Net net stocks are not just cheap stocks. Cheap stocks reference anything where the current stock price is lower than the underlying intrinsic value. Net net stocks are dirty, trodden, haven't had a bath in 10 years types of stocks.
[These companies] are often very troubled - they're facing large business problems that investors just don't think the company can come back from. Sometimes these problems reach to the core of the business, such as a major industry disruption that has all but killed a company's only product.
People like Graham and Buffett have made money with net nets in the past. Both Jun and Bleker have approaches that promise to make money today, approaches that may well be worthwhile. I've thought about checking into them more, but have always stopped short. Why?
I like quality stocks. I prefer companies that are sound financially and pay a dividend. I would much rather have a dozen of those stocks than a basket of stocks from companies that have difficult, systemic problems. That's my style, based on some foundational principles I have long held. For years, I followed a simple screen to find solid stocks:
- The company is debt-free
- The company pays a dividend
- The company has positive cash flow
This actually worked. Companies that do these three things tend to have managers that do what I would like them do. But then something happened. A couple of my investments took on debt. I still liked the companies, and the amount of debt was modest, but I realized my screen was insufficient. I was missing good buys. I needed a better way to evaluate value.
After some looking around, I ran across the net net metrics. At first I was disappointed. I knew of no way to find net net stocks as they were defined. But then I thought, what if I just ignored one part of the calculation? This proved to be one of the most interesting ways I have found to discover the intrinsic value of stocks. So let's look at it.
Net Net Calculations Defined
Net net calculations are figured two ways. The simpler one is the net current asset value (NCAV). The other is slightly more nuanced, and definitely more conservative. It is the net net working value (NNWV). While earnings have to do with how much money a company is bringing in at present, NCAV and NNWC show how well the company has managed the money it has already earned in the past. The calculations do this basically by comparing liabilities against assets.
To illustrate, take two companies that earn identical, amounts of money. The earnings are small because the economy just went into a recession. The first is sitting on a pile of cash and other liquid assets, and still has the ability to put its earnings into interesting things like expansion, R&D, or higher dividend payments. The other has millions in long-term debt and needs to put half of its earnings into paying that down. Which company would you rather invest in?
First, let's consider net current asset value, or NCAV. It's not complicated. It's a sister calculation to the more familiar net asset value calculation. Like NAV, the NCAV considers total liabilities, but unlike NAV, it considers only current assets in its calculations, not total assets. (Current assets are generally: cash, short term investments, accounts receivable, inventory, and a smattering of other current assets.) The version of NCAV I use also does not consider preferred shares to be part of value. So the calculation is:
- NCAV = current assets - total liabilities - preferred shares
Once you have these figures, divide by diluted shares to get the value per share:
- NCAV / diluted shares
Compare that result against the current share price. For it to be a true net net stock, the price needs to be lower than NCAV/share. Graham wanted the price to be at 2/3s of NCAV, or a ratio of 0.67.
So, for example, Movado's (NYSE:MOV) most recent 10Q the numbers are (in thousands):
- NCAV = $494,540 - $134,644 - $0 = $359,896
Divide the NCAV by the diluted shares outstanding to get NCAV per share:
- $359,896 / 23,349 = $15.41
Compare that against the current price. On July 2, this was $22.31. So dividing Movado's price against the NCAV per share gets you Price/NCAV ratio of 1.45:
- $22.31 price / $15.41 NCAV = 1.45
Clearly a ratio of 1.45 is higher than 1.0, and it is roughly double the number of 0.67 that Graham wanted. Those sorts of stocks are hard to find, especially quality stocks with positive cash flow. I have not yet found any that pay dividends. So while a number less than 1.0 is an interesting target, I don't expect to ever hit it. I will discuss this more shortly.
The net net working capital calculation, NNWC, is an even stricter measurement than NCAV. The theory behind NNWC is that if a company is liquidated, the calculation expects that only 75% of accounts receivable will be realized, and only 50% of the value of inventory. This is the version of the calculation I've been using:
- NNWC = (0.75 * accounts receivable + 0.50 * inventory + remaining current assets) - total liabilities - preferred shares
12 Selected Dividend Payers Evaluated
Let's put the calculations to use and see what we find. Here is a chart of twelve dividend payers, ordered by NCAV. Following that are a short descriptions and a few observations about each company. I will start with the bottom of the list and work up to the top in my discussion:
10-K filings for quarters ending March or April. Prices were taken from BigCharts.com after market closing on July 1st, 2016.
Apple (NASDAQ:AAPL): I have more than doubled my money with investments in Apple in the past, but no longer hold any shares today. It may indeed be a great investment still, but its total liabilities more than quadruples its current assets, so it no longer passes my NCAV screen. I have included it here only for comparison purposes.
MasterCard (NYSE:MA): If you think this financial services provider has a model is like its competitors, you may want to look closer. It just barely passes my screen with a positive Price/NCAV of 466.04. That is a far, far cry from 0.67 or even 1.0. Analyses I have read recently still expect it to grow even bigger than it already has, but the stock has gone sideways the last twelve months, and it may be breaking out of the steady, upward trend it has had since 2008. I continue to watch it closely.
Tractor Supply Company (NASDAQ:TSCO): Except for Apple, I have made more money with this investment than any other, but the Price/NCAV is at 30.07. I have wondered if the price over the last couple of quarters reflects that. Its has also gone sideways the last twelve months.
Since the NNWC discounts inventory heavily, the ratio is harder on retailers than many other stocks, and it is not surprising that Tractor Supply Company has a negative Price/NNWC of -38.79. But as we will see, some retailers still do just fine with NNWC.
