ValueWalk’s Raul Panganiban interviews Evan Bleker, founder of Net-Net Hunter, and author of “Benjamin Graham’s Net-Net Stock Strategy.” In this part, Evan discusses why buying stocks below net current asset value works, the objections people have with investors, the behavioural gap, the net-net scorecard, and the must haves in a company. See the full transcript.
Q2 2020 hedge fund letters, conferences and more
Why Do Net-Nets Work?
So I think net nets have worked out, you know, over the last 90 or 100 years because you're essentially buying a company based on incredibly conservative assessment of fair value. So as value investors were all interested in buying a company for you know, they say, you know, buy $1 for 50 cents.
This Tiger Cub Giant Is Betting On Banks And Tech Stocks In The Recovery
The first two months of the third quarter were the best months for D1 Capital Partners' public portfolio since inception, that's according to a copy of the firm's August update, which ValueWalk has been able to review. Q2 2020 hedge fund letters, conferences and more According to the update, D1's public portfolio returned 20.1% gross Read More
We want to buy a company cheap, but not a lot of value investors discuss how conservative conservative, their valuation framework is. And I think that when it comes to assessing fair value, the net current asset value approach might be the most conservative approach, or at least the most conservative that I can think about. Because what you're doing is you're, you know, even if you have a terrible company, it's still worth its liquidation value.
So if you look at, if you look at a growth company, for example, you know, you might be applying your discounted cash flow formula and, and then that company, you know, hits a hiccup, or maybe its competitive advantages and as strong as you initially thought it was. And so, let's say the company erodes and it's not able to grow nearly as fast as it as it was.
Or you assess that it would. And so you could still evaluate on a PE basis, right, because it's still earning money, but you know, what, if their earnings fall apart Well, if their earnings fall apart, what do you have you have book value. But you know, tied up with book value or intangible assets and fixed assets that might be worth far different than what's stated on the balance sheet. So. So if you take a step further down the wrong, you end up at net current asset value. And so you're completely ignoring those long term assets and just focusing on the current assets. And that will give you a more rock solid assessment of minimum fair value.
But, you know, these companies are given up for dead. That's the reason that why they're trading so cheaply. Graham said that, you know, it's fundamentally irrational for investors to be selling their company below what they can liquidate it for. And the argument there as well, you know, maybe they're justified because the businesses might not work out they might depreciate They might waste all the capital in the company, they might never turn around, they might actually go bankrupt. But, you know, from a practical point of view, most companies that traders net nets tend to work out, or at least tend to rise back up above net current asset value.
A lot of these companies end up doing decently as businesses going forward not well, not particularly well, because they're still, you know, marginal companies. But they're not they don't enter bankruptcy in most cases, the vast majority of cases. So it's just an it's an overreaction on the part of investors in general. But when they do work out, they could possibly work out beautiful and and some of them some of them really do. So I said, you know, maybe they recover as businesses, but if management's also pushing To develop new products, those new products can spur a whole new growth cycle for the company.
Say for example you have you know a company and its and its net current asset value is dollar it's trading at 50 cents it's been given up for dead and management's busy working on some new piece of software or you know some new piece of technology that they can use in a warehouse or something like that the the launch the technology it does catch on with the market and suddenly this given up for dead company is is making a lot of money it's growing orders are growing, you know?
You know, the company is not it's not uncommon to see these things go up a few hundred percent within years. Now, it's not commonplace, but it does happen. And so when it does happen that really pulls your portfolio returns up.
Why Do You Think Net Current Asset Value Investing Is Not As Popular?
Hmm, let's see. Well, I guess the first, the first objection that most people have most investors have maybe investors that haven't read a lot of Graham or they're not deep down the value investing rabbit holes that a lot of these stocks trade at under $1. Though, technically they are penny stocks in most cases. And so you know, people hear the term penny stock and the amount of immediately grab their wallet thinking that they're going to lose, lose their entire life savings rate.
So if you can't get past the fact that a lot of these companies trade for less than $1, then you're not going to use the strategy. So it's not going to be something that you're going to want to do. But, you know, there's a world of difference between buying, say, a marijuana stock It has a lot of speculation behind it no real assets, no real business that's trading below $1.
