Net-Net Stocks — Are they Really Free Money? — Value Stock Guide
In the lore of value investing, net-net stocks hold a special position. These are true, so-called free money stocks. To see why, consider the following hypothetical question:
Suppose there is a company that you can buy up for $100. Once you do, you can simply close up shop. You payoff everyone you owe in cash, and when all is said and done, you are left with $120 in cash plus a few odd buildings and machinery.
I know I would. Ben Graham thought so as well. Ben Graham net-nets were quite common in those days. Today, these stocks are hard to find, but they do exist, and every now and then we come across a few examples. We have made some good money investing in the net-nets in the past.
Let’s dispense with the definition first.
What is Net Net?
On a very basic level, a net net is defined as a stock where the price is below the net current asset value.
You must recall that the net current asset value, or NCAV = Current Assets — Total Liabilities.
Current assets are assets that can be converted to cash in less than 12 months. These are close to the market value of these assets. Some examples include account receivables, and inventory.
If you are a conservative investor, you may want to adjust the current assets in the net net formula to discount the doubtful accounts and inventory spoilage
In fact, Ben Graham painted with broader strokes. He decided to give the NCAV a haircut of 30%-40% and insisted that the price paid for the stock be below this value. Margin of safety, as this is called, has remained the mainstay of value investing ever since.
If you run a net net screener and ask for a margin of safety of 30%-40% today, you will get very few results. But like they say, a value investor only needs to wait for a hittable pitch and swing hard when he gets it. This is a game of patience.
Net Net Screener — How to Find Net Net Stocks?
Most of the free stock screeners in the market, or even the ones offered by the brokers to their clients, are unable to calculate…
Цены net net что это
Да нет, местный прикол. А кто сказал, что менеджмент системен у всех: в сетях, у иностранцев? Ну вот и сочиняют, порою. термины на забаву поставщикам.
Да, как обычно, ничего
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Net-Net: Definition, How It Works, Formula To Calculate
James Chen, CMT is an expert trader, investment adviser, and global market strategist.
Gordon Scott has been an active investor and technical analyst or 20+ years. He is a Chartered Market Technician (CMT).
What Is Net-Net?
Net-net is a value investing technique developed by the economist Benjamin Graham, in which a company’s stock is valued based solely on its net current assets per share (NCAVPS). Net-net investing thus focuses on current assets, taking cash and cash equivalents at full value, then reducing accounts receivable for doubtful accounts, and reducing inventories to liquidation values. Net-net value is calculated by deducting total liabilities from the adjusted current assets.
Net-net should not be confused with a double net lease, which is a commercial rental agreement where the tenant is responsible for both property taxes and premiums for insuring the property.
Key Takeaways
- The net-net value investing strategy was developed by Benjamin Graham using net current asset value per share (NCAVPS) as the primary measure to evaluate the merits of a stock.
- According to the net-net strategy, the ability to generate revenue from current assets is the true value proposition of a business.
- Current assets, which are used in the net-net approach, are defined as assets that are cash, and assets that are converted into cash within 12 months, including accounts receivable and inventory.
- The net-net investing strategy does not consider long-term assets or liabilities, making it unreliable for long-term investments according to its critics.
Understanding Net-Net Investing
Graham used this method at a time when financial information was not as readily available, and net-nets were more accepted as a company valuation model. When a viable company is identified as a net-net, the analysis focused only on the firm’s current assets and liabilities, without taking other tangible assets or long-term liabilities into account. Advances in financial data collection now allow analysts to quickly access a firm’s entire set of financial statements, ratios, and other benchmarks.
Essentially, investing in a net-net was a safe play in the short term because its current assets were worth more than its market price. In a sense, the long-term growth potential and any value from long-term assets are free to an investor in a net-net. Net-net stocks will usually be reassessed by the market and priced closer to their true value in the short term. Long term, however, net-net stocks can be problematic.
The formula for net current asset value per share (NCAVPS) is:
According to Graham, investors will benefit greatly if they invest in companies whose stock prices are no more than 67% of their NCAV per share. And, in fact, a study done by the State University of New York showed that from the period of 1970 to 1983 an investor could have earned an average return of 29.4% by purchasing stocks that fulfilled Graham’s requirement and holding them for one year.
However, Graham made it clear that not all stocks chosen using the NCAVPS formula would have strong returns, and that investors should also diversify their holdings when using this strategy. Graham recommended holding at least 30 stocks.
Special Considerations
Current assets, which are used in the net-net approach, are defined as assets that are cash, and assets that are converted into cash within 12 months, including accounts receivable and inventory. As a business sells inventory and customers submit payments, the firm reduces inventory levels and receivables. This ability to collect cash is the true value of a business, according to the net-net approach.
Current assets are reduced by current liabilities, such as accounts payable, to calculate net current assets. Long-term assets and liabilities are excluded from this analysis, which only focuses on cash that the firm can generate within the next 12 months.
