What Does Net-Net Mean? How To Calculate Net-Net Valuations
Net net investing was Ben Graham's strategy of choice and even helped Warren Buffett earn the best returns of his career. Get our Essential Net Net Stocks Guide to understand this strategy in detail. Click Here.
The term “net-net” refers to a specific type of investing. Popularized in the 1930’s by the “godfather” of value investing, Benjamin Graham, net-net investing is the process of buying a company’s common shares below a conservative estimate of the firm’s per-share liquidation value. In this article, we will review how to calculate possible values of net net stocks by paying special attention to their net current asset value. But first, what does net net mean?
Unlike net current assets, which is calculated by subtracting the current liabilities from the current assets to arrive at “net working capital”, the net- net formula subtracts total liabilities and the value of preferred shares from the current assets. The end result is an extremely conservative assessment of a company’s liquidation value. What this means for you – the investor – is a very large margin of safety should you be wrong.
What Does Net-Net Investing Mean For Investors? Potentially Big Returns...
Before committing to any investment strategy, a prudent investor should first examine the evidence. Fortunately for us, there is quite significant evidence that net-net investing will produce outsized returns. If performed rigorously and methodically, the benefits to investors could mean the difference between merely performing the same as the S&P Index, which has an average annualized return of around 10% since its inception through 2019 – to well above 20%.
For example, in a 2010 study, Jeffrey Oxman, Sunil Mohanty, and Tobias Carlisle tracked net-net performance from 1983-2008, and found that net-nets listed on American stock exchanges provided an average yearly return of 35.3%.
Another net-net study published by James Montier, a well-regarded value investor, tested baskets of global net-nets from 1985-2007, and found that net-nets trading at two-thirds of NCAV or less produced an average yearly return of 35%.
What does net net mean for consistent returns? While these returns are fantastic, one of the most important things to remember with net-net investing is that performance varies drastically from year to year. It is incorrect to assume that these outsized returns will happen each year. Instead, these returns are the average annualized returns, which means that your portfolio of net-net stocks can swing from 140% return in Year 1 to -40% return in Year 2. Investors, therefore, should expect moderate performance in most years, with a few years of outstanding Returns. Investors should also expect to underperform the market on Occasion. In the long-run, however, net-net investing is a strategy well worth your time to learn.
Often considered “The Godfather” of value investing due to his teaching and seminal writing on the subject, Benjamin Graham was also a practitioner of net-net investing. While Ben Graham’s books lack specifics, in a seminar in 1976 Graham stated:
“My first, more limited, technique confines itself to the purchase of common stocks at their working capital value, or NCAV, giving no weight to the plant and other fixed assets and deducing all liabilities in full from the current assets…I consider it a foolproof method of systematic investment once again, not on the basis of individual results but in terms of the expectable group outcome.”
Benjamin Graham’s protege and eager student at Columbia University was none other than Warren Buffett. While Buffett’s investing career and fame is mostly due to his success building Berkshire Hathaway and largely investing in large-cap companies, few investors realize that he earned his highest returns investing in what he called “cigar butt” stocks, which were net-net working capital stocks. He used this approach from 1956 until 1969, and his portfolio’s compound annual growth rate was 29.5% versus the Dow Jones at 7.4%. Why did he stop investing in net-nets? As we’ll see, net-net opportunities are mostly found in the smallest companies in the investable universe - simply put, Buffett made so much money investing in net-nets that he had to move on to large companies for investment opportunities.
Another famous investor also got his start investing in net-net stocks. Peter Cundhill, often referred to as “The Warren Buffett of Canada” completely adopted net-net investing when he learned about Benjamin Graham. Over the first ten years of his investing career, using Graham’s net-net approach Cundhill achieved a compound growth rate of 26% with no down years!
Walter Schloss was another disciple of Benjamin Graham. Schloss earned a compound annual growth rate of 16% over an incredible 40-year time span sticking to Graham’s strategy and also purchasing stocks at a low price to book ratio. While this is not a religious adherence to net-net investing, it still goes to the heart of the principle – buying stocks for less than they’re worth.
