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by Evan Bleker

Question: Suppose you have $10,000 to invest right now and wanted to buy a net net.

Which one of these companies should you buy?

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Quiz: Which one is better?

A lot of value investors will look at both companies and conclude that they're both worth putting money into - while Company A seems like a better buy at first glance. Still, both are trading for a significant discount to their NCAVs. And that's what I did-- I bought both. One went on to push my portfolio to new heights while the other turned into one of my portfolio's heaviest anchors. This is a walk through of the decisions that went into these purchases and what I learned.

Buy Them Tiny and Buy Them Cheap

When I dig through the pile of net net stocks from Net Net Hunter, I first look for stocks exactly like these two.

  • Small or micro cap plays
  • Trading for far less than NCAV

Both characteristics are important.

Some of the best returns in net net stock investing is earned when you buy a group of small companies for a small fraction of its net current asset values. You see, smaller companies consistently outperform larger companies in the net net stock universe. Buying it as cheap as you can is also vitally important since the cheaper the stock, the further up in price it has to go before reaching fair value.

Despite how important these characteristics are, there is a much more valuable factor in choosing net net stocks. If you take advantage of it, you can shift your portfolio from a bunch of solid performing deep value stocks to a group of stocks likely to show rocket ship like returns. I'll get to that factor in a bit. For now, let's take a deeper look at each company.

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The Balance Sheet Advantage

Both firms have strong balance sheets but Company A's balance sheet is slightly better. Both companies have no debt - a critical characteristic that I've talked about when it comes to net net investing strategies. Sticking with net net stocks that have less than 20% debt-to-equity ratios will actually boost your returns by an average of 6% a year. That's pretty impressive considering the market returns about 10% per year.

Neither company has unfunded pension liabilities that have to be added back into the balance sheet. Unfunded pensions are a big source of off balance sheet liabilities. If either of these companies had unfunded pension liabilities in the off balance sheet, then I would have to reduce the NCAV by the estimated shortfall and the stock might not look like quite the bargain anymore. At any rate, both companies check out initially.

I Love Net Cash

Unfortunately, neither company had net cash. Net cash is calculated the exact same way that NCAV is calculated, except that instead of using current assets, you just look at the company's cash and cash equivalents. If a low price to NCAV stock has most of its current assets in cash and cash equivalents, then the value of the company's current assets is much more certain. While receivables sometimes have to be sold to debt collectors at reduced prices, and inventories can take a huge hit in value, a dollar is always worth a dollar.

Companies that trade below net cash are the ultimate value investments. Essentially, buying a company for less than the net cash it has in the bank means that other shareholders are paying you to take their company. Imagine getting an entire company for free, because that's what happens with net cash net nets. If you spent $1 million to buy a company that has $1 million in net cash, then you are essentially just swapping the same value in cash and getting a free firm for your trouble. As unrealistic as it sounds, I've managed to invest in a few of these with great results.

A Simple Current Ratio Check for Stability

While both Company A and Company B do not have net cash, Company A has a much better current ratio. Current ratios are more dry, but no less important. You can calculate a company's current ratio by dividing the current assets of a company by its current liabilities. I like to see a large current ratio since it means that the company will have an easier time paying its short-term creditors, even if the firm's current assets take a hit in value.

A large current ratio has another advantage. It indicates NCAV stability. The bigger the current ratio, the more the current assets have to erode in value before the company's NCAV is wiped out. If a company has $100 million in current assets and $90 in current liabilities then a 10% impairment in the value of the current assets would wipe out all of the company's NCAV. A company with $15 million in current assets and $5 million in current liabilities is in much better shape. It has to see its current assets drop in value by 67% before the firm's NCAV is gone.

When assessing how strong this margin of safety is, you should take into account total liabilities. Company A and Company B didn't have much in the way of long-term liabilities. No worries there. Despite its lower current ratio, Company B's situation seemed solid. After some investigation, I found that most of the current assets consisted of government receivables, a customer who could - at the time - be counted on to pay its debts.