Healthcare Services Group (NASDAQ:HCSG): As its name implies, Healthcare Services Group provides a variety of services to the healthcare industry, such housekeeping, facility maintenance, and food services. Its P/E is always at a premium, probably because it is a favorite of dividend hunters, and because of its steady consistent growth year after year. I was actually surprised to find its Price/NCAV of 15.06 is not higher than it is.
Nike (NYSE:NKE): Nike is best known for its shoes, but it has been making strides with its athleisure clothing. While its Price/NCAV is slightly lower than Healthcare Services Group, its Price/NNWC is higher, due to higher inventory levels.
National Oilwell Varco (NYSE:NOV). The company has taken a horrible beating along with the rest of the oil industry the last couple of years. A fair bit of its income has dried up with the drop in oil prices, and billions of its backlog has vanished. However, it still has positive cash flow, and it still pays a dividend. Whether it has seen bottom or not is still a matter of debate, but there is not much question that it is one of the strongest players in the industry. A Price/NCAV of 7.48 is not necessarily a bargain rate, but it is considerably better than MasterCard, and is still well worth watching.
Robert Half (NYSE:RHI): The company offers staffing services. It is dependent upon employment rates around the world, and is sensitive to economies. At just over $38, the price is down considerably from over $60 a bit more than a year ago. It now has a Price/NCAV of 7.28. In comparison, competitor Manpower (NYSE:MAN) has a Price/NCAV of 14.89. (Manpower is not in the chart above.)
Cisco Systems (NASDAQ:CSCO): At the risk of oversimplification, Cisco makes hardware for the internet. Of the large companies I am watching, it has the best Price/NCAV at 6.55. It is also noteworthy that Cisco's liquid assets of cash plus short term investments alone are greater than total liabilities. Its price is currently at the top of the band it has been trading in for the past two years, so I will wait to buy in.
Cato (NYSE:CATO): I have read more than one article that wonders how Cato can command the price it does. I suspect one reason is that few retailers or many other companies can match its value. Its Price/NCAV is 3.87. None of the retailers on my watch list have that number. It is even more remarkable considering that company's business is in clothing retail, a difficult industry to even survive in. Its short term investments alone are greater than its total liabilities. Its $/NNWC is 5.43, proving that retailers can achieve great value even by that metric.
Graham (NYSEMKT:GHM): According to its last 10-K, Graham "designs, manufactures and sells critical equipment for the energy, defense and chemical/petrochemical industries." It has long been at the top of my list for value. Its Price/NCAV is 2.74.
Miller Industries (NYSE:MLR): At one time, Miller was investigated for having on a monopoly in the tow truck industry. It did not, but Miller remains the market leader in the business. Their factories have been running close to capacity, but they have been expanding those factories. It is an interesting story, and I hope to write another Seeking Alpha article story on it soon. Its Price/NCAV is 1.97.
Movado Group: Movado makes watches. They have a remarkable Price/NCAV of 1.45. They have more cash than total liabilities. They have been regularly increasing their dividend, and have been reducing outstanding shares. I recently wrote about the company in this article.
Both the NCAV and NNWC of the stocks I watch are fairly stable from quarter to quarter, so the metrics are valuable for determining underlying value, even when the stock prices are in flux. For example, if a company has a price of $200 and a NCAV of $10, it will have a ratio of 20. A 20% drop in price will drop the ratio to 18. While that is significant to the individual stock, it is not a great difference when comparing against stocks with a NCAV of 4 or 100.
NCAV provides an effective screen. I don't even look at a stock now unless it has a positive NCAV. In other words, a positive NCAV has replaced my requirement that a company be debt-free. I figure that if a company has enough current assets to wipe out every single liability it has, including debt, the debt is quite manageable.
NCAV and NNWC were originally meant to evaluate the liquidation value of companies. The companies I watch, including the companies on the list above, most likely will never be liquidated. The NNWC usually matches the NVAC when ranking companies, and often penalizes companies with high amounts of inventory, such as retailers. The NVAC is easier to figure. As a result, I use the NVAC more, especially for the initial screen.
Net net metrics provide an objective view of whether a net net stock's price has a low risk of falling. In general, the closer a stock gets to a value of 1.0 by either NCAV or NNWC, the less likely the price will drop more. This may be true for net net stocks, but I have found it to be less true for stocks such as those found in the list above.
Since both the NCAV and the NNWC rely on current assets, they do not work for financial institutions or other compaines that do not report current assets.
As I have used NCAV and NNWC, I have made several interesting discoveries:
- Bigger companies tend to have higher NCAVs, and better value can more often be found in smaller companies.
- As has been stated earlier, price swings do not greatly affect ratio comparisons between stocks.
- As a company approaches a Price/NCAV of 1.0 and net net status, the greater its value, but the more likely it is to have some problem that makes it an undesirable buy. For instance, the top company on my chart, Movado, is facing the disruptive technology of smart watches. Graham has business with the oil industry, nuclear energy, and the U.S. navy, any one of which makes it undesirable for many people. Cato has great value, and does an incredible job as a retailer, but it nevertheless competes in a very difficult environment. So further due diligence is needed to determine risks.
- A sweet spot seems for Price/NCAV seems to be somewhere between 2.0 and 7.0. I will continue to watch those numbers. Having said that, any company with a positive NCAV deserves further consideration.
The net net ratios NCAV and NNWC can be valuable in determining the intrinsic value of stocks. As such, they can be used as a screen. The twelve stocks evaluated in this article are worth further research.
Disclosure: I am/we are long GHM, HCSG, MA, MLR, NKE, RHI, TSCO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.