth in revenue or earnings that just didn't happen.

Understandably, these companies don't make for the best net nets. After all, if you're going to be basing your investment decisions on Balance Sheet figures, it's usually best to stick to firms you have reasonable grounds to assume are producing accurate financial statements.

Resource exploration firms are a whole other can of worms. While they may have more accurate financial statements (ie. they're less likely to be outright frauds), these companies have a long history of destroying shareholder wealth. They start with a public offering of stock and then spend the money trying to find resources to harvest. This process can take years, if they find anything at all, and the entire time the company keeps draining its bank account. Most companies never actually find a deposit, but do a very good job of eroding shareholder value.

9 Net Nets for 2014? Maybe?

These facts aren't exactly a secret on the Street, so it's interesting that David Sandel of Simcoe Partners would choose to include Chinese reverse merger and resource exploration firms in his followup portfolio for 2014.

Just like Tattersall's 2012/2013 portfolio, Sandel picked a basket of net nets that he suggested investors purchase for 2014:

Automodular Corp. -10.16%
Monument Mining Ltd. -41.17%
Energold Drilling Corp. -50%
Indigo Books & Music Inc. +46.25%
Greenstar Agricultural Corp. -51.17%
Goodfellow Inc. +5.73%
Mirasol Resources Ltd. +20.44%
ACE Aviation Holdings Inc. 0%
Coopers Park Corp. +43.93%

All 9 net nets were still listed on Google Finance 12 months. If equally weighted, the portfolio would have produced a loss of -4.02%.

A quick look at the firms is instructive. Of the firms selected, 3 were resource exploration firms (Monument, Energold, Mirasol) and one was actually a Chinese firm (Greenstar). The return to this group of 4 stocks was an average loss of -24.38%. If investors had skipped over the resource exploration and Chinese firms, they would have enjoyed a much more rewarding +17.15% return versus the TSX's +6.23% gain. Not exactly statistically significant, but illustrative.

Wise Stock Selection for the Best Returns

At this point, astute readers will point out that these exploration firms were purchased right before a big drop in commodity prices generally. That's a fair point, and one more reason to avoid resource firms altogether unless purchased in the depths of a serious bear market. While retail and industrial firms can turn themselves around with effort, planning, and decent judgement, the fate of resource firms are more or less wedded to commodity prices.

Net nets don't work out every year, and not every company will see positive returns. Seeing losses from time to time comes with the territory when buying net nets. Still, despite the occasional loss, net nets produce better returns over the long run than any other value strategy. Returns are consistently above a 25% CAGR in academic studies and my own portfolio has done very well.

You shouldn't just buy any net net, however. Some net nets have a much greater chance of suffering large losses; while other net nets have characteristics associated with outsized returns. Most of my net nets are debt free, have been growing NCAV, are increasing earnings, were bought with a PE below 10x (less than half the market PE!) and at an average discount to NCAV of 55%.

If you want to make the most of your net net stock investing, you really have to group the best possible stocks into your portfolio. You can start by looking over my Core7 Scorecard. Better yet, sign up for free net net stock picks below.

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Article Author: Evan Bleker