No, this isn't a get-rich-quick-scheme! It’s definitely one of the boldest title I’ve written so far. But, if it has tripled my portfolio over the past 4.5 years, I think there’s a good reason to share how I did it with net net investing.
In late 2015/2016, I decided to allocate a portion of my capital into net net stocks. My intention was to diversify not only by stocks, but also by strategy. The result was astonishing! An impressive +30% annual return since I started this portfolio.
In this article, I want to share with you how I did this, what methods I use, what to look for in a net net stocks and a review of my existing portfolio. Before we go in to detail on how I did this, let’s revisit the basics first.
What is net net investing?
In our previous articles, we wrote about how to build a profitable portfolio by incorporating different blocks of investment strategies within your portfolio. For most people, fundamental analysis remains the largest allocation of capital. Today, we'll talk about the old school investing method "net net investing", made famous by Warren Buffett.
Net net investing is a style of value investing. The idea is to buy companies that are priced significantly below even its most conservative asset value.
Consider a company with the following balance sheet below. A balance sheet of a company shows what they own (assets) and what they owe (liabilities) at a particular time.
Within your assets, there are current and non-current assets. You can think of current assets as anything that you can turn into cash relatively quickly. These are stuff like current stocks in the warehouse, cash that your customers owe you, cash at hand etc.
Similarly, as the name suggest, non-current assets are things you own that cannot be quickly turn into cash. These includes brand name, patents, land, equipment etc. Now, the goal here is to determine the ratio/multiple of “Price to Net Current Asset Value” or P/NCAV.
Net current asset value = Current asset – Total liabilities
P/NCAV = Current market cap / Net current asset value
I sense a few questions here already. For example, why are we only concerned about “current assets”, as opposed to “total assets”? Remember that we mentioned that the idea is to look for companies that are priced below even in its most conservative asset value. Hence, why we used only the current assets.
In addition, because current assets are liquid, we have a higher confidence of its true value. So, by subtracting “total liabilities”, what NCAV is really implying is “the minimum value of a company if it decides to shut down its business”.
Now, we take another step further in our screening process. We are interested in companies that are currently trading with a P/NCAV of <0.65x. Why 65%? Well, it’s sort of a rule of thumb that I don’t have a logical answer to back this. But, at least 30% of margin of safety is somewhat of the consensus of practitioners of this investing method.
In short, we want to look for companies with a P/NCAV of <0.65x. Don’t forget that with this particular investment strategy, we are focusing on the asset of the company, NOT the earnings! This contrast with our traditional fundamental bottom-up investing.
Why do net net stocks exist?
Net net stocks are best described using the Buffett’s ‘cigar butt’ approach to investing. Imagine a discarded cigar butt you find on the streets, there’s usually a few more puffs left. Yes, it’s unpleasant to get a few more puffs out of it, but it’s free!
Net net stocks are similar in a way. Consequently, they also tend have the following characteristics.
- Small cap
- Distressed companies
- Usually a mono-line company that is active in one particular product
- Facing serious industry disruption
- Illiquid stocks
- Loss-making companies
Investing in such companies may be uncomfortable for some investors. However, if done correctly, the return can be extremely rewarding.
What do you look for in net net stocks?
Here are some free resources/stock screeners you may find useful to look for net net stocks.
In general, I usually relax the max criteria for P/NCAV to 1.0x (as opposed to 0.65x) , just so that I have a larger group of stocks to consider.
Next, I go through the following checklist to filter further before doing more analysis.
- Leverage ratio: look for companies who has less than 20-25%. We define leverage as Debt/Equity. This is important as most net net companies are loss making. For this reason, you will want to avoid the situation that the company isn't able to service its debt.
- Avoid China-based companies: The main reason is its fairly opaque and less transparent accounting regime. For this reason, it doesn’t give us confidence when assessing its NCAV.
- NCAV stability. This is an important indicator. Given that P/NCAV <0.65x, you will want to look for evidence that the stock has been trading at or above its NCAV in the past. This can signal the possibility of that happening again.
