One of my favorite strategies still revolve around Graham’s Net Net stocks.
I sound like a weirdo, but it’s dear to my heart.
But I’ve come and gone with this over the years because it’s not easy to find good quality net net stocks in the US at the moment.
The last thing I want to do is compromise on quality, simply to follow a net net strategy.
Net net stocks work best when the markets are down and right now, it’s not the best time for USA net net stocks.
One way that I measure market valuations is to simply look at how many net net stocks there in the market.
I did this a year ago and noticed that the market wasn’t cheap.
Sure there were some NCAV and NNWC stocks out there, but none of them were screaming buys.
But before getting into all the hows, whys and whens on buying and making money with net nets, let’s review the basics first and work our way from there.
Understanding Net Nets
Net net stocks are not just cheap stocks.
Cheap stocks reference anything where the current stock price is lower than the underlying intrinsic value.
Net net stocks are dirty, trodden, haven’t had a bath in 10 years types of stocks.
It’s a value investing technique where the stock is valued purely on its current assets.
- Accounts receivables
- subtract debt
In fact, Graham basically said that net nets are stocks that are priced for liquidation.
Here’s how he described how to calculate the net net value.
Working capital (current assets less current liabilities) then subtract any debt not included in current liabilities.
What Graham is describing is the NCAV (Net Current Asset Value). You can see that he’s not talking about book value because he values intangibles and other non current assets as zero.
When people mention net nets, they usually mean NCAV. But I use NCAV as well as NNWC and you can see the difference below.
Calculating the NCAV (Net Current Asset Value) for Stocks
The formula to calculate NCAV is simple and the idea is to find stocks where the NCAV is higher than the market price.
NCAV = Current Assets – Total Liabilities
To get a per share value, simply divide by the number of diluted shares outstanding.
NCAV per Share = (Current Assets – Total Liabilities) / Shares Outstanding
Graham’s criteria for buying NCAV stocks was if the stock price was 2/3 of the NCAV.
e.g. If the NCAV per share was $10, then Graham wanted to buy it when the stock price was at $6.66.
More on that later.
Calculating the NNWC (Net Net Working Capital) for Stocks
NNWC is a very close cousin to the NCAV but the difference is that NNWC is a fire sale liquidation calculation.
NNWC stands for Net Net Working Capital and the formula is as follows.
NNWC = Cash and short-term investments
+ (0.75 x Accounts Receivable)
+ (0.5 x Total Inventory )
– Total Liabilities
Then divide by shares outstanding to get the per share value.
NNWC per Share = NNWC / Shares Outstanding
The big difference is that NNWC looks purely at liquid and tangible asset value. It doesn’t include any prepaid expenses or even deferred taxes that NCAV does include.
Accounts receivables are marked down for doubtful accounts and inventory gets a 50% off haircut and to reflect a rapid fire sale.
When Circuit City was going through its liquidation, they didn’t try to sell what they had left at 10% or even 20% off.
Prices were marked 50% and more because it just had to be cleared.
The key distinction however is that liquidations are very rare in the market. There are a lot of costs associated with liquidating and it takes a long time to fully unwind.
So NNWC is more of a theoretical number to help you see how conservative the valuation is.
Why You Would Buy a Net Net
Knowing how to calculate NCAV and NNWC is all well and good, but what’s the point?
If a stock is priced for liquidation, why even bother buying it?
Well, here are some reasons why I buy net net stocks.
- Very easy to value
- There is a solid floor
- Most are simple businesses to understand
- Nobody wants it
- Small to micro caps usually
- Low volume
I’m not talking about just any net net stock though. A net net has to pass a set of criteria before I buy it.
But I love the fact that it is so black and white.
Assuming you found a good one, your downside is protected by the liquid assets and you are buying with a huge margin of safety.
If the company has other long term assets like buildings or cash overseas, that’s an included bonus if it can get unlocked.
It’s such a rare strategy where you don’t even have to know much about the industry or the future.
You can just focus on the individual business and that’s it.
And because it’s so simple, people stay away from it.
When I purchased Friedman Industries (FRD), it wasn’t a net net at the time, but the downside was well protected with a NCAV of $7.29 per share.
Right now, the stock price is $7.57 so it’s trading close to NCAV from when I first calculated it.
Whether it’s by luck or just coincidence, you can see that the NCAV is acting as a floor for this troubled yet well managed company.
It’s just a matter of keeping an eye on the NCAV each quarter to make sure that there is no sudden deterioration.
Why You Wouldn’t Buy a Net Net
Why You Shouldn’t Buy Net Nets
There are very real reasons for why you wouldn’t buy net nets though.
The main one is that any company trading at or below NCAV/NNWC is going through some serious troubles.
Here are some reasons companies become net nets.
- Just lost their major customer who makes up 95% of sales
- Management was embezzling money for years and cooking the books
- Their main product is making CD’s
- They have no operating business
- The market doesn’t believe their new drug will ever get approved
- and the list goes on
Definitely some scary reasons.
Actually, let’s face it.
They are garbage.
I’m sure you’ve walked into a store and saw a table or a small basket with items being liquidated.
Everything is so cheap.
But 99% of them are useless.
Why would you want an open pack of sliced cheese that is close to expiration for just 50c?
What are you going to do with that slow and outdated laptop with some keys missing?
That’s what net nets are like after all and it definitely doesn’t suit everybody.
It requires a certain type of personality to make net nets work.
The type of person who buys that pack of cheese, makes a nice sandwich and sells it to his friend for a few bucks and makes a profit.
Or the type of person who pulls the laptop apart and sells the parts for a nice profit.
Net nets are a big no no if you have the following traits:
- Don’t want volatility
- Want to hold something for as long as possible with very minimal turnover
- Don’t like buying small caps
- Don’t like analyzing OTC stocks
- Want to stick to