Intro to Net-Net Investing
Benjamin Graham, considered by many to be the father of value investing, popularized a systematic approach to buying companies at far less than their intrinsic value (i.e., with a wide margin of safety). This approach is largely insulated from institutional investors and remains a somewhat inefficient market today. These are often referred to as cigar-butt businesses, as they have been discarded by investors but may have a few good puffs left in them.
This technique is called net-net investing, due to buying a company for less than its net-net working capital (or net current asset value, depending on which method you choose). This is an extremely conservative approach to equity valuation, as it takes into account only cash-like assets and often discounts them in the case of adverse events.
Effectively, this means that if the company trading at below its net-net working capital were to be liquidated today, shareholders would earn a handsome return. I would argue that not doing so (or at least aggressively buying back shares) is a violation of their fiduciary responsibility -- but until then, inefficient markets are our friend. If you’d like to read more about net-net investing, I highly recommend The Intelligent Investor and Security Analysis by Ben Graham, as well as this introduction.
I’ve only recently begun investing in net-nets, with my first purchases occurring on July 31st. The returns have been fairly promising, beating the market at the time of writing by 0.61%, despite being slightly negative (-1.59%). Some drawdowns are to be expected when investing in net-nets, as they are, by definition, distressed companies and often have good reason to trade at depressed valuations. This figure is promising, and is certainly a satisfactory return for the timeframe and market conditions.
In any case, let’s get right to it -- I’ll discuss how to go about identifying net-nets in today’s changing market, give you my own software to analyze balance sheets and validate a screener, illustrate how to filter out companies that aren’t likely to provide adequate return, and my current list of net-net holdings.
Step 1: Screeners
My favorite screeners for net-nets have been from fintel.io. Though they do require due diligence after the fact, the tools themselves are fantastic and the free access to fundamental data is almost unparalleled (short of reading a balance sheet yourself). Some other resources offering net-net specific coverage include Net Net Hunter, GuruFocus, and sometimes TheStreet. A net-net screener is always the best way to start looking for these cigar-butt deals, so let’s start with this net-net working capital screen from fintel: https://fintel.io/screen/nnwc-net-net-working-capital-screen
Generally, you should start with sorting by market cap so you can tailor your selection. This will help sort out companies that have bad data or have been delisted. A simple click on the company’s name will take you to its fundamentals page, where you can view key statistics and its price to net current asset value. SeekingAlpha is my go-to resource to analyze a balance sheet, and I almost always find that data to be the most reliable (even more than paid sources).
You can simply plug in the figures from the latest balance sheet into this formula to get its net-net working capital:
NNWC = Cash and short-term investments
+ (0.75 x Accounts Receivable)
+ (0.5 x Total Inventory )
– Total Liabilities
NNWC is a fire-sale liquidation price. For a slightly less conservative valuation, this formula for net current asset value will serve you just fine:
NCAV = Current Assets - Total Liabilities
When using NCAV, Ben Graham recommends that the market cap of the company is less than 2/3rds of net current asset value. Given that markets have changed somewhat since Graham’s day and net-nets are far less prevalent, I believe there is some room for flexibility here, but investors should bear in mind that this comes at the expense of your margin of safety.
Step 2: Read the balance sheet - or automate it
However, if you don’t want to do these calculations manually and feel like you’re sure enough that a company is a net-net, I wrote a Python script to analyze balance sheets and ascertain a company’s price to NNWC and NCAV. I won't link to my own tool for this, but Web scraping or interfacing with your favorite market data API is trivial enough.
Automating these kinds of operations has been invaluable to me in investing and elsewhere. It allows you to be much more efficient in your security analysis, and is far from complex once you pick up the basics. I recommend Automate the Boring Stuff if you want to learn how to do this.
Step 3: Make sure you won’t lose money
Once you have your list of net-nets and have ensured that the screener has accurate data when cross-referenced with the balance sheet, you may feel like you’re ready to start buying. Not quite! Often, there’s a reason companies trade below their liquidation value -- notably, biotech firms require a large cash runway to attempt to develop a marketable product and generally fail at it. This may leave us with a cash-rich company that burns through it with nothing to show within just a couple of years, which is no good for shareholders. This is an example of efficient markets in the net-net world. As a rule, I filter out all biotech companies (unless they are profitable and will probably remain so) from my net-net operations.
Another such case of efficient markets is when a net-net company dilutes their shares by issuing more equity. This doesn’t actually make sense -- since shareholders own the assets of the company (in proportion to the shares they hold), it would be good for shareholders to initiate buybacks rather than further dilute. However, due to the popularity of index funds and lazy managers, scarcely any shareholders actually assert this fact – even when it is clearly in their interests to do so. As follows, I also eliminate companies that have been diluting shares to an unreasonable degree or indicate plans to do so. On the other side, buyback activity is a positive catalyst for a net-net investor as it means that management is willing to act to restore shareholder value and increase the price at least to that of liquidation value.
Some net-nets trade at a depressed valuation due to pending legal action, potential fraud, or overexposure to a single customer. This should be taken in a case by case basis -- Nova Lifestyle (NVFY) is a great example of this with their pending lawsuit alleging fictitious sales, which may warrant a greater margin of safety than another net-net company.
When you feel that you truly understand the company, pull the trigger and buy. Graham recommends that you sell off the holding once it reaches a fair value -- around net current asset value. You might miss out on further gains, but generally net-nets are not fantastic businesses that are worth holding forever.
A net-net strategy has generally returned in excess of 20% historically. Because markets are more efficient than they were in the past, investors should not expect to earn returns quite that high, but a strong premium is not an unreasonable expectation to have.
My list of “discarded cigar butts”
Currently, I have four net-net holdings and am closely watching three more that have a lower margin of safety. I discovered these companies through the same process I gave above, and bought them in the open market. It’s been quite interesting so far, and I anticipate more articles to come.
Ocean Power Technologies (OPTT)
OPTT successfully deployed one of their signature buoys for a 9-month lease. Wall Street seems happy and the company is receiving increased coverage.
SPRT is trading below net cash.
CSS Industries Inc (CSS)
Analysts expect CSS to turn a profit as soon as next quarter.
Nova L ifestyle (NVFY)
Richardson Electronics, Ltd. (RELL)
The dividend is at risk of being cut since it is not covered by cash flow.
Acacia Research Corp (ACTG)
ACTG is an oddball company and helps patent owners license patents that have been infringed. It has revenue, but often reports net losses.
Flexsteel Industries, Inc. (FLXS)
FLXS makes furniture and targets the USA. The stock has high institutional buying and falling short interest.
Manning and Napier (MN)
Manning and Napier is an investment management company. Such a high payout ratio (140%) is appropriate given the high cash balance, but does indicate an eventual dividend cut.
- Manning and Napier's corporate structure is odd, with public shareholders holding a minority voting interest.
Gulf Resources, Inc. (GURE)
Gulf Resources is a Chinese chemical manufacturer. As with all Chinese firms, there is substantial risk of accounting malpractice.
Shineco is a Chinese health products company. They are known for beginning to integrate hemp into many of their consumer products.
Though this is a smaller list than would be ideal -- Graham recommends a basket of 30 -- I believe net-net investing is not only a fascinating corner of the market, but also one of the few places that skillful investors can still exploit market inefficiencies in an increasingly connected and efficient world. If you have any questions about my software, don’t hesitate to send me a PM -- and feel free to mention some net-nets I’ve missed!
Disclosure: I am/we are long OPTT, CSS, SPR,T NVFY. 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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