The Net-Net Bet

[Lizard]

Not too long ago, I read the following post by Roger Montgomery:

Should a Value Investor Imitate Ben Graham? (http://blog.rogermontgomery.com/should-a-value-investor-imitate-ben-graham/)

He refers to the following investment method:


Ben Graham advocated a mostly, if not purely, quantitative approach to finding bargains. He sought to buy businesses trading at a discount to net current asset values – what has been subsequently referred to as ‘net-nets’. That is, he sought companies whose shares could be purchased for less than the current assets – the cash, inventory and receivables – of the company, minus all the liabilities.

He concludes that:

Many investors cling to the Graham approach to investing even though some, if not many of his brightest and most successful students, moved on decades ago.

I found it somewhat odd to think there is a silent bevy of value investors out there looking for "net-nets" - personally, my impression has been that value investors have been looking at a lot of different parameters in the last few years - P/E, yield, ROE, PEG and even EV/EBITDA always seem to get many more mentions than net working capital. And for at least 5 years prior to 2007 (and perhaps more like 15), it seemed almost impossible to find a company that fitted the Ben Graham description - particularly not one that was booking a profit.

Now since this is one of those rare occasions in my investing career when it might be possible to find enough net-nets, I thought perhaps we should test this!

Roger is comparing against his own, mostly ROE-based, style of investing. I thought it would be interesting to find perhaps 10 net-nets and test their performance. (I haven't quite decided what to compare with - perhaps Roger's Valueline portfolio, although that varies in composition).

However, I need help to find more Net-Nets - all they need is lots of current assets, not many liabilities and a market cap that is going to be less than the difference (i.e. start by looking for low NTA).

So far, in the "net-nets" department, I have the following:

AMO - $0.40 - market cap $12.3m, current assets - total liabilities = $17.3m
CPI - $0.29 - market cap $17.9, current assets - total liabilities = $46.2m
ESS - $0.19 - market cap $9.9m, current assets - total liabilities = $14.0m

Any suggestions welcome!

[h2so4]

Careful Lizard, you maybe inviting a P chart onslaught.

[Lizard]

Careful Lizard, you maybe inviting a P chart onslaught.

Wow!

Time for a break... :huh:

[Snoopy]

However, I need help to find more Net-Nets - all they need is lots of current assets, not many liabilities and a market cap that is going to be less than the difference (i.e. start by looking for low NTA).


NZS - $0.44 - market cap $NZ107.5m, current assets - total liabilities = $US162.0m or $NZ231.4m

based on a $NZ1 = $US0.7 exchange rate

SNOOPY

[Lizard]

Thanks Snoopy, much appreciated... I will take a look!

I did consider CSS, but I am not really willing to count the valuation of biological assets under IFRS as being equivalent to the valuation methods of Ben Graham's day.

[shasta]

Thanks Snoopy, much appreciated... I will take a look!

I did consider CSS, but I am not really willing to count the valuation of biological assets under IFRS as being equivalent to the valuation methods of Ben Graham's day.

Liz

Have a look at the MLM thread, is that the kind of company you're after?

[drew]

Correct me if im wrong but thought the Net-Net investment is where the market cap that is 2/3rds or less of working capital to give a sufficient margin of safety?

[Lizard]

Hi Shasta,

The main criteria for a net-net is that if total liabilities are subtracted from current assets, the remainder is greater than the market cap. In the case of MLM, I get the difference of $22.7 - $9.2 = $13.5m, while market cap is $27.5m, so it wouldn't pass the hurdle.

Ideally (if I was actually going to be buying them), I'd also want companies that expected to be profitable in the current period. However, I'm not sure if I will find enough of them for this experiment! So I'm interested to follow the progress of any shares that pass the net-net test.

[Lizard]

Correct me if im wrong but thought the Net-Net investment is where the market cap that is 2/3rds or less of working capital to give a sufficient margin of safety?

I think in Ben Graham's case, his team typically purchased at two-thirds of net working capital, but I don't think it was an exact criteria.

I'm not so fussy - if I actually decided to buy any, they'd have to jump a few more of my own hurdles first anyway. This is just a paper-based exercise and still not sure we'll find enough stocks for this experiment.

[CJ]

However, I'm not sure if I will find enough of them for this experiment! So I'm interested to follow the progress of any shares that pass the net-net test.In the information age, and with limited amount of options (in NZ at least) I wonder if it will be possible.

