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I-O Data Devices: Your Free Net Net Stock Pick For December

Your Free Net Net Stock Pick For December by Evan Bleker — Net Net Hunter
In this issue…

[1] What a -31% Market Drop Means for My Portfolio

[2] Joel Greenblatt’s Forgotten Original Magic Formula

[3] Your Free Net Net Stock Pick

[4] How Each of My Positions Have Performed Since Inception


Net Net Stock – What a -31% Market Drop Means for My Portfolio

Hi There,

Merry Christmas from Melbourne Australia! I hope that Santa treated you well this year and that you have a great New Years eve.

This holiday has been interesting for me because it’s the first time that I’ve had a summer Christmas and because of how my portfolio has done year to date despite the dramatic drop in the US micro cap market.

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Just how bad?

This year the smallest firms in the market, as shown here in the breakdown of the Russell 2000, have taken a deep dive while the larger companies have surged ahead. Take a look at this chart here:

net net stock

While this image isn’t very clear, micro caps with market capitalizations below $50 million have suffered a -31% drop year to date. That’s a pretty large drop.

The drop is significant for a very important reason: net net stocks are found among the smallest firms in the market and rarely are found above, say, $200 Million US. Actually, most of the net net stocks I find have market caps of under $50 Million USD. This is what keeps the strategy open for you or me to use.

Luckily, my own portfolio has avoided the drop and is actually up 8%, ahead of the NASDAQ’s 6.6% return. Not spectacular, but still beating the market.

As a net net stock investor, you’re bound to have years like this. All of your yearly returns, good and bad, lump together into the final average annual CAGR that you achieve over the course of your life. While I expect most years ahead to be much better, some will be worse, so I’m just trying to execute my strategy as best I can and let the chips fall where they may.

So, why is my portfolio up this year while tiny micro caps are down in general?

Three reasons:

1. Net nets outperform stocks in general by a wide margin on average… so odds are that my portfolio would be up versus the NASDAQ in any given year.
2. I’m mostly invested outside of the US, which allows me to take advantage of depressed markets in other first world countries. Because of that, I’m partly sheltered from market drops in the US.
3. The stocks that I buy are among the best available in the first world. They are often growing NCAV or earnings by 10-15% a year, have low PEs, and have no debt.

In fact, I’m going to bring you one of those companies below, but first a really powerful bit of good news. Markets fluctuate a lot and markets often cycle between good and bad years. Really bad years for stocks set up really good years to come, so see this -31% drop for what it is: a market shift that sets up a future market surge for micro caps. If we have another large drop in the micro cap market, that drop will increase the odds of a great year to come even further so make sure you stay fully invested to reap the rewards. Odds are that the future is going to be bright!

Now, on to that great stock I mentioned. Read on!


Joel Greenblatt’s Forgotten Original Magic Formula

Long before the Little Book That Beats the Market, Joel Greenblatt was busy testing a different magic formula — one with far better returns.

Did you know that long before Magic Formula investing went mainstream, Joel Greenblatt was developing and testing an even more powerful investment technique?

Joel Greenblatt: A Beautiful (Investment) Mind

Joel Greenblatt has one of the best records on Wall Street. Aside from being an adjunct professor at Columbia University Graduate School of Business, he’s also well entrenched in the Hedge Fund industry through his management of Gotham Capital. From 1985 to 2005, Greenblatt is reported to have racked up an even better record than Warren Buffett did during his partnership days, earning 48.5% compounded over 10 years through a combination of special situation and deep value investing.

If you’ve heard about Joel Greenblatt, it’s probably due to his widely read book, “The Little Book That Beats the Market“. In it, Greenblatt makes the case for a formula that investors can use to achieve superior results over the long run. Essentially, the formula looks for businesses with a large earnings yield and a high return on capital. The premise is that, over the long run, stocks of firms that are both cheap and good would vastly outperform the stocks of firms that are just cheap — and it definitely seems to have worked. As Greenblatt reported in his book, from 1988 to 2009 the magic formula produced a CAGR of 23.8% versus a 9.6% CAGR for the S&P 500.

The Original Magic Formula

Joel Greenblatt’s love for cheap stocks of good companies started long before he developed his latest Magic Formula, however.

