Strategy| Guides to Net-Net (Cigarbutt) Investing

This article: Your Essential Guide to Net Net Stocks I found that it's interesting to know the investing strategy of net-net (cigarbutt) that Benjamin Graham advocated and practised. This author has done a great job to share with the readers as to the essential guide to net net stocks. After reading, I would like to highlight the key points of the articles that were shared.

Excerpts

Here's what you can expect in this essential net net stock guide:

1. What Exactly Is a Net Net Stock?

Essentially a net net stock is a low Price to Book stock but where the “B” in the P/B ratio has been stripped of all long-term assets. That's about the easiest way to explain the concept.

Why strip away long term assets?

Stripping away long term assets turns book value into what net net stock investors call net current asset value (NCAV). By focusing only on the NCAV of the company, a net net stock investor is calculating a highly conservative estimate of the company’s liquidation value.

2. Why Are Net Net Stocks So Cheap?

Companies with Market Caps below their NCAV are often very troubled – they’re facing large business problems that investors just don’t think the company can come back from. Sometimes these problems reach to the core of the business, such as a major industry disruption that has all but killed a company’s only product.

It's not uncommon to find companies that have seen their revenue decimated by as much as 90%, and their earnings turn to large losses. If you see a company devastated this way, the last thing you want to do is buy stock in the company. In fact, if a typical investor owns shares in the company, he's very likely to want to dump the investment.

That reaction is understandable. In situations like that, investors have little hope that the company will survive, especially if the firm has debt to pay off. But, not all distressed situations are created equally. Some distressed firms are stuffed with current assets and have little in the way of debt or liabilities. It's these companies that astute value investors swarm in to buy.

The key fact to remember is that Graham's net net stock strategy is focused on assets, not earnings, and specifically current assets. Many firms that have quickly eroding operations still have current assets that remain resilient. If the stock is priced low enough relative to the firm's net current assets, it may constitute a net net stock and be an outstanding buy candidate. In the end, it doesn’t matter if the company continues operations or not since there are a number of ways that the investment can turn out really well.

3. Four Common Ways to Win Big

I want to point out right here that Graham favoured net nets that had positive earnings and were paying a dividend. Having said that, the evidence from academic and industry white papers show that positive earnings aren't really important when it comes to buying net nets and dividends can actually reduce returns. This is partly due to how investors tend to profit by buying net nets.

I’ve found that there are four common ways value investors make money from net net stocks: 

[1] liquidation, 
[2] 3rd party buyout, 
[3] price spike due to good news, and 
[4] recovery in operations.

Obviously, if the company doesn’t have a hope of continuing its business then liquidation is a real possibility. Since net net stocks are purchased so cheap, though, liquidations can ultimately mean a quick cash windfall. In these situations, the company distributes the cash received for the assets directly to shareholders. In a full liquidation scenario, the firm will have to cover its liabilities before distributing anything to shareholders.

A firm can also partly liquidate, selling the assets associated with a money-losing division and then distributing that cash to shareholders. Ironically, while Graham's strategy is based on liquidation value, firms rarely liquidate.

6. Narrow Focus Vs. Broad Focus in NCAV Investing

The discussion above should make one thing fairly clear: investors should really take a broad focus rather than a narrow focus on their investing when it comes to net net stocks.

Investors have to make two mental shifts before they start investing in net net stocks. Focusing on the Balance Sheet over the Income Statement is the first shift, and adopting a broad view of investing is the second.

A narrow focus refers to performance over a short time horizon or focusing on the success or failure of individual stocks. Most value investors focus a lot of attention on what an individual company will do going forward and focus far less attention on how their portfolio is constructed. They end up putting a lot of time and effort into conducting in depth research on individual stocks in an attempt to forecast the future.

Net net stock investors, on the other hand, focus on a few telling characteristics of a company and almost totally ignore qualitative research. This is because net net stock investors know that they are using a mechanical investment strategy and that the success of their portfolio depends on the statistical return characteristics of net nets in general. Net nets as a group have yielded roughly 15% over the market return since the 1930s so, as long as they have selected their net net stocks intelligently, they should see a very similar return on average over their lifetime.

Taking a broad perspective and leveraging the returns associated with net net stocks in general takes a good amount of diversification. How much? The more the better. If you're randomly selecting net net stocks then, according to my university statistics professor, 30 stocks is when your portfolio would start to approximate the population of net net stocks. Graham bought 100s of net nets, but I'm after the highest possible returns.

That means that whenever I buy net nets, I try to buy the highest quality picks. These are stocks that have growing NCAV, growing earnings, no debt, tiny Market Caps, are trading at 50% of NCAV or less, and have PEs of 10x or less. These sort of stocks are as rare as they are profitable. If I can find enough of these companies, then I'd be comfortable holding ten stocks. The further away from this ideal that the stocks available get, the more diversification I demand. I recommend that Net Net Hunter members buy 10 to 20 net net stocks, and never buy average quality net nets. Doing so should drastically increase the returns achieved and help prevent investors from buying into frauds.