- Catalyst and management action. Since we’re dealing with distressed companies (most of the time), it’s important to understand what the catalyst are. For example, it may announce a strategic review to sell itself or a turnaround plan to reinvigorate the business.
- Small market cap. Ideally, we would focus on companies with a market cap of between $10-100m say. In fact, the smaller the better. The stock market works in such a way that there are very little focus/attention paid to small cap companies. This strategy avoids crowdedness and less competition, leading to higher chances of making outsized returns.
- Avoid financials, real estate/trust funds and other regulated companies. Financials and regulated companies are generally the hardest companies to analyse. One of the key reason we are avoiding it is because of its accounting regime. In short, regulated companies’ accounting differs from our framework of this strategy. This convolutes our balance sheet analysis.
Execution of this strategy
Here are few things to highlight while executing this investment strategy.
- Net net investing is a buy-and-hold long term strategy. Avoid as much as you can on short term trading. Don't forget you can always add to a position.
- Pay attention to the evolution of P/NCAV over time. It’s more of an art than science as to when to take profits. Generally, I would reassess the full position when P/NCAV > 1.0x.
- Things may not always go your way. So, it’s always good to have an idea of what level of stop losses for a single stock and what action plan to take in advance.
- There’s no guarantees in investing and this strategy is no exception. Start with small amount of capital while diversifying across a number of net net stocks.
Pros and cons of net net investing
We highlight a few pros and cons of net net investing.
- Net net stocks are stocks that offer a huge discount, in general. For that reason, return can generally be outsized relatively to blue chip companies.
- In addition, the deep discount makes it an attractive takeover target.
- Most net net stocks are mono-line businesses, making research/analysis much simpler versus other large cap stocks.
- Small cap. Because of its small cap nature, it’s difficult to scale as a strategy once your portfolio grow. Buffett moved away from this strategy partly driven by this.
- Small cap in general tend to have more volatile swings due to its illiquid nature. Definitely not for the faint-hearted. More on this later.
- No dividend. Companies of this sort usually do not pay dividend. In other words, your return will be solely capital gain.
A brief review of my portfolio
In late 2015/16, I decided to employ the net net investing method as part of my overall stock portfolio strategy. In fact, given the returns, I’m definitely kicking myself. This particular book has been bringing it ~30% per annum in returns!
Here are a listed of net net stocks that I’ve bought in 2016, along with my thought process.
You will have noticed that I did not fully adhere to criteria that stock has to have a P/NCAV of <0.65x to qualify for consideration. This is a subjective matter depending on investors' risk appetite. But, I do highly recommend to look for companies that trades at a P/NCAV of <0.65x.
One of the key things I learned throughout this process is to set a stop loss. Retrospectively, I made the right choice in cutting my losses in Sears Hometown as it breached my stop loss limit. Furthermore, it’s operating in a structurally declining industry, with online retailers being the preferred choice of consumers. It was painful loss, but at least we learn something here.
My main winner is Adverum Biotechnologies. To be honest, I got pretty lucky here. A net net stock, Avalanche Biotech (as it was then known) presented a disappointing trial results on its promising gene therapy AVA-101 in June 2015. Consequently, it stock price nose-dive by >80%.
While I’m not an expert in analysing FDA's validation process and clinical trial data, I do understand, to a certain extent, its balance sheet and net worth, despite this event. I bought the stock at ~0.8x P/NCAV and is now trading at ~14.5x. This yields a return on investment of ~450% since inception, which I'm still holding the stock until today.
Did I make it too good/easy to be true? I beg to differ. This strategy is about finding stocks in places that nobody would otherwise look at.
The idea here is simple, you’re buying a company that if it cease doing business tomorrow, you will have a good portion of margin to safety to protect you against potential losses (more or less).
To conclude, here are the steps
- Use a screener of your choice to find stocks that trades on a P/NCAV of <0.7x, say.
- Go through my checklist on what to look for / avoid.
- Do further analysis on the company that meets the criteria.
- Make a decision, sit back and relax.
I believe this mantra is perfect for net net stocks.
“Price is what you pay. Value is what you get.”
This strategy requires patience. We look forward to writing and highlighting more ideas using this strategy. If you have any ideas/questions, drop us a comment!