What Does Net-Net Mean? A Formula May Help
While I prefer the common sense rule that “if you buy something for less than it’s worth, it will likely be a good investment”, the operative word is “worth” and there are several ways to calculate it. To answer “What Does Net-Net Mean?” we must look at three calculations.
There are three variations of the net-net formula.
- “Quick NCAV” Net Current Asset Value = Current Assets – [Total Liabilities + Preferred Share Value]
Using the Quick NCAV approach is a quick way to assess the conservative value of a stock by calculating the net current asset value of a net net stock. You can easily access the stock’s financials using a number of different websites or the company’s annual or quarterly reports, and do some back-of-the-envelope math to determine whether the stock’s Quick NCAV warrants a deeper look at the stock. Think of Quick NCAV as a screening function.
2. “Strict NCAV” Net Current Asset Value = Current Assets – [Total Liabilities + Preferred Share Value + Off Balance Sheet Items]
Using the Strict NCAV approach, you’ll dive deeper into the net net stock by calculating the net current asset value and also looking at off balance sheet items such as pension plans, legal penalties, operating leases and others. With this approach, you’re looking at the whole company to determine whether it is a good investing opportunity.
3. “NNWC” Net-net Working Capital = [(Cash + Receivables * 75%) + (Inventory * 50%)] – [Total Liabilities + Preferred Share Value + Off
Balance Sheet Items]
Net-net Working Capital (or NNWC) was a preferred method of valuation by Benjamin Graham for a net net stock. The logic is illustrated by this quote from Charlie Munger, “The liabilities are always 100% good. It’s the assets you have to worry about.” The NNWC formula excludes the value of long term assets and discounts the value of current assets. This is a much more conservative approach to valuing a company, because you’re discounting several items.
For example, if a company has $2 Million in receivables, you might discount it by 75% on the chance that the company’s customers don’t pay or dispute the bill. Or, another example would be to discount the inventory lower than market value on the chance that the company isn’t able to sell its inventory (for example, if the inventory is very unique or customized for a specific customer) or if the market drops out of that industry and the inventory must be sold at a discount. So here, the advantages are that you could get a very, very conservative valuation on the company and demand a bigger discount, and the disadvantage is that if you are strict with this approach, it could possibly blind you to the bigger picture of putting your money to work and losing investing opportunities. Remember - stock valuation is a range, not a strict number. Be flexible.
What Does Net-net Mean For Your Portfolio?
Net-net investing is a strategy of investing in net net stocks that performs very well for small investors for a few reasons. First, there is less competition. Professional investors (mutual funds, hedge funds, and family offices) are working with large amounts of capital. By large, I mean $10M+, but in reality its generally more than $100M. What this means is that they can’t purchase stock in net-net companies that have small market caps under, say, $10M, because if they did then they would basically be taking over the company. This would go against their main business - buying stocks instead of operating businesses.
What this means for you is that there is less competition in the way of eyeballs - whether it be analysts, money managers, or the media looking at these micro and nano cap companies, so you have an opportunity to purchase them. And the smaller companies have a well-documented history of outperforming the larger companies. A 2010 study of European net-nets found a material negative relationship between firm size and returns, where the returns for the smallest net-nets came in at 16.57% versus 1.58% for the largest companies; a recent study by Ying Xiao and Glen Arnold found similar results in the UK.
Now, net-net investing works well for smaller amounts of capital, but how small? Generally, based on research by Evan Bleker, we’ve found that net- net investing works best for portfolios under $1 Million because if you were to invest that in blocks of 5% positions, you could take positions in some of the smallest publicly-traded companies, which historically perform the best. Larger portfolios up to $10 Million can still invest in net-net stocks, but it will take longer to build positions due to the low trading volume of smaller companies and you may have fewer opportunities to invest in because you may need to find larger companies than an investor with a portfolio of $1 Million or less. So, as we’ve seen, when answering the question “What Does Net Net Mean?” there are multiple avenues to address the question. Hopefully this article provided some color on strategy, returns, calculations and, ultimately, what net nets could mean for your portfolio.
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