And a company that has, you know, 50 to 100 years of history behind it. That is marginally profitable, but has a lot of cash and receivables and inventory and and has good prospects say coming forward in the future. I mean, those two scenarios are completely different even though both companies can be trading below $1. To give you one example, there's a company in Singapore called to view holdings and it is a jewellery and gold jewellery retailer and it's trading I think right now at about five cents a share.
That's Singaporean cents. So you know, definitely in penny stock territory if there ever was a company, but if you look at the management board, you got like, you know, retire Judge you've got, you know, members of who are basically chartered accountants, a lot of really high quality, reputable people. And the company's been around for 25 years. So yeah, so I guess that would be the first reason why people don't use it, you know, the penny stock category. A lot of these companies are also junk. So, you know, people really want to buy companies, they're making a lot of money that are growing. But if you look at any net net stock, what you'll typically see is that the company's price has collapsed by about 90%.
And so, you know, automatically that's that some people will have an extreme negative reaction, just looking at the stock chart. Because, you know, if you buy a company that's dropped 90% you know, maybe you'll drop another 90%. At least that's what the feeling that a lot of people have, is. But, you know, again, most of these companies do end up working out, at least price wise. So, so it's just not the case. But they are junky companies. So they're losing money. Maybe they've had their main line of business. The main line of businesses, you know, collapsed. Maybe they lost their patents, and it doesn't seem like the company's viable anymore.
And people just don't want to own that. So I guess another reason would be impatience and chasing performance. So even the people that do end up turning to the strategy, if the strategy doesn't work in a given year, they'll tend to abandon it and follow whatever strategy or whatever formula has worked over the last, you know, one or two years that a problem with investors generally I think is well documented. And then, of course, there's scepticism, the laziness and i think that you know, this plagues a lot of the retail investors community will say, you know, this strategy doesn't work. What are you talking about?
No, you can earn those returns or, you know, no, the the strategy didn't perform that well, in the past or, you know, yeah, maybe the returns are there for the papers, but you can't practically apply it. But they're also lazy. So a lot of the people that don't think I'll work won't go out and look for. They won't look for evidence one way or the other to see if it will or will not work. And you asked a question about studies earlier. And in the book, I list, I think about 10 or 12 academic studies that have been published in major academic journals over the last 50 years.
They also tremendous health performance. And I actually didn't answer that question earlier. But I think if you're, if your listeners want to go on to Google and just start googling net That study or Oppenheimer, montair those type of people, you can easily find studies that that support the strategy. But most people don't even look for the evidence to see if the strategy will work. So. So I would say that that is another strong factor. And just as an aside, I, I don't think it's useful to only look for confirming evidence, you know, just to confirm your own biases.
So what I do is I, I try to get a good look at all the evidence. And I purposely went out and I looked for studies that disconfirm the strategy to say that the strategy doesn't work. And I found two out of 10 to 12 studies total.
One study was written I believe in the 1930s. I don't remember much about that study, but that study was out there. There was another study that was that came out in the 80s or 90s. And the author says, Oh, yeah, there's no risk, adjusted, advantaged by net net. And then he went out, and he did a follow up study, and he found exactly the opposite. So he took back his previous study. Um, so, so yeah, I guess that's a long answer.
Do You Think That Retail Investors Have Enough Knowledge Or To Interpret Those Studies Correctly? And The Studies Or Academic Studies In General, Do You Think They Do A Good Job In Showing The, Like The Returns That You Can Get And Versus The Actual Results That You'll Get As A When You Implement It?
Yeah. So a couple good questions. I'll start with your Last one first. So I guess they call that the behavioural gap. And no, I don't think that the studies do a good job of taking into account the behavioural gap in most cases. So just for your listeners here, there is a difference between what a study says a strategy can produce in terms of returns, and what practical application will allow you to realise in your portfolio. And a lot of that practical application comes down to, I guess a couple of things, it comes down to difficulties with trading.
