Sunday, August 5, 2012

What is a Net Net Investment

What is a net net?
A net-net is a stock that is trading below the value of its current assets (cash, receivables, inventory) minus all liabilities (short term liabilities, long term liabilities, all debt). A value this low is really an absurdity. In theory a net net could be liquidated and would give a positive return to shareholders if purchased at the current price. Moreover, given that property, plant and equipment aren't included in the calculation, the value those fixed assets could provide even more possible upside if a company actually decided to liquidate.

The reality is very few net net's actually liquidate themselves because management would be out of a job. So while a company might be trading below a conservative liquidation value it is typically unreasonable to actually expect a net net to liquidate. A better way to look at liquidation value is as an absolute downside. Very few sales of entire companies that occur at arm’s length involve one company purchasing another for less than working capital, or for less than net current asset value (NCAV).

If it's unreasonable for a business to sell to a private buyer for less than net current NCAV why do such things happen in the stock market? I will get to that in a moment in discussing investor objections to net net companies below.

The margin of safety concept is that as an investor makes assumptions about an investment, value of assets, future earnings, and quality of management and as they do they need to build in padding to their estimates to account for errors. A net-net gives a built in margin of safety, a business with a lot of warts is presented for sale at far less than a reasonable outside buyer would pay. To use the extreme example if the company was wound down even in that situation the net-net buyer would expect a positive gain.

As I work through different objections I've heard over the years by the majority of security analysts and fund managers keep in mind the idea that a net is a company selling for less than current assets minus all liabilities or a reasonable liquidation value.

Objections i.e. excuse to not invest
1) The business has no competitive advantage. When I hear this objection I often think of the phrase "To the man with the hammer everything looks like a nail." As I have stated in many of these letters there are many ways to skin a cat i.e. many different approaches to investing, and the franchise style is just one of them. Not every company has a competitive advantage; I would actually argue a true competitive advantage, as referred to above, is very rare. Investors are able to convince themselves they see one at every turn of the road, but I think that's just a bit of confirmation bias. I've seen some writers even mention that a net net has a competitive advantage, I have news, if a company has a true competitive advantage it's not selling for less than NCAV.

Most companies are in competitive industries and earn a normal profit, a franchise company might i.e. a company with a moat around its business will earn an above average economic profit. A net-net in 99% of cases is not a company with a competitive advantage, if they had one why are they selling below NCAV? (In the last thirty years we have found some—truly overlooked or ignored by otherwise intelligent investors—and they were grand slam-like sensational to the nth root investments. The last one we had which qualified was Compass Knowledge.)

A company doesn't need to have a competitive advantage to be successful. There are millions of businesses in the world that continue to pay employees and make their founders rich that have no advantage whatsoever. The companies have a small piece of market share in a crowded space, but it's enough to earn a profit, which is what matters.

While a competitive advantage allows a company to earn an above average return, when evaluating a company selling below NCAV we don't need an above average return to be successful, any profit will be fine. In some cases no profit at all is needed because the assets alone are valuable.

2) This is a bad business in a bad industry
This is either the most valid or second most valid claim along with the following one. The problem is when people pose this objection they make it sound as if all bad companies and all bad industries expire eventually. While this would be great, it's simply not true. Many terrible industries continue to persist with companies happily making below average returns. One industry that comes to mind is that of the traditional telephone. Landline telephones and phone calls are in a steep decline yet there are companies that continue to exclusively serve this market, and will continue to serve it for years to come. Even though the demographics are bad wire lines will be around for a long time.
It can be shortsighted to ignore a company in a bad industry or to ignore a bad business because of general industry trends. We would agree with this notion if you are looking for a long term investment where you might want to buy an industry leader, but a net-net isn't likely that. A net-net is a company that even in a bad industry is selling for an irrationally low price.

Indeed sometimes a bad industry is a passing phase. In the 1970s railroads in the US were a very bad industry; they destroyed a lot of shareholder capital. The industry eventually consolidated and now railroads are considered a good industry with a competitive advantage. In the 1970s you could barely give away railroad stock, now Warren Buffett has bought a railroad—a very major investment too it was for his Berkshire.

3) The company's management is bad
This is probably the most valid reason on the list. If a company's management steered the company into the current bad situation and the future course looks to be the same as the past it might be worth passing on the investment.

Don't for a minute think a management's inclination to destroy shareholder value is isolated to net net's. Many large and well known companies bought back stock in 2007 at highs only to refuse to buy stock when their price cratered in 2009. Some of those companies even took out expensive debt in 2009 so they could have liquidity.

We prefer net net's where the cause of the undervaluation is external and not due to management action. We specifically look for management that isn't going to spend excess cash on dubious acquisitions.

4) A company that cheap must be a fraud
This line of thinking has possibly come out of the recent burst of China reverse merger stocks that are now showing up on net net screens.

We don't think fraud is any more common with net net's than with any other business. In all situations an investor needs to look for signs of fraud, check the quality of earnings, check accruals, and look to see if there are signs balance sheet items might be fudged.

5) Since a stock's value is the present value of future cash flows the company is worthless because it's not a significant cash generator.
Our response to this objection is similar to the first one; there is more than one way to go about valuing a stock. One way is to use a discount cash flow analysis which takes future guesstimated cash flows and assigns a present value to them. The sum of the guesstimated cash flows is what the stock should be worth. (Many will criticize us for using the word guesstimated, but unless the future cash flows are guaranteed by a bulletproof contract it really is a guess, maybe an educated one, but still a guess.

Another way is to attempt to buy a business for less than the hard tangible assets such as cash, inventory, factory, which is what buying a net net is. When looking at a net net we are evaluating the company on the basis of its assets and asking is the discount to asset value merited? Should this company be selling for less than a liquidation value? At times no discussion of the actual business is warranted, other times estimating the business value is of vital importance.

The key to looking at net net stocks is to keep them in perspective. Yes these might not be great companies, but for the most part they are probably selling for incorrect prices. Sometimes you can find a great company that's hidden behind a wall of cash or a company that's stumbled on temporary hard times. Once in a blue moon you find one which is really a great one but to the ignorers “too small” or “too closely held” or its variations “doesn’t trade enough” or is “ illiquid” or too this or too that. In almost all cases these companies don't deserve their undervaluation. How do we as investor’s profit? Value will out in time. It always does. Keywords being“in time” meaning you have got have patience, lots of patience. Bear in mind if the company is earning profits its book value is always increasing. The company sells out or goes private or uses a cash hoard to pay a special dividend or to purchase a good business or it liquidates or it is finally discovered by other investors who suddenly see something about its business prospects that "excite."

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