This post is the first part of a three part series.
First off I think it's helpful to consider what Ben Graham said about net-net investing and market conditions:
"It may be pointed out, however, that investment in such bargain issues needs to be carried on with some regard to general market conditions at the time. Strangely enough, this is a type of operation that fares best, relatively speaking, when price levels are neither extremely high nor extremely low." (Graham, Security Analysis 6th edition, p571)
What Graham contends is that when the market bottoms it's much better to buy quality companies that have fallen disproportionately with the market rather than focus on net-nets. I would agree with this with the caveat as you'll see below, market bottoms offer opportunities to buy "quality" net-nets, companies that have long records of profitability and are selling below NCAV. There's no reason an investor couldn't combine investment styles, purchasing some quality companies cheap as well as quality net-nets in a low market.
Of course the data shows that net-nets purchased in 2002 and 2009 with long strings of profitability rewarded shareholders. This is an obvious conclusion, buying almost anything at a market bottom had positive returns. These are the results of the point in time screen Geoff ran for me. The picture shows the results of the screen, there are the important pieces of information. First is the ticker and company name. The start column is the price at 6/15/2002, and end is the price at 6/15/2012, or the buyout price. The other columns are self explanatory, but I want to highlight the last one, it's the number of years with positive earnings. Here are the results:
As a comparison I imagine a hypothetical portfolio where someone invests $1000 equally into the ten stocks. For comparison I use the Vanguard Small Cap Value Index with the same starting sum and same date range.
Starting sum: $10,000
Net-net investor: $16,558
Index investor: $14,511
Net-net investor outperformed by 14%.
I should also note none of these figures include dividends, they're prices only. The index is price return as well, so it should be a good comparison.
Sure raw data is nice to look at, but I'm always fascinated with the stories of the actual companies. So in VH1 style I went and dug around to find out what these old net-nets were up to now.
Blair - Bought out in 2007 by Appleseeds and Golden Gate Capital. A value investor talking to management was the catalyst for this transaction.
Friedman Industries - Still trading and looks decently attractive, 5.2% dividend, P/E of 9x.
Electro-Sensors - Still trading, it hit $11 back in 2006 but has generally traded in the $2-4 range since the early 1990s.
Refac Optical Group - Bought out by a Private Equity firm in a LBO.
Books-A-Million - Going private. I want to make a mention with them, if a shareholder purchased in 2002 and held on they'd be looking at a 25% gain over the last ten years. This masks the fact that coming out of the 2002 recession Books-A-Million shares climbed almost 10x topping out close to $25. It's a shame the shares didn't do the same thing the second time they found themselves in the net-net bin.
Allou Healthcare - It turns out this net-net was a massive fraud. Execs booked phony sales, inflated inventory and eventually burned down their warehouse. Fraud is always a concern with net-nets, I have a post coming up on this in the very near future.
Ambassadors International - The data appears incorrect on this one, the company is around and trading at $5.18 a share. The company has made some acquisitions over the years and is slightly profitable.
BCT International - Management bought out shareholders in 2003. The company appears to still be operating. I find it ironic that in the news release mentioning the going private transaction it also notes earnings grew 59% and revenue grew 10% that year.
Control Chief Holdings - They executed a reverse merger and went dark, very dark. To get financials one needs to be a shareholder, and becoming a shareholder isn't easy. I've had bids out at times over the past year without getting a hit. The last trade supposedly took place in 2011. If anyone has information on this company please email me below.
TransNet Corporation - The company struggled through the decade and has been consistently losing money over the past few years. They haven't been able to file with the SEC for the past year. They're literally a penny stock, their price is 1¢.
The results from 2002 were pretty remarkable, as a group an investor who purchased the top ten did very well. It's interesting that the results are polarized, companies either went to zero, or recovered nicely. There are no companies on that list down 30% over the decade, if there were losses they were total losses.
Here are the companies from 2009:
My first observation is that five of the ten are still net-nets! The good news is that the share prices haven't remained flat the entire time. Here's how the hypothetical investor would have fared investing $10,000 equally into these stocks using the same criteria that I mentioned above.
Starting sum: $10,000
Net-net investor: $17,457
Index investor: $14,191
Net-net investor outperformed by 23%.