[Lizard]

NZS - $0.44 - market cap $NZ107.5m, current assets - total liabilities = $US162.0m or $NZ231.4m

based on a $NZ1 = $US0.7 exchange rate

SNOOPY

Hi Snoopy,
I just got a chance to check out NZS, but it looks like you are using total assets, not just current ones for that calculation. Current assets are only $US30.4m, so they are not going to cover total liabilities.

Thanks for the suggestions. Will keep looking - I'm sure there must be more out there somewhere!

[drew]

I think in Ben Graham's case, his team typically purchased at two-thirds of net working capital, but I don't think it was an exact criteria.

I'm not so fussy - if I actually decided to buy any, they'd have to jump a few more of my own hurdles first anyway. This is just a paper-based exercise and still not sure we'll find enough stocks for this experiment.

Thanks I thought that was the case because I dont recall reading it in any of his books but a lot of the value investing sites/blogs refer to this being his criteria.

Agree that nowadays it will be very difficult to find these type of situations particularly in NZ. The only instance I have seen recently was NPX after it announced its rights issue last year. It didnt quite go as low as 2/3rds of the market cap (post rights issue) but came very close.

I have also seen this kind of low valuation in the US regularly with small caps. In these cases there is usually a reason for the low valuation such as a controlling shareholder/insider, no dividends, low liquidity in share turnover etc.

[Lizard]

Thanks AA. I have the Market Analysis database - not completely accurate, but good enough to screen for low Pr/NTA as starters. Of course the majority that come up have huge amounts of non-current assets (and usually huge amounts of debt to go with it), so don't end up being anywhere near. However, so far have the four mentioned above (if I count CSS in).

I have twice invested in shares which met net-net criteria in the past - LMC and MAQ both did at times and both turned out to be very good investments for me. Neither currently meet the criteria due to increase in their market cap (and, in LMC's case, payment of special divs with excess cash).

Roger Montgomery has done well with his approach, but sometimes his attempts to diss other investors irritate me - in this case, I think he is totally off the mark in his statement that "many investors stick to the Ben Graham approach"... while there may be some that look for low Pr/NTA, it seems unlikely to me that there are more than a handful of investors relying on Ben Graham net-net situations. As we've established, they're pretty difficult to even find! And I don't think he would have sufficient evidence to prove that they don't work either...

I will get back to the search soon...

[Snoopy]

Hi Snoopy,
I just got a chance to check out NZS, but it looks like you are using total assets, not just current ones for that calculation. Current assets are only $US30.4m, so they are not going to cover total liabilities.

Thanks for the suggestions. Will keep looking - I'm sure there must be more out there somewhere!


Yes I was talking about total net assets with NZS. I can see why Ben Graham was considering just current assets, meaning those that can be turned into cash quickly. If a company has enough such current assets to cover all liabilities then it doesn't really matter what other assets the company has. Buying into such a company is a good deal, no matter what.

I would argue that in the case of property companies, where those properties have been independently valued, those properties are as good as cash from an investor perspective. That's because an independent valuation of property is based on the 'best use' value of that property, regardless of the actual use of that property at the time of valuation. The sole reason that property should be considered inferior to cash or stock that can be quit quickly for book value, is that selling commercial property is something that is best done over a matter of months rather than days or weeks if existing shareholder value is to be maximised. From my investment perspective, whether I wait weeks or months is immaterial. But perhaps it did matter to Ben Graham? Perhaps there were a lot more companies actually being stripped of assets in those days?

I must admit I have never targeted looking for 'net-net' shares myself. I considered the chances of finding them was so low that such a specific search wasn't worth it. I am constantly looking for shares selling well below (total) net asset backing though. That is why I think NZS, with all of their farmland assets, is worth a look. Despite not meeting 'that' Graham criterion.

SNOOPY

[Lizard]

Found a rather mixed bag of possibles last night:
ASC, CLT, CMI, EPY, GLE, HIT, PPX...

PPX by far the largest and most liquid - and also going in the right direction today. (What is it about the print industry and having a very low receivables turnover?)

I will keep looking and also go back and check these ones for any fish-hooks such as quasi-equity or in-the-money options that I didn't pick up in a quick screen.

[Lizard]

Just updating the thread to summarise the shares being followed and cover a couple of results... List of shares was AMO, ASC, CLT, CMI, CPI, CSS, EPY, ESS, GLE, HIT, PPX.

So far, average return is 9.1%, helped by a star performance from ESS on Friday result (now up 89% since start date) and a strong showing from ASC (up 36%). Of the remainder, 3 are unchanged, 2 are positive and 4 are negative - with EPY the worst performer at -13.8%.