Introducing the Rocket Fuel

At this point in the analysis, the numbers point towards Company A over Company B. Both investments seem great, but Company A's current ratio advantage and much lower valuation give it a definite edge. But, these two metrics are not enough to justify dumping all of your money into Company A over Company B. To see if everything is covered, another important aspect of deep value investing has to be analyzed. The soft facts.

Rocket Fuel + The Soft Facts = Blast Off

The soft facts constitute what Peter Lynch called a company's story, and can often make a huge difference in investment returns. While just putting together a portfolio of stocks based on balance sheet figures can definitely yield great results - this is exactly what every academic study of net net stocks has done - a company's qualitative facts can really send portfolio returns flying.

Qualitative characteristics can't be quantified in the way that cold, hard, financial figures can. While debt-to-equity is a solid quantitative figure, the relationship of the creditors with the debtors can be important but isn't expressible through mathematics. The same goes for the attitude of management or legal issues a company may be facing.

Fueling the Shuttle

Speaking of legal issues, let's get back to our two companies. Company A was Meade Instruments (NASDAQ:MEAD) back in December 2011. At that point in time the numbers showed a great investment opportunity but the qualitative facts were a bit off. For one, the company's products were being hammered in the market by consumers and the firm was having a tough time regaining its footing.

A story like this is not enough to exclude a net net stock from being an investment candidate. After all, it is rare to find a "good" company trading at such low valuations and such companies are net nets for a reason and often still work out very well.

However, what worried me was another soft fact. Over the last 4 years, the company had been stuck trading below its net current asset value.

Meade was what I like to call a perennial net net. Perennial net nets are companies that are stuck trading below their NCAV. Of course, some companies are more perennial than others, but the 4 years Meade spent below NCAV was not a good sign.

But What About Company B?

Contrast this situation to Company B, GTSI Corp (NASDAQ:GTSI), which was a new net net. Just over a year prior, it was penalized for unethical dealings when bidding on government contracts. As a consequence, the company was barred from bidding on Small Business Administration contracts in the U.S. for 2 years. That ban was a huge business disruption and hammered the company's stock.

The great thing was that the ban was eventually lifted and GTSI could resume bidding on government contracts. As with the case of Trans World Entertainment, when the ban was lifted it gave way to improved operations. On top of this, the company had fired its CEO as well as a few other top-level executives after the scandal, and was now busy buying back its own shares in the market. Buying back its own stock was a huge signal that management thought the company was undervalued and was focused on improving shareholder value.

While insiders owned 32% of Meade Instruments, GTSI Corp's situation obviously looked better and eventually that fact was reflected in the share price.

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A few months after I picked up the shares, GTSI Corp was acquired for $7.75/share. That amounted to an 86% increase in less than 6 months. Its trajectory is plotted with the red line above. At around the same time, Meade Instruments was bid for at a price just below my purchase price. That bid fell apart and the company ended up being acquired on September 11th, 2013 for $4.52/share. The 43% gain just fell short of the NASDAQ's return during the same period.

What You Should Take Away From This

Quantitative investment strategies can outperform the market by wide margins, and Ben Graham's net net strategy is one of the all-time best. If an investor wants to, he or she can put together a diversified portfolio of net net stocks based on quantitative metrics alone and drastically outperform the market over the long run. The portfolio building is the easy part, but it's the pain of being a loner in the world of deep value investing that you have to endure.

Also, include some soft facts into the analysis for larger returns. Especially when the company's qualitative story paints the investment in a very favorable light.

But, how do you recognize a great qualitative picture when you see it? Well, that's always the hard part. It all just comes down to reading as much as broadly as possible on a range of topics; accounting, competitive strategy, investor psychology, and, of course, net net stock investing itself.

Source: Add Rocket Fuel To Your Net Net Stock Portfolio To Boost Your Returns