Value Investing

Net Nets: How To Exploit Near Terminal Companies For Fun And Profit

By Net Net Hunter

I don’t look at ROE or ROA… and I rarely look at profit margins. I find earnings projections or market leadership completely uninteresting… and industry analysis a bore.

The only thing that matters to me is how near death the patient is.

That’s right — near death…

How to Make Tiny Uncertain Returns

If you want the best returns possible, then I advise you to run as quickly as you can from great situations.

Most investors don’t have the stomach for real value investing. It’s true. Most people who call themselves “value investors” are really just growth investors in disguise. Sure, value and growth may be joined at the hip, but when you’re buying into situations where certainty is being sold at a premium and growth is nearly assumed to be a scientific law, you can only achieve mediocre results over the long term at best.

Certain situations often prove to be fatal while real opportunity is hiding where most people fail to look.

In order to make tiny uncertain profits in investing, look for the best companies with good expected growth rates and then hold those companies for the long term. Go ahead, do it. You know you want to.

Leave the largest yearly returns for real value investors.

What the Real Value Investors are Doing

Let me tell you a secret about investing.

This isn’t as much a secret, actually, as it is a fundamental fact that many retail investors fail to realize: if you want large investment returns with any certainty then you have to buy into situations where pessimism and skepticism are the norm.

My company is going to go bankrupt? Good.

People will never use this firm’s services again? Sounds peachy.

I’ll do my own research and draw my own conclusions, thanks.

The worse the public thinks the situation/strategy/management/political situation/economy/market is, the better the hunting grounds are. The complete opposite is true, as well. The better the public thinks the situation looks, the poorer the prospects for profit.

Real value investors are patiently waiting for your gem of a company to slip up and break your heart (not to mention your 401k). Real value investors are patiently waiting for you to hand over your ownership stake in the company you once loved for a fraction of its real world value. Real value investors pray on your pessimism, and avoid your infective exuberance like rabies.

And real value investors will grow richer for it.

Think Strategy if You Want to Win

The key word here is the word “think”.

Most investors don’t actually think — they feel. Most investors feel good when they see a wonderful situation. Most investors feel great thinking about how solid their DCF analysis is. Most investors feel as if firms suffering problems are too risky to buy into. Most investors feel more comfortable as part of the herd.

It amazes me that investors don’t spend more time figuring out what investment strategies actually work well… and then just use them.

The best investment candidates are stocks which are either loathed, unloved, ignored, or feared. These stocks have explosive potential and are exactly what I send readers who requested free net net stock ideas. Sir John Templeton’s advice was dead-on when he said to buy at the point of maximum pessimism. It’s at this point that prices have been driven down to their most depressed levels and the only direction left to go is up.

While actually nailing that exact moment with any regularity is impossible, his principle is sound. Perception and reality are two different things — and unloved, feared, or hated stocks get battered ruthlessly based on public perception/emotion. If you can dig down to get a better understanding of the story and then buy at a steep discount to a solid assessment of intrinsic value… that’s how you nail down solid returns over the long run.

This is where “think,” temperament, and near terminal patients interlock to form the basis of a truly profitable value investment strategy. Not all stocks that have gotten hammered will work out so its up to you to sort the terminal firms from the ones that will pull through and survive. That task is easier than you might think, however.

 The King of Value Investing Strategies

I’m biased — but then again I’ve done my homework.

You can opt for a number of different strategies to exploit the emotionally fragile investing public. You don’t have to hand over your 401K. Low price to earnings, low price to cash flow, low price to book value, high dividend yields, and low enterprise value to earnings are all Benjamin Graham -type value investing strategies that yield results in the high teens. Any one of these classic Benjamin Graham strategies will work if you employ it properly.

I’ve chosen something a little better, however. I’ve opted for a classic Benjamin Graham low price to NCAV strategy.

Why? Simple. There is no other strategy that has been shown to offer as high of returns as consistently as Benjamin Graham’s NCAV strategy. It’s been used in practice by investment legends such as Benjamin Graham, Warren Buffett, Walter Schloss, Tweedy Browne, and Peter Cundill, as well as tested in academic studies which have all shown massive out performance.

How high? Expect 20-35% per year over the long term.

Net net stocks offer serious performance for smart investors.

This is a completely different kind of value investing strategy from your typical low PE, or Buffett & Munger style strategy. Most of these companies have suffered devastating problems so there’s no profit margins or ratios to assess. That’s why I don’t pay attention to ROE or ROA — profits just aren’t there.

The whole idea is to buy into a really bad situation where the assets have been offered up at an insanely cheap price and then wait for the inevitable correction. Buying below NCAV means buying below a conservative estimate of the firm’s liquidation value. This is bargain basement investing at its finest.

But, even though value is based on liquidation value, Benjamin Graham’s NCAV stocks rarely liquidate. Usually there’s a jump in the stock price due to a bit of good news, as other investors are jolted into realizing just how unduly pessimistic they’ve been. Takeovers happen just as frequently — since most of these firms have intellectual property, divisions, or valuable business relationships on top of being conservatively financed, they’re also attractive takeover candidates. In other cases, the company simply solves its problem and returns to profitability & growth.

When Warren Buffett was busily using Benjamin Graham’s investment strategies to earn the highest returns of his career, he wrote that net net stocks worked out within 2 or 3 years 70-80% of the time. My own experience is consistent with this and has led my portfolio to grow by more than 30% per year since 2010. Not bad at all considering the S&P 500 returned just over 16% over that same period.

If these Benjamin Graham net net stocks are this ridiculously profitable, why on earth would people give them up? Typically, people look at earnings to value a company — it’s profits that usually support a company’s stock price. In this case, however, assets support the stock price but extreme pessimism has caused these earnings infatuated investors to jump ship. As a consequence, the price is pushed well below a conservative estimate of the firm’s liquidation value.

Is Benjamin Graham’s Famous Strategy Too Risky?

Believe me when I say that I was really skeptical about classic Benjamin Graham net nets, too.

I won’t try to convince you right here with stats and figures, however. I think it’s better to do the homework for yourself to really understand Benjamin Graham’s strategy.

Before I started using the strategy I had a lot of doubt that firms suffering such massive problems could yield such great returns. It seemed obvious that the exact opposite was true and I’d just end up losing a lot of money.

I pored back over Benjamin Graham’s writings and then a few articles online to see exactly what the claims were. I was still in university at the time, so I also took advantage of my university’s library database, searching for as many journal articles on classic Benjamin Graham net nets as I could find. There were a bunch of academic papers which looked at them and each paper showed massive outperformance. One paper was even written by Joel Greenblatt. I turned to the Buffett Partnership letters next and finally took the leap of faith that would prove enormously profitable over the next few years.

I don’t think everyone has the emotional stability to be able to invest in Benjamin Graham styled deep value stocks. That’s fine with me. Classic Benjamin Graham value investors will need someone to take money from and the fewer people who are able to use this strategy the more opportunity there will be for those who recognize its value and have the emotional temperament to invest.

If you’re looking for a better investment strategy than the one you’re currently using but are skeptical about classic Benjamin Graham net nets then — ironically — you’re probably the perfect candidate to take up the strategy. If that’s you, then I advise you to do your own homework the same way I did mine to see for yourself if the strategy is all people say it is.

That’s the easy part. The leap of faith, of course, is up to you.

Via: netnethunter