In both cases of buying at the market bottom the pure net-net investor came out ahead of someone buying the value index. The difference between 2002 and 2009 is that since 2009 there haven't been any total losses yet.
Superior Uniform Group - The company has recovered strongly coming out of the recession by doubling profit.
Flexsteel Industries - I wrote them up last August, I don't believe they're a net-net anymore.
Abatix Corp - Still a net-net, there's a great writeup about them at OTC Adventures.
Nortech Systems - Still a net-net, I just looked at them recently, they're steadily plodding along.
Performance Technologies - The chart for them is a line steadily sloping down and to the right, not a good sign. It appears their earnings have taken the same path.
Movado Group - This stock's outperformance came pretty recently, it had traded in the $10 range until the end of 2011 when the company stopped losing money and reported profits.
TSR - Still a net-net, Whopper has covered them here.
Lakeland Industries - A net-net that's taken a turn for the worst, they lost an important court case that requires them to pay $10m. This company has also been covered by Whopper.
RF Industries - The company's results have been lumpy over the past few years but their price has recovered and now the company sells above book value with a P/E of 39. Just as the market can overshoot to the downside, it can overshoot on the way back up as well.
Paradise - This is still a net-net and a bit of a niche hidden champion. Despite still selling below NCAV the company's results have improved and the share price has reflected that.
A general observation is that none of the top net-nets in 2009 were bought out or went private. The ones that performed well were due to company results improving. In a few cases it looks like the market went from overly pessimistic to overly optimistic.
In the next part of this post I'm going to take a look at what happens when an investor buys net-nets in a market that's neither high nor low.
Talk to Nate
Disclosure: No positions
Good stuff. Thanks for sharing.
ReplyDeleteNate,
ReplyDelete1. Statistical strategies should be compared to other statistical strategies, like low P/B, "magic formula", Piotroski,GP/EV and so forth -- rather than to an index -- don't you think? Virtually all statistical strategies outperform; the net-net strategy's claim is that it outperforms those others. Otherwise, why bother?
2. The risk in a net-net strategy is the use of human discretion -- thinking that one can separate the wheat from the chaff through judgment. For example, it seems to me that PARF is in no way a "hidden champion" -- it earns barely 6% on the capital invested in the business and its cost of capital is clearly above 6%. The business is certainly worth nothing and probably the opposite - it has negative economic value. That, I would reason, is why its a net-net: the cash has value, the business has negative value, add it up and you get the current price. You, however, would perhaps think the opposite. One of us would be mistaken. In a statistical strategy, where net-nets are bought as a big bunch it doesn't matter that we disagree: some will win, some will lose, but in general and over time, the winners will more than make up for the losers. But in a concentrated net-net portfolio, where human discretion is involved, I wonder if the outcome would be as happy.
Thanks for the post, and for your site generally.
Red,
DeleteThanks for the comment so to try and answer some of the issues you raise:
1. I'm no data wizard if you have the ability to do this please do, I'd love to see the results, I'll post them as well. What I like about net-nets is that this is an actionable strategy that Graham discussed back in the 1930s that's proven to work. Some of the other strategies such as Magic Formula work in backtesting only. There was a great post by a researcher recently about how they've found it impossible to replicate the Magic Formula performance. So Greenblatt is doing something extra that he doesn't tell us, maybe that's the magic?
2. Yes, the big risk is human, first being able to buy some of these businesses, and second being patient. Sure there's the academic point for PARF the business stinks but they have a pile of cash. The problem for me is in a private market where reasonable businessmen make decisions a company wouldn't sell this cheap, most net-nets wouldn't. My experience with private acquisitions is it's very hard if not impossible to buy a company privately that's as cheap as some of these public companies. I also question a negative economic value, doesn't PARF provide jobs and tax revenue for the local economy? They're turning a profit by providing a service to someone. I guess it would be a negative value if those customers didn't deserve to be served, but I don't really have an indication of that.
The general point Graham makes is the same chapter I quoted is something is wrong when a company sells below NCAV, either management should liquidate which would bring a positive return, or management needs to be changed. Of course there are limits to both mainly managers who want to keep their jobs, but a company should never be selling for less than it could be liquidated for.