Maybe company's extremely hard to buy. Or, you know, maybe there's just not enough volume there for example, so you have you want to invest $5,000 but there's only you know, 50 to $100 worth of stock trading today. Well, you're not going to be able to That, but the studies might not account for that. So that's that's one issue that they don't necessarily take into account. Another issue is the behavioural biases.
So as humans, we're all subject to certain cognitive and psychological biases, that really trips up our ability to make strong rational decisions. And it doesn't matter who you are, you know, you could be Warren Buffett, you're still going to be subject to these things. And so what you can do is you can put in processes that that really helped you sidestep a lot of them, but you're still going to be subject to them. Ah, now in terms of, in in terms of viability, one of the objections that people have about the strategy is that well, you can't buy them because they're, they're illiquid, that huge bid ask spreads.
So you know, how you, how can you possibly buy these, these companies, for example, you have one company, it's, it's true, you know, the market, the last trade went through at 25, the bid is maybe 10 cents and the ask is maybe 30 cents. So, you know, if you if you're paying 30, and then suddenly you can sell it at 10. That's not a good strategy. But these same people that argue the same way, don't take into account limit orders
A limit order is in order to your broker not to buy or sell past a certain price. So you're looking at these net nets and that same company that has, say, a bid of 10 and an ask of 30, traded at 25. Well, you just put in a limit order at 25. And, and somebody has to come to your, your 25 figure in order for the trade to go through and that's that's what we do. And you know, the bid ask spread is not a problem. But low liquidity can be a problem some studies
Net Current Asset Value And Coke
Take, take that into account. And some studies don't. But I think that this is also a problem for it's a bigger problem for people who have bigger portfolios. So if we go back to the example where the comm or the where the stock has, you know, only a couple hundred dollars of volume in a given day, well, if you have a portfolio, that's $5,000, maybe that's enough volume for you. Also, you know, professionals don't go out and buy their entire block of shares in one purchase, like, you know, what did Warren Buffett buy for Coca Cola stock? I think they had, he was buying a stock over the over a number of weeks just to get off first portfolio.
So but retail investors seemed to think that you should be able to buy your entire position in one go, which is kind of an erroneous way of thinking about trading. So what I do when I'm trying to buy stocks that are, you know, very, very low in liquidity is I, I tried to put in small orders, small limit orders, try and get those orders filled. And I, you know, it could take, you could take a couple days to a couple weeks in order to fill the orders, but you can also just look for bigger stocks. But not all, not all the studies look at those factors.
What Is The Net-Net Scorecard?
Yeah, so I mean, the net-net scorecard is basically a checklist. It's a little bit different because in your checklist, it'll just be a list of things that you have to check or the company has to meet. And a scorecard, I guess would be a similar thing. But, you know, there's some optional criteria there. And the more criteria that a company meets, the better off it's going to be as an investment so. So we have our nethunter scorecard. Can't remember offhand how many criteria it's comprised of, we'll say 10 to 12. Roughly, it has a number of criteria that I consider must haves in a company. And then of the number of criteria that I say, Well, you know, if, if you have a few of these, then you're starting to look at a pretty good opportunity. And so that's basically what the scorecard is.
Can You Give Some Examples Of The Must Haves With Net Current Asset Value Investing?
So the must haves, it would have to be trading below net current asset value for ripple. I also like a situation where the company doesn't have a lot of debt because the last thing that You want in a troubled company that's lost most of its revenue, or most of its ongoing businesses, you know a lot of debt that it has to service. So I look for a very conservative balance sheet and price below net current asset value just as basics. Now, if you get further below net current asset value, obviously you're buying more liquidation value for less money, that's always good. But also if you if you're looking at things that you may, you may want to identify to see if the company is a better than average prospect, you might look at growth is the company actually growing?
Not all companies are terrible, some are just overlooked. So especially looking in Japan, you can find companies that are actually growing revenue, net profits, and their asset base and so you know if you can buy one Have those that 50% of net current asset value, and it looks like the company will continue on this trend for, you know, whatever reason, that can be an outstanding buy, especially if it does. Also low PE in certain cases can be, can be great, but not in all cases. So yeah. I mean, basically, we're looking at two different sets of criteria, you know, one of the must haves, which I shall give you a couple examples, and then the ranking criteria.