Criticisms of Net-Net
The reason net-net stocks may not be a great long-term investment is simply because management teams rarely choose to fully liquidate the company at the first sign of trouble. In the short term, a net-net stock may make up the gap between current assets and market cap. However, over the long term, an incompetent management team or a flawed business model can ruin a balance sheet quite rapidly.
So a net-net stock may find itself in that position because the market has already identified long-term issues that will negatively affect that stock. For example, the rise of Amazon.com has pushed various retailers into net-net positions over time and some investors have profited in the short term. In the long term, however, many of those same stocks have gone under or been acquired at a discount.
The net-net strategy of finding companies with a market value below its net-net working capital (NNWC)—cash and short-term investments + 75% of accounts receivable + 50% of inventory — total liabilities—may be an effective strategy for small investors. Net-net companies are sought after by day traders which may contribute to their rise in month-to-month valuation.
Net-Net
Net-net is a term used for a company with a market capitalization that is less than the difference between the company’s current assets and total liabilities. The equation does not consider long-term assets, such as property, plant, and equipment (PP&E), and intangibles.
Net-net investing is used with the underlying understanding that if the net-net (company) is sold, the current assets would be used to settle the obligations or liabilities, and the leftover amount (cash) will be worth more than the market capitalization of the company. In other words, the stock price is below the net current asset value (NCAV) of the company.
What is the Net Current Asset Value (NCAV)?
Net current asset value (NCAV) is the value of the current assets minus total liabilities, including preferred shares and off-balance sheet liabilities. NCAV is derived when you remove the long-term assets component from total assets, leaving a highly conservative estimate for a company’s value in case of liquidation. The NCAV strategy and net-net investing was founded in the 1930s by Benjamin Graham and was thought of as a good proxy to gauge a company’s real-world solvency value.
Price to NCAV of an Investment
A related concept is a multiple involving NCAV. P/NCAV can help investors and analysts determine whether a stock is under or overvalued. A low P/NCAV means the stock is undervalued. A company can alter its NCAV by buying back or issuing common shares.
Net-Net Investing: The Warren Buffet Perspective
The net-net strategy was used by Warren Buffet to grow his investments. He popularly referred to this as the “cigar-butt” investing technique. The strategy was taken from Graham, and Buffet came up with a simple rule to buy a stock. He said that if the stock price is less than 2/3 of the difference of the current assets and total liabilities, it is a net-net stock. The equation is given below:
Buffet stated that the only rule of thumb was the equation, and one does not need to analyze the company’s financial statements, conduct fundamental analysis, or make any qualitative or quantitative judgments. The strategy was a bit controversial, as most of the stocks trading as net-net stocks are not very sought after, and people avoid them as they are trading at ridiculously low prices. Moreover, people are scared to invest in companies that may undergo bankruptcy (although, there are instances of profit generation in such cases, too).
Success of Net-Net Investing Strategy
It is interesting to see that despite net-net being such a volatile strategy, the strategy yields positive returns. There are several factors as to why the net-net strategy is considered successful, including:
1. Riskiness of stocks
Looking at market data for a basket of net-net stocks, the stocks tend to show a beta (volatility) greater than 1, indicating that any movement in the markets will cause a larger impact on the change in the stock price of the stocks (indicating why such stocks might’ve historically outperformed relative to other average stocks).
2. Market liquidity
If a company’s stock is selling below its NVAC, it is normally a small company with illiquid stock. As the stock is hard to buy/sell, it will take time for the investor to react to any news that comes regarding the stock. Therefore, for such stocks, investors get a higher premium to compensate for the illiquid risk they are being exposed to.
3. Long-term reversal
A common concept in trading is that everything will eventually revert to the mean, and if anything’s previously been performing badly, it will perform well now. Studies indicate that net-net stocks performing well could be because they were not doing too well earlier (although this argument may seem flawed and biased).
4. Financial distress
Any company that is showing liquidity or solvency problems tends to garner a negative reaction from the market. The negative reaction often leads to the stock price falling way below the fair market price (making the company undervalued and, therefore, a potentially attractive investment).
Pitfalls of the Net-Net Investing Strategy
The net-net strategy comes with certain pitfalls, as not everyone can benefit from it. The investing technique does not always work, with certain investors demonstrating months of underperformance when employing the strategy. The strategy tends to do well if used for a longer time horizon (based on the success factors mentioned in the earlier section).
Another problem of the strategy arises if investors do not diversify and focus on one to two stocks to do the work. It is possible that not every net-net stock posts the gains expected, so it is very important to diversify and invest in a basket of net-net stocks. The net-net strategy works well for illiquid stocks, and as most investors are unable to purchase shares due to the thinly traded volume, they end up not benefitting from the strategy.
Related Readings
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: