How To Use +EV To Pick the Highest Potential Net Net Stocks by Evan Bleker, Net Net Hunter.
he following is a guest post by Danny Harper and may or may not reflect the views of anyone else at Net Net Hunter.
Value investing with an emphasis on identifying positive expected value is a tried-and true-strategy that rewards calculated investors who play the long game with a large portfolio of stocks.
As the 3000 people who signed up for free net net stock picks already know, the vetting process is heavily numbers-based and not all net net opportunities are created equal.
A few weeks ago I wrote about the key things to look for to boost positive expected value when selecting net net stocks for investment. In order to clarify exactly what a net net investor should be looking for, let’s focus on a case sample of one particular stock whose characteristics and recent price performance demonstrate the power of positive expected value as a way to assess the likely return of investing in a specific net net stock.
What is Sangoma Technologies?
Founded in 1984, Sangoma Technologies Corporation started as a traditional Canadian telecom company, offering PSTN solutions to enterprise customers.
When I originally looked at Sangoma back in 2013, the company was in the process of transforming its business. Needless to say, the technological landscape has changed a great deal over the past 30 years, and with digital controls taking over, Sangoma made the decision to follow suit by transitioning into VoIP. They are now a provider of hardware and software components that enable or enhance IP communication for voice, data, and video applications.
Sangoma’s current focus is on deploying a cost-effective communication toolset to service providers, carriers, and enterprises who need to interconnect their devices, while also being able to leverage their existing infrastructure for maximum financial return.
From the business description, we see a company with a long history and a willingness to adapt by evolving technically and seeking out more profitable markets. These are good characteristics for a net net stock investment to have, but alone they’re just not enough. What else was it about Sangoma that made it such a strong net net candidate back in 2013?
To answer that, we have to dig a bit deeper.
Why Sangoma as a Net Net Stock?
While Sangoma seemed interesting, the numbers still had to be right, along with a host of other important factors, before pulling the trigger on the investment. Evan made all of these critical factors available for download as part of his NCAV Investment Scorecard.
Fortunately, when I dug deeper I saw an increasingly promising picture coming together which made it easy to see the potential of the investment. From a positive expected value perspective, this stock seemed to check all the right boxes.
Size – They are a little-known Canadian stock with a market cap of 9 million… small enough to fly under the radar of large mutual funds. This is an important aspect because the fewer people who can buy these firms due to their size, the better the opportunity is for investors with small portfolios.
There is almost a 1-to-1 correlation between how small a firm is with a stock trading below NCAV, and the size of its expected returns. The smaller the companies gets, the higher their returns as a group, all else being equal. The largest returns are found among the smallest net net firms — and at $9 Million CAD, Sangoma was tiny.
Valuation – Valuation is a critical factor in assessing the merits of a net net stock. The lower the stock is priced relative to net current assets, the higher it has to rise before reaching fair value and the less it’s likely to fall from your purchase price if it doesn’t work out within 2 or 3 years. Looking at the literature, firms with the largest discounts to NCAV tend to always outperform their peers.
Sangoma was priced at a 45% discount to net current asset value. That’s a massive discount, which provided both safety and profit potential for investors who got in when it was brought up on the Net Net Hunter forums. To get back to fair value, the stock would have to rise 82%.
Stability – Not only was Sangoma’s NCAV very stable, it was actually up over a 4 year period. This is very important because the value placed on a net net stock comes from its net current assets. If those net current assets are shrinking, so is your profit potential. In Sangoma’s case, the company’s NCAV was actually increasing. If its NCAV increased over the next 3 years, so would an investor’s profit potential.
Financial Position – Evan once wrote that firms that don’t have debt can’t go bankrupt. I’d extend the principle, firms that have only a small amount of debt have a small chance of running into solvency problems. This is important when it comes to overall returns. Tweedy Browne showed that net net firms with total debt to equity ratios of less than 20 or 25% returned roughly 5% more than their peers. Sangoma had next to no debt, which was great.
Share Buybacks – You can glean a lot of information from the balance sheet, and Sangoma’s has been a treasure trove of indicators. A critical one is the fact that the company’s basic share count has been falling every year since 2009 (currently at 28.8M). When companies are confident, the buy back stock, because they are not expecting a cash shortfall. In short, this is a huge vote of confidence.
Business Strategy – This one is very important when it comes to Sangoma. One of the big reasons why the firm is undervalued currently is the way they approached business. Up until 2011, Sangoma was a pure telecom, but the ebb and flow of technological progress made their market much more difficult. As sales started to take a turn for the worse, instead of attempting to stay the course with new spins on old ideas, Sangoma made the tough managment choice to evolve.
Even with the short-term pain that resulted from the transition, most notably higher expenses, lower profits, and a consequent drop in stock price, Sangoma decided that acquisitions and innovation were more valuable than staying the course with old technology. The drop below NCAV, combined with an ambitious (yet calculated) business strategy shift, is exactly what net net investors should be on the lookout for.
As you can see, all of these factors played important roles in Sangoma reaching fair value after being depressed.
Positive Expected Value at Work
Given all of the positive indicators, how did I assess the expected value of the company?
Warren Buffett claimed that net net stocks worked out roughly 75% of the time within 2 or 3 years. Starting with that assumption as our baseline, I assumed the following:
Return – Probability – Impact on $10 000
82% Gain – 90% – $7 380 Gain
50% Gain – 10% – $500 Gain
0% Change – 0% – No Impact
50% Loss – 0% – No Impact
100% Loss – 0% – no Impact
Total: $7 880, or a 78.8% Gain
Clearly Sangoma was no bankruptcy target and it was a far better than average net net stock candidate, so I gave it a much higher probability to rising back up to NCAV.