ESS reported on Friday and finished at 34cps (up from 18cps at start date). The result included an increase in current assets and a decrease in total liabilities, so the difference increased to $17.2m, but the share price just took it through to $17.8m market cap on Friday, so it no longer fits the criteria. I don't think Ben Graham would have sold at these levels (I doubt it), but I guess he wouldn't be buying any more.

CPI also reported. Both the current assets and total liabilities fell in this case, resulting in the difference increasing from $40.2m to $46.5m. As the share price and market cap of CPI have fallen, the actual discount has improved considerably (market cap only $17.5m). Though it is not a share I would normally hold, it makes an interesting test case as probably the most undervalued at present on the net-net criteria.

[Silverlight]

Post was too big... and also wrong

[Silverlight]

Post was too big... and also wrong

[Lizard]

Hi Silverlight, before I check them all, are they actually selling below current assets less total liabilities? Glancing through your list, I suspect most of them have high non-current assets, so don't meet the criteria.

[Silverlight]

Apologies, to quick on the trigger.


ATR Market Cap 126m vs 170m current assets - liabilities. (as at 30 June 2010).

[Lizard]

Just had a review of a couple more of these from recent results season. CSS, after large cap raising and other events, no longer meets criteria for a net-net. However, probably still an interesting hold.

HIT is ridiculously cheap if it was realistically possible to buy some at current price (1.5cps), as this gives market cap of just $465k - it could go ten-bags and still only be a below-radar micro-spec. Cash on hand is $535k and the company reported an after tax profit of $136k, on revenues of $1.5m. On a net-net basis, it has about $1.5m of current assets - total liabilities. But try and buy some at market and you'll probably spend more on brokerage than you get offered in shares...

CLT is a little more practical to buy. It has a market cap of $25.6m (at 35cps) and net cash on hand of $20.8m. It is also still running a $77m revenue business, although margins are slim and profit barely more than the interest received on cash. Possibly somewhat seasonal business too, as first half generally seems better. Outlook statement was optimistic for improvement in earnings in first half.

So far the portfolio is up an average of 14.1%. Best performer is ESS, up 105.6%, worst performer is PPX (which probably shouldn't really be there) at -10.2%. Six are up, two are neutral, three are down.

I will add ATR to the list to look at. Thanks Silverlight.

[buns]

I will add ATR to the list to look at. Thanks Silverlight.

Hey Liz, I would be interested in your thoughts on ATR and these types of companies (well mentioned round here CFE nearly fits the bill), and if it meets the Net Net criteria..

These companies essentially hold a load of cash but do so because they have large projects around the corner. The projects are quite often start ups in the smaller cap companies so do carry increased risk, and you never really know how the business case stacks up. ATR for example are essentially creating a whole company around Donald mineral sands out of Melbourne, this requires a huge outlay early on with profits coming in steadily in the future.

Surely these don't meet the net net criteria, as the cash is just a timing thing, and not created by operations.

So, I think any resource company could pretty much be excluded from this investment strategy.

[buns]

Thinking out loud here..Aren't all of these situations where companies are cashed up, essentially temporary, or just timing differences? What kind of well run company would hold such cash for any period of time?

They are missing out on two things
1 - Paying out FCF in dividends
2 - Dipping into FCF for new projects

If a company has a high cash balance for quite some time, I would begin to wonder do these guys even know what they are doing? Then when they eventually do spend this money, can you trust what they have spent it on will add value to shareholders?

[Lizard]

Here is another one for the list that I stumbled across today:

MOD - Medical Corporation. Market Cap $4.9m (at 2.0cps), current assets-total liabilities of $6.2m.

Having said that, it doesn't appear that they do very much beyond tweaking their investments and supposedly looking for something new to do - not something I'd want to buy. But, this being an experiment, I will add it to the watchlist.

[CJ]

If a company has a high cash balance for quite some time, I would begin to wonder do these guys even know what they are doing? Then when they eventually do spend this money, can you trust what they have spent it on will add value to shareholders?And how much cash does Microsoft hold??

Just kidding - I know what you are saying. You are essentially gambling that they will find a good investment before they burn through the cash.

[Lizard]

HIT is ridiculously cheap if it was realistically possible to buy some at current price (1.5cps), as this gives market cap of just $465k - it could go ten-bags and still only be a below-radar micro-spec. Cash on hand is $535k and the company reported an after tax profit of $136k, on revenues of $1.5m. On a net-net basis, it has about $1.5m of current assets - total liabilities. But try and buy some at market and you'll probably spend more on brokerage than you get offered in shares...