It’s probably no surprise that the backbone of Joel Greenblatt’s original magic formula rested on Benjamin Graham’s net net stocks strategy. Greenblatt had been following Graham for years, carefully studying the principles and philosophies of the Dean of Wall Street, and was deeply impressed by, in his words, “the dramatic success of companies that the market priced below their value in liquidation…”.

Benjamin Graham’s own NCAV stocks strategy was to buy a diversified list of net net stocks that were trading at least 1/3rd below their net current asset value. Graham screened out stocks that failed to show a decent past record and those that were losing money. By putting together a diversified list, Graham hoped to take advantage of the population returns of net net stocks and ride that fantastic statistical record to great profits.

In 1981, at just 24 years old, Joel Greenblatt teamed up with Richard Pzena (a great value investor in his own right), and Bruce Newberg to test their own version of Graham’s NCAV investing approach. The result was a fantastic research paper called, “How the Small Investor Can Beat the Market: By Buying Stocks That Are Selling Below Their Liquidation Value” (The Journal of Portfolio Management 1981.7.4:48-52).

Defining Net Current Asset Value
According to Joel Greenblatt:
Current Assets (Cash, Accounts Receivable, Inventory, etc.), less…
Current Liabilities (Short Term Debt, Accounts Payable, etc), less…
Long Term Liabilities (Long Term Debt, Capitalized leases, etc), less…
Preferred Stock (Claims On Corporate Assets Before Common Stock)…
Divided by the Number of Shares Outstanding…
Equals Liquidating Value Per Share (NCAV Per Share).

 

In his paper, Joel Greenblatt wondered what would happen if he carved up the world of net net stocks even further, eliminating a lot of the terrible firms from contention. To do this he turned to one of the most widely recognized valuation metric in value investing: the PE ratio.

Using both Graham’s net current asset value and value investing’s classic PE ratio, he put together 4 different portfolios and compared those portfolios against the OTC and Value Line’s own value index from 1972 to 1978. According to Joel Greenblatt, this period was characterized by an extreme amount of volatility which made for a much more robust test.

To select the stocks, Greenblatt only looked at firms in the Standard and Poor’s Stock Guide with market caps of over $3 million and names that started with either an A or a B. He then drew net net stocks from the roughly 750 candidates left in order to put together his model portfolios.

Portfolio 1

Price below NCAV

PE floating with corporate bond yields

No dividends required

Portfolio 2

Price below 85% of NCAV

PE floating with corporate bond yields

No dividends required

Portfolio 3

Price below NCAV

PE of less than 5x

No dividends required

Portfolio 4

Price below 85% of NCAV

PE of less than 5x

No dividends required

 

Purchases were made based on the above criteria. Stocks were sold after a 100% gain or two years had passed, whichever resulted first. The portfolios themselves were equal weighted, so the actual yearly returns of each portfolio were just the average returns of the stocks within each portfolio.

All of the portfolios beat the indexes by a wide margin. By combining liquidation value with smaller PE ratios, however, results exploded.

Net Net Stock

Take a look at portfolio #4. The CAGR of portfolio #4, Greenblatt’s original Magic Formula, blew the market away. While the OTC CAGR totalled just 1.3% for the 6 year period, and the Value Line index came to a slight loss, Joel Greenblatt’s original Magic Formula was up over 42% compounded per year from August 1973 to April 1978!

Greenblatt & Pzena broke the 6 year period up into 18 4 month periods. During that time, the market fell from 130 to 50, a decline of 61.5%! It then climbed back to just under 120, a gain of nearly 140%. But at the end of the study, the market was still underwater… but take a look at the results of the pair’s net nets:

Net Net Stock

The end result for the group of net net portfolios was very good. From a starting value of 100, each ended the 6 year period before taxes and fees as follows:

Portfolio 1: 248

Portfolio 2: 331

Portfolio 3: 363

Portfolio 4: 517

As you can see, the highest quality net nets, represented by Portfolio 4, more then doubled the return of the lowest quality net nets in the study.

Greenblatt et al even included returns after commissions and taxes, for those of you who aren’t holding your portfolio in a tax free retirement account for some strange reason. Re-examined, Greenblatt’s best performing portfolio still destroyed the market, up over 29% versus flat returns for the indexers.

It’s important to realize what this means for average investors. Since the American market indexes return roughly 10% per year on average, Greenblatt’s forgotten original Magic Formula should be good for between 29% and 39% on average over the long run.

