Rules for net-net investing

I often write about net-net's on this blog and from time to time I get questions asking for certain clarifications to my net-net investment process.  I don't have a written guide so I thought this would be a good place to put down some rules I try to follow.

I guess in a way this could be considered a checklist for investing in a net-net.  I prefer to think of these notes as my net-net guidelines.  Even though these rules are numbered there is no importance to the numbering.  The reason for this is that each investment is different, for some companies #6 might be the most important issue, whereas for others #2 might be more important.

1) All rules can be broken but only for a very good reason.  Good reasons must have a much higher burden of proof.

2) Always prefer cash to inventory and receivables unless:

• Management is acquisitive, in general stay away.
• There are restrictions on a dividend.

3) If there are securities on the balance sheet consider if they are encumbered by a relationship.  Are the securities a company in the supply chain, or a cross holding?

4) Prefer shrinking receivables and shrinking inventory accounts.

• If inventory is shrinking too fast cash will need to be used to build it back up soon, beware.

5) Prefer cash flow and free cash flow over net income if a decision is forced.  Prefer both if possible.

• Check the accruals ratio for both balance sheet and cash flow accruals.  High accruals are a concern.

6) Stay away from companies that continually change strategy and business line.

7) If operating results are poor is there a chance they will turn around?

8) Determine why the company is selling below NCAV.

• Is it a good reason?
• Is the general industry in decline?
• How obvious is the reason?
• What changed recently?

9) Would I loan this company my own money for a five year term?  How likely is it I would get it back?

10) Am I relying on non-liquid assets that need to be liquidated?  Is there a market for those assets?  How quickly do those assets sell?

11) If possible try to ascertain how long the company has been trading below NCAV.

12) Always check message boards and blogs if possible.  Current investors have much better insight into the ongoing operations and past struggles.

13) Are there a ton of value investors already invested in this stock?  If this is such a popular idea why is it still cheap?

14) Is there a catalyst on the horizon?  Have there been rumors of catalysts for years that have never materialized?

15) Do I need to rely on a catalyst to realize my investment?


If you have any more suggestions to add I'd love to hear them, leave them in the comments or feel free to send me an email.

Talk to Nate about net-net investing