I've been thinking about a mechanical investment strategy more often nowadays than ever before. Ever since I created the theoretical, Rising Sun Portfolio, a more mechanical approach to investment management has been making more sense to me. At the same time, I enjoy the research approach for investing in individual stocks and believe that picking individual stocks will continue to produce a significant amount of utility for me. But on the other hand, a mechanical strategy where I buy cheap stocks, sell them when they hit my intrinsic value and buy more cheap stocks - rise, wash, repeat - appears to be very attractive and seemingly emotionless.
Investor emotions are powerful and I am not totally sure my emotions are 100% in check. Writing on Seeking Alpha has helped in regard to understanding my investment incentives. However, to say I one-hundred percent know the epistemology of my decision making would be ignorant - to say the least. Moreover, I do not think I will ever understand the reasons why I do some things and the reasons why I don't do others down to the dot. What I am trying to say is: I think my emotions could significantly damper my long-term returns.
But what if investors could somehow become more mechanical in their investment approach - blocking out all negative and even positive emotions? Does a machine like approach to investing make sense to you? It certainly makes sense to me. Likewise, if possible, what is the best way to approach a mechanical investing strategy? In my opinion, a diversified basket of net-net stocks - seems to be the best tactic.
The mechanical approach that makes the most sense to me is a net-net strategy. Net-nets have historically outperformed the greater market - 28% or so historical compounded returns - you can't beat that. However, given that net-nets have historically outperformed the market, why doesn't everyone adopt this investing methodology? Furthermore, wouldn't so many people jump on the net-net boat that the returns would eventually dissipate - going back to the theory that if there is a $100-dollar bill on the street, it probably doesn't exist, since someone would have picked it up already.
There are a few reasons why the net-net approach continues to be relevant. Furthermore, the approach will most likely not be halted by the efficient market theory anytime soon. For theoretical aspects, why does the net-net approach continue to work?
I think there are a few reasons the net-net approach works and continues to work. The biggest reason why it works is due to the garbage investors using the approach are forced to buy. Net-net stocks are not best companies out there - in fact, they are some of the worst ones; how else would they have gotten into the net-net position?
There is a huge psychological hurdle one must jump over in order to buy the ugliest and hairiest securities out there. Buying net-nets are not like buying Coca-Cola (NYSE:KO), Amazon (NASDAQ:AMZN) or Apple (OTC:APPL) - high quality securities that are great compounders of capital. You are effectively buying a company that has been beaten down by the market so much that it is now selling below its net current asset value. And the thing is, these companies have been beaten down by the market for a reason - and its usually not a good reason, but a very horrid reason.
For an example, a net-net could have been beaten down due to an entrenched management team - that is not shareholder friendly - Barnwell Industries (NYSEMKT:BRN), Richardson Electronics (NASDAQ:RELL) and Surge Components (OTCPK:SPRS) are a few real life examples. Another example is due to secular declines in the business model or the loss of a key customer - Emerson Radio (NYSEMKT:MSN), Outerwall (NASDAQ:OUTR) and Trans World Entertainment (NASDAQ:TWMC) should ring a few bells. Overall, net-nets are not high quality companies and investors using the approach are forced to buy the crappiest companies out there - say goodbye to long-term compounders such as New England Realty Associates (NYSEMKT:NEN), National Oilwell Varco (NYSE:NOV) and Infusystem Holdings (NYSEMKT:INFU).
A second reason why the net-net approach works and will continue to work is due to the small factor. Most net-nets are micro-cap stocks that no one talks about. This not only forces big money out of the picture, but many retail investors as well. Furthermore, micro-cap investing is perceived as risky by the majority of the crowd. Thus, the investor who wants to adopt the net-net approach will not only have to buy garbage securities, but they will have to buy garbage micro-cap securities - sounds like a double edged sword.
An example of the small-factor can be seen in the seven US net-nets that I know of: Emerson Radio, Allied Healthcare Products (NASDAQ:AHPI), LiveWorld (OTCPK:LVWD), eRoomSystem Technologies (OTCPK:ERMS), Universal Power Group (OTCPK:UPGI), Surge Components, and CCOM Group (OTCPK:CCOM), with market caps of $23 million, $4.66 million, $1.50 million, $1.65 million, $7.38 million, $8.07 million and $3.94 million, respectively. And this now brings us to the third reason - the net-net approach needs international stocks to be successful.
