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How To Sidestep Blowups In Net-Net Investing

"If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that."

- Warren Buffett, 1999 Businessweek interview.

Buffett was a true blue Ben Graham follower in the 1950s, investing in companies that were trading well below liquidation values, like Sanborn Maps. These types of companies are known as "net-nets" because they trade at prices net of all liabilities deducted from adjusted net working capital". In other words, these companies are worth more dead than alive.

Of course, markets have changed since Graham's era and Buffett's early days. But even today, small investors using the net-net approach have done tremendously well, beating the markets with several percentage points.

I spent some time today finding net nets. I found one company that looked great at first glance. But alas! Here's my quick take on the company and why I would not touch it with a 10 foot pole.

Current Market Cap = SGD 37.5 million

Current Assets - All Liabilities = SGD 85.85 million

So it looks great, right? Theoretically, if I could buy up all the stock through the public market and liquidate the company, I can can double my investment.

But in reality, I know that I am just going to be a passive minority shareholder, having no influence whatsoever with the management.

So, I have to rely on the management to take action so that the market price of the shares reflect at least the underlying asset value through a) improvement in business performance b) liquidation or sale or c) return of capital in the form of dividends or buybacks.

So how should I assess if the company's management can be entrusted with my money? Well, Buffett says you should ask if the management are a) good operators b) good capital allocators and c) honest and shareholder friendly.

For a long time I didn't know what that meant, but in this case all I had to do was look at the number of outstanding shares to know that my money will be sunk if I buy this stock with the current management in charge.

Fully diluted outstanding shares (millions of shares):

2010: 151.8

2011: 315.6

2012: 378.3

2013: 398.4

2014: 450.7

The share count has been going up at nearly 25% per year. That's spectacular! In other words, if I owned 10% of the company five years ago, I would only be owning 3% of the company today, assuming I didn't buy any more shares. The shares would need to triple in price for me have a flat return - which is a hereculean task. So, clearly, this management is not shareholder friendly.

I have to ask myself, which CEO issues new shares when traded share prices are so low that they are below liquidation values?

Well, the answer is either a) a CEO who's not a good capital allocator, or b) the management are probably issuing shares to themselves in the form of stock options, etc. (I haven't verified this, but there are some indications in the financial statements to suggest that).

The whole analysis took 10 minutes, but its clear that this stock have all the makings of a value trap - an investment that looks like a bargain, but forever remains a bargain, sinking your money in the process!

I have deliberately left out the name of the company and other details. It is Singapore listed, China connected, and in the tech/media sector. The idea of this article was to highlight the investment process rather than to provide comments on a particular stock.

I'm planning to write a series of articles to help readers become more successful value investors. Please let me know your feedback on this article and suggestions for future topics. Thank you.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.