Overall the net-net portfolio is going quite well, up 27.5% since start (21 June). The lead is held by ESS, with a gain of 192%.

However, also influencing the result is the small and illiquid HIT (see quote above), up 67%... so I am going to be totally upfront and admit that this is just because I finally managed to buy just a few yesterday at 2.5cps! However, I also want to note that the agm today says revenue is up 49% for first quarter and that NPAT is likely to be in the $500-$750k range. So, even though this is the craziest, most illiquid thing I have ever added to my portfolio (and most will know that I've added a few daft and illiquid buys in my time), I reckon that at a forward P/E of about 1.3 and EV/EBIT not much above zero, this has more than an even chance of working out okay...

[Lizard]

The net-net portfolio hasn't done too badly for six months - currently up 58.1% since mid-June.

Best performer, ESS, will probably have to drop out with a takeover offer at 73cps (it entered the portfolio at 18cps). Second best performer is HIT, now at 5.3cps (entered at 1.5cps). Worst performer is PPX (down 34%) - which was a dubious entrant due to not counting the quasi-equity on issue. Also in the paper realm, CPI has fallen slightly. AMO a disappointing retailer, down 20%.

Late entrants, ATR and MOD are both up (10% and 50% respectively). Reasonable performances from CLT and EPY at around 36% each.

[robo]

[QUOTE=Lizard;329609]The net-net portfolio hasn't done too badly for six months - currently up 58.1% since mid-June.

Not too badly........58% for six months, you are a modest person lizard, welldone I'd be happy with 20% in six months.

I wish I had read this thread in june when it started damn

[Lizard]

Well recent entrant, MOD, looks to have turned into a little back-door play and, post trading halt, has leapt up in price today - currently trading at 14.5cps (entered at 2.5cps). MOD and ATR replaced PPX and ESS in the portfolio.

With this latest jump and continued move in HIT, the portfolio is now up 106%. Apart from the (removed) PPX (later determined not to qualify), the only share on the 11 member list to fall is now AMO, down 17.5%.

Overall, although this strategy has relied on some rather dubious and illiquid investments - and the returns were probably not achievable with any significant amount of money - the results to date suggest that Benjamin Graham's net-net strategy is not to be sneered at...

[Lizard]

Well, after MOD flew away on a wing and a prayer yesterday, I have had a hunt around for something to replace it in the net-net portfolio and managed to track down TSH. However, I'm not convinced it has bottomed yet - still making losses, so I wouldn't be super bullish about this one yet. But might have some potential in another 6-12 months...

[Lizard]

CPI scheme of arrangement for takeover, so another score for the Net-nets, with an 80% gain over the June starting price of 25cps.

Going to have to find another one to replace it!

[Lizard]

Adding CLS at 75cps. Has market cap of $3.5m and net current assets of $12.2m. A few different strands to the business, so could be some potential here - although the company is pretty taciturn, without even an agm presentation, let alone shareholder update.

Even 50k on the offer, so buying is feasible... though normally pretty illiquid.

[Lizard]

Well, after MOD flew away on a wing and a prayer yesterday, I have had a hunt around for something to replace it in the net-net portfolio and managed to track down TSH. However, I'm not convinced it has bottomed yet - still making losses, so I wouldn't be super bullish about this one yet. But might have some potential in another 6-12 months...

The TSH half year report really couldn't have been much worse and it is now down 20% from the entry price of 5cps. So glad I wasn't convinced enough to buy it. Despite lower market cap, it has fallen outside of net-net parameters for now due to reduced cash and higher debt. Could well be curtains for them if they can't convince the bankers things are back on track by 31 march.

Am taking them out of the (paper) portfolio for now, but still worth keeping watch on them as a possible turn around.

[mamos]

Great results.

I'm invested in a few of these in Singapore. One currently has net cash at 30% discount to MC. Also strongly cash flow positive. Hopefully this limits the downside risk.

The problem is the companies in SGX small-caps generally have poor capital management so the valuation gap is hard to close. Unlikely to pay dividends or buy back, just hoard cash.

[mamos]

Unbelievable.

The question is does the cash exist?
3239

[Lizard]

Interesting stuff, Mamos.

I can see why they have the last column - one of the most frustrating shareholder situations has to be knowing a company has cash or substantial assets and watching powerlessly while major shareholders and management find a way to divert it all to their own benefit.

If I had to pick one off that table without further research, it would have to be Cacola Furniture... now I'm tempted to look it up and find out what the catch is!

[Silverlight]

Hi Lizard,

Does PPP fit the net-net requirements?

Trading below Cash, and no debt.