Your Free Net Net Stock Pick For December by Evan Bleker — Net Net Hunter
In this issue…
 What a -31% Market Drop Means for My Portfolio
 Joel Greenblatt’s Forgotten Original Magic Formula
 Your Free Net Net Stock Pick
 How Each of My Positions Have Performed Since Inception
Net Net Stock – What a -31% Market Drop Means for My Portfolio
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.
[drizzle]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:
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?
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