Glad you enjoy the site, thanks for the comments, they're though provoking.
Red,
DeleteYou may be interested in this paper. You would be correct in thinking that active value investors underperform mechanical value investors. For example, the average return from 2010-2011 for self managed magic formula accounts was just under 60%. Not bad. How did the S&P perform? About 63%. How about the statistical magic formula accounts? A whopping 84%.
http://www.scribd.com/fullscreen/97001708?access_key=key-277kw4gpzmb8o27srpuv
http://www.scribd.com/fullscreen/97001708?access_key=key-277kw4gpzmb8o27srpuv
Thanks for the links, Taylor.
DeleteThanks for the reply.
ReplyDeleteAs far as I'm aware, Graham (and Shloss) bought net-nets in bunches, thirty or forty at a time.
As for "economic value", I use that awkward expression as a substitute for an even more awkward phrase - "intrinsic value". Your investment in a business like PARF has costs -- the returns that you could have earned in treasuries, bonds, ETFs, or some other stock.
If one invests $100 in PARF's assets, one can expect 6% back per year; if one invests the same amount in the S&P or some other index, one can expect ~9% back a year. Every year one holds PARF, one loses 3% of the value of one's investment via opportunity cost.
That's why the business has negative economic value for the investor. Everyone else, -- employees, suppliers, customers, tax authorities -- are quite happy with PARF.As for the private investor,given that PARF's under-performance is built into the business (tremendous amount of working capital required to generate very little in terms of profit), why would a rational person -- private buyer or Mr. Market -- want to pay full price?
I don't think they would: the'd pay 2/3 of the price of the assets, just in order to break even.
And that missing 1/3, the proxy for value destruction, has a value of ~$5-$6 million, which, not coincidentally, is the value of the excess cash.
I understand your economic value expression now. So I've never actually looked at PARF before, your comment spurred me into action. So let me break down where a net-net has value here.
DeleteThe company has $7m in cash on the balance sheet and a book value of $19m for 2011. Let's say they pay out $5m of the cash as a special dividend, they clearly don't need it. Now the company's ROE is 8.37%, yes we're not talking Apple numbers here, but for an agricultural business 8.37% is decent. Compared to a bank account earning 0%, or a Treasury earning 2%, 8.37% looks pretty darn good.
That is taking things in a vacuum, so let's consider this with the market price, so they have an enterprise value of $2.135m and had $2.679 of FCF in 2011. So as a thought experiment, if the company gave back all the cash does this deserve to trade below FCF generated in 2011? I don't know many companies trading for less than a single year FCF. I'm not even sure you can argue a company earning 6% or 8% deserves to trade that low.
So that's the paradox with the net-net, yes PARF is an average or below average company. But in PARF's case if they gave back all the cash (which might or might not happen) even being a crappy company it doesn't deserve to trade this low.
If this is a reasonable price I'd love to see some transaction history for small companies selling for less than 1x FCF in the food industry. I don't have the data, but my suspicion is it just doesn't exist.
So is PARF a company to buy and hold forever? Nope I wouldn't say that at all. But they're worth buying for less than NCAV and selling when they hit a reasonable valuation, maybe 50-100% higher than now.
I'd also question the 9% S&P assumption, that surely hasn't been true over the last decade. There are thousands of companies getting nailed by their pensions because they've made those assumptions.
I also agree it's silly to concentrate in the "best" net-nets, I advocate buying a bunch of these as well as I've done for myself. I personally own 17 net-nets, and I plan on continuing to buy more as the opportunities arise.
Oh, I like your blog, Richard Beddard had linked to it recently.
Thanks again for the thoughtful response.
DeleteYou have a great deal more confidence in PARF as a value investment than I do (my answer is yes, it deserves to trade that low - as it has for a decade), but, as I say, I could well be wrong. Owning a bunch of net-nets is protection against being wrong about any one net-net so I'm glad we that we agree on that.
Cheers. I've followed you blog since its inception, so I'm a fan.
I'm not sure I actually do have confidence in PARF, it's just the price seems too low. I don't own any shares and like I said above before a few hours ago I'd never looked at it.
DeleteI don't think a stock going nowhere for a decade means much, I mean look at MSFT or DELL, or INTC or many of the other