Granted, Greenblatt’s study only covered a period of 6 years, but in my experience buying net net stocks with tiny PE ratios has proven to be a very profitable strategy. In fact, most of my best performing stocks have been these sort of net nets. Also keep in mind just how tumultuous the markets were during that period which, as Greenblatt wrote, made for a much more robust test.

(As an aside: if you’re stuck holding your funds outside a tax shelter, for some reason, you can boost the tax efficiency of your portfolio by just holding your stocks for longer. This becomes a lot more viable if you’re investing in the highest quality net nets.)

Three Major Takeaways from Joel Greenblatt’s Study

It’s hard to argue with returns like that.

Still, the more observant of you might have noticed a few potential flaws with the study and results.

At first glance, it definitely appears that you can’t hold a large number of stocks in a portfolio using Joel Greenblatt’s criteria. If you look to the right of each period’s return, you’ll see exactly how many stocks he held. In fact, Greenblatt et al were out of the market entirely for a lot of 1972 and 1973.

I don’t think this is a crippling flaw to his strategy at all, however.

It’s important to realize that Benjamin Graham’s obsession with wide diversification isn’t really necessary. In Joel Greenblatt’s first book, “You can Be a Stock Market Genius,” he argues that you need fewer than 10 stocks to eliminate most of the systemic risk that you face while investing in stocks. Ultimately, you don’t need 30 or 100 different stocks to diversify away most of your risk. You can do it with ten.

You can even leverage Greenblatt’s original Magic Formula, portfolio #4, while maintaining a fully stocked portfolio during the upper reaches of a bull market. The trick is to put together a portfolio of other net net stocks and then replace the weakest links in your portfolio with a portfolio #4 type net net when new candidates become available. Doing so would allow you to leverage the returns of NCAV stocks as a group while still employing Greenblatt’s original magic formula when available.

You could even chose the best net net stocks that don’t meet Greenblatt’s criteria by focusing on NCAV stocks that are trading at an incredibly cheap price to NCAV, have no debt, are growing NCAV per share, are buying back stock, or which have insiders who are buying big blocks of shares, themselves.

Lastly, remember that Joel Greenblatt et al only looked at companies with names that began with the letters A or B. That inevitably eliminated most net nets from contention. In my own experience, there are a lot of net net stocks available for smart investors willing to invest internationally. I send many of these stocks out to those who requested free net net stock ideas.

The second takeaway is that both quality and price have a major impact on returns. Looking at the results, when holding PE requirements constant, the cheaper portfolios in terms of price to NCAV outperformed the more expensive portfolioes. Likewise, when holding price to NCAV requirements constant, the portfolios that demanded more earnings for the price paid outperformed their peers. By combining both value and quality, as Greenblatt did in portfolio #4, an investor can do very well in the stock market.

Finally, it’s fairly clear that Joel Greenblatt’s original Magic Formula, and NCAV stocks in general, trumps Greenblatt’s contemporary Magic Formula. Sure, the Magic Formula that Greenblatt champions in his latest book is a good investment strategy, on the whole, but it just doesn’t live up to his forgotten original Magic Formula. While his contemporary Magic Formula was reported to return just north of 23% per year vs. the S&P 500’s 9.6% return, Greenblatt’s original Magic Formula spanked that return — and did so during a flat market, as well!

Click Here to view my 2014 10 month returns.

 How I’m Leveraging Greenblatt’s Original Magic Formula

As you can see, Greenblatt’s original Magic Formula is magical indeed.

His study has had a huge impact on my own selection criteria. When selecting net net stocks, I look for firms that have a deep discount to NCAV but still focus on high quality situations. For example, I currently own two deeply discounted stocks based on NCAV and earnings: one trading at just over 5x earnings and just over 40% of NCAV; the other offering a PE of 6 and trading at 68% of NCAV. Joel Greenblatt would be proud.

The biggest challenge to earning 25-35% annual returns is not the actual investing — it’s finding the investment opportunities. Right now Net Net Hunter members have access to over 450 net net stocks in 5 countries, as well as Shortlists of the best possible net net stock opportunities in each country. Make the most of your time by quickly finding the best net net stocks available.


Your Free Net Net Stock Pick

Here’s another company located outside of the US, but in a friendly first world international country. This is exactly the sort of stock that I love to buy, which is why I stuffed it into my portfolio last month.

Why venture outside of your own domestic markets? Quite simply because the bargains on offer can be much better in terms of price to value and quality. I’ve found some truly outstanding investments, such as Creighton’s in London or Twinbird Corp. in Japan, which have added to my overall portfolio returns. Let’s go over one more here:

Name                   I-O Data Devices
Country               Japan
Symbol                6916
MT Unit               100 Shares

NCAV/Share        1295 Yen  
Price/Share          559 Yen
Discount              56.8%
PE                         ~8x

Current Ratio       3.06x
Debt to Equity     2.3x

Burn Rate YoY     15.8% incr
Burn Rate QoQ    < 1% Incr

I-O Data Devices is one of my favourite stocks, and it’s currently trading at a massive discount to NCAV. Actually, that’s one of the reasons I like it.

Take a look at the vital stats above. This company is hitting the mark on nearly all counts. On top of those stats, the company has also increased its NCAV over the previous 4 years by an average of 14.1% per year. That’s great growth for a net net stock, and another solid reason for including it on your short list.

Important DisclaimerPlease remember that the stocks mentioned here are not recommendations for investment. I mention them purely as recommendations for your own further research after which you must decide for yourself whether the stock is worth investing in or not. All investments are subject to risk, including total loss of capital, and these stocks are no different. While I send these in good faith, any one of these stocks could lead to significant losses.

Graham’s net net stock strategy is a statistical investment strategy so investment success depends on putting together a diverse portfolio of good quality net net stocks. A net net stock investor always aims to have his portfolio work out well as a whole, while remaining indifferent as to the success of any one stock.

Also, keep in mind that I have personally invested in many of the stocks that I mention here, so readers should assume – unless clearly stated otherwise – that I own shares in any company mentioned.

Purchasing shares and then recommending them to others to drive up the stock price is a common scam known as front running. I offer these stock picks in good faith and since 2013 I have yet to see the price of any stock recommended here advance meaningfully within two weeks after sending out our monthly stock pick. If you have doubts about my intentions, don’t purchase the stock.


My NCAV Stocks Returned 38% Per Year – Here’s How

Over the past 4 or 5 years I’ve been on a quest to dissect Benjamin Graham’s famous net net stock value investing strategy to see just how good it is, what makes it work, and how to reap the best possible returns after adopting it.

As the title suggests, this strategy has been rocket fuel for my portfolio. 38% returns are not just good — they’re phenomenally good.

After I show you the charts and data below, I want to qualify a couple things and leave you with the most accurate sense of how my NCAV portfolio and picks performed from the start of 2011 until now, February 16th, 2014.

My Returns — Position by Position

I put together this little chart to give you a really good idea of how these NCAV positions do, and over what time period. This list includes all of my positions — every single net net stock that I bought during the 3 year stretch. The data on the chart is data I took from my own personal real money portfolio and shows results net of fees:

Net Net Stock
Net Net Stock

Below, I’ve annualized the returns to give you an idea of the average annual increase of each NCAV holding over the life of the holding period. Some of these positions were held for under a year, so their annualized returns are higher than their actual returns shown above. In other cases, stocks were held for more than a year so their annualized performance is shown as smaller than their actual realized returns over the holding period.

Net Net Stock
Net Net Stock

It’s important to remember that NCAV stocks don’t go up by a unified amount each year so many of these stocks were a random walk until the price spiked up to the firm’s NCAV. The only stock that had a somewhat linear rise to fair value was Trans World Entertainment.

To view my 2014 10 month returns ( stock broker statement), Click Here.

Net Net Stock Returns vs. Real Money Portfolio Returns

Now a bit of qualification…

First of all: The quoted 38% figure is not the returns my portfolio saw over the 3 year stretch — 38% is the average annualized return of each one of my NCAV stock picks.

My own real money NCAV portfolio has done spectacularly well, also, but not 38% well. Over the same time period, my portfolio has increased by 140%, or just over 100% from January 1st 2011 to December 31st, 2013. That performance is life-changing, but not as good as the 38% per year achieved by my actual picks.

The difference between the results of my net net stocks and my actual portfolio return comes down to:

  1. transitioning into a NCAV stock saturated portfolio during 2011,
  2. taking time away from stock picking during 2013 to build this members’ site,
  3. which caused me to hold more cash than I would have liked throughout 2013 and the beginning of 2014.

Barring those qualifications, my NCAV portfolio would have done better and come to approximate the returns of my actual NCAV stocks.

38% Annualized Per Year

Second, these returns are average annualized returns — not compound returns. They take into account the real dollar returns of my actual real money NCAV portfolio, which includes trading costs. The compound returns would be slightly lower, perhaps 34 or  35% — but still well above 30% per year.

This is very impressive and lends support to my overall net net stock sub-strategy. Picking the cheapest NCAV stocks, the NCAV stocks with the strongest balance sheets, and the net net stocks that have strong insider activity or a promising story has proven to work very, very well.

These stocks are true money-makers.

I also find it very interesting that my win %, the percentage of NCAV companies that show positive gains, is right in the zone where Warren Buffett forecasted decades earlier. In one of Warren Buffett’s partnership letters, Buffett says that these NCAV stocks tend to work out well within 3 years, 70-80% of the time. My own portfolio achieved nearly a 78% win percentage over three years, with TotalTelcom being my only massive loss.

38% Average Annualized Returns in Context

Whenever you look at quoted returns you should always compare the figures against what the market has done in general. I brought up stats from two indexes, the well known S&P 500 and the Russel 2000 small cap index. The S & P 500 provides a familiar benchmark by which to measure results but the Russel 2000 fits better with my actual portfolio for reasons I’ll get to below.

S&P 500 (Wikipedia) Total Return Including Dividends:

  • 2011 – 2.11%
  • 2012 – 16%
  • 2013 – 32.39%

Average Annual Gain: 16.83%

Russel 2000 (Google Finance) Index Price Change:

  • 2011 – (5.45)%
  • 2012 – 12.31%
  • 2013- 39.54%

Average Annual Gain: 15.46%

As you can see, the results of the indexes are higher than normal. The typical return to the S&P 500, for example, is usually around 10% per year.

I don’t expect the market to keep shooting upwards indefinitely — at some point it has to stop. At the time or writing this, the S&P 500 is down half a percent and the Russel 2000 is down 1.24% for the first month and a half of 2014. When the market stops performing as well as it has during the last 3 years then I expect the results of my real money NCAV portfolio to come down somewhat — though the portfolio should still significantly beat the market over the next 3 to 5 year stretch.

Large Classic Benjamin Graham Investors Need Not Apply

How exactly did I achieve these results, and how can you do the same?

Large investors with more than $10 million can’t invest in NCAV stocks.

I focused on the best possible NCAV investments among the 400 net net stocks available on the site and held a fairly concentrated portfolio. As you saw above, I had a total of 18 NCAV positions over the last 3 years and rarely held more than 8 positions at any one time. Concentrating on a small number of high quality investment opportunities boosted both returns and volatility.

Some investors might not be able to stomach the same amount of volatility I could — though it’s definitely possible for you to develop the emotional temperament that great returns require.  I have.

Investing in this concentrated of a portfolio also requires a decent amount of skill and experience in analysis — something that all investors (myself included) should be striving for throughout their career. Still, it’s not necessary to achieve fantastic returns by concentrating. You can do very well by putting together a portfolio of net net stocks that meet basic core requirements. This would mean holding 20+ stocks in your portfolio to realize the statistical returns of net net stocks to a greater degree.

I also focused on small stocks — tinny stocks in fact. My smallest stock was just over $1 000 000 Canadian dollars, while my largest approached $60 000 000 USD. One of the reasons why this strategy works so well is because most of Wall Street is shut out of the net net stock bonanza. Firms with big portfolios just can’t buy these stocks. For that matter, individuals with big portfolios just can’t buy these stocks… and the available firms get smaller as the market rises.

And this gets back to the reason why I opted for the Russel 2000 index as a comparison. The Russel 2000 is a small cap index so better reflects the population of net net stocks. NCAV stocks, however, are worlds smaller than the average size stock on the Russel 2000.

Where Do We Go From Here?

Over the next few months I hope to look back at my past picks to understand how they stacked up against my evolving net net stocks strategy. Over the three years I’ve further refined my understanding of the strategy and what I should be looking for when I pick companies, so I look forward to seeing if some of these past picks would have passed my more rigorous standards today.

If you haven’t yet signed up for full Net Net Hunter membership then now is the time to do so. Click here. As you can see, the money that you’ll enevitably make off of even just one of these holdings is enough to pay for membership for years — and right now we have nearly 20 high-potential stocks shorlisted.

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