For whatever reason, there are not many US net-net stocks around. Maybe it is because the market is more efficient in the US and people know the strategy works. Or maybe it's because there hasn't been an economic correction in a while. Whatever the reason, net-net investors are forced to look internationally.
International investing is a psychological hurdle in itself. First, there is the language barrier. Secondly, there is a lack of GAAP accounting. Thirdly, you have to deal with exchange rates and foreign taxes. And finally, there are vast cultural differences. Investing in your home country is easy. GAAP accounting exists, you know the language and you can see the companies/products with your own eyes. Unless you plan on traveling to Japan in order to see the company and product you are investing in, it will be more than a psychological challenge investing globally.
I also think the hurdle of investing in net-nets internationally will always be a significant barrier - thus, providing opportunities for the investors willing to pick this low hanging fruit. Moreover, buying lousy companies, that are micro-caps, all on an international basis - doesn't sound like the best strategy out there. However, the historical returns prove otherwise.
So how should an investor build a portfolio of net-nets? Well for one, I don't think a concentrated strategy is the best idea. You are going to want to hold a well-diversified basket of these companies. I would say the minimum of 20 - if not more. The reason for the diversified approach is two-fold.
First, if you hold a concentrated portfolio, you will most likely get burned. Remember, net-nets are lousy companies. You are buying for mean reversion. Having too much concentration in any single net-net puts your portfolio at risk of underperformance. Moreover, it's hard to tell which net-net will experience mean reversion or which one will continue to be beaten down. Diversification helps to protect against this.
Secondly, if you have a concentrated portfolio, I believe the net-net approach will become less mechanical and have more emotions involved. A concentrated portfolio requires a significant amount of deep research. Doing deep research on net-nets is the antithesis of a mechanical strategy - you will start to have biases from the research and emotions will get involved.
In my theoretical portfolio, I hold 19 net-nets, consisting of Japanese, Hong-Kong and Singapore securities. In the near-term, I would like to increase the position size of the fund to at least 25 securities. In regard to position sizing, each position represented the same size initially. This was done so there were not any biases involved with one security over the other.
As for selling, I have dabbled with selling once a stock went up ~50%. This methodology was the Walter Schloss approach - which he argued selling is one of the hardest things to do in investment management. Thus, selling once a security hit 50% took a lot of emotions out of the playing field.
However, I have decided to not use this approach and wait for a sale once the security hits or gets relatively close to its calculated NCAV. I feel like this will allow for higher upside potential. I am sure as time passes I may change my selling strategy.
If the net-net approach intrigues, you, where should you start? Well for one, you can take a look at my theoretical portfolio and build your portfolio off it. Two, you can screen for net-nets and build your own portfolio. Three, you can use the following list as starting point:
Imperial Ginseng Products (OTCPK:IGPFF) - Canadian
Logan International (OTC:LIIZF) - Canadian
Newnorth Projects (NNP.V) - Canadian
General Commercial & Industrial (GEBKA) - Athens
IRCE SpA (NYSE:IRC) - MILAN
Newsphone Hellas SA (NASDAQ:NEWS) - Athens
Solar Company S.A. (NYSE:SOL) - Warsaw
KDM Shipping Public Limited (KDM) - Warsaw
TTA Holdings Limited (TTA.ASX) - Australia
PV Crystaloz Solar PLC (PVCS.L) - London
Enteq Upstream Plc (NTQ.L) - London
Scholium Group Plc (SCHO.L) - London
Mobile Stream Plc. (MOS.L) - London
Holders Technology (HDT.L) - London
Odawara Auto-Machine (7314) - Japan
Chuokeizai-Sha Holdings (9476) - Japan
Fukuvi Chemical Industry (7871) - Japan
Jedat Inc. (3841) - Japan
Tokyo Radiator Mfg. (7235) - Japan
Nakakita Seisakusho (6496) - Japan
Finally, there are a handful of Seeking Alpha contributors who focus on the net-net approach that are worth following:
If you think the mechanical approach of buying cheap net-net stocks sounds intriguing feel free to message me or leave a comment. Furthermore, I would love to hear your approach to net-net investing - or why one shouldn't invest in net-nets.
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Disclosure: I am/we are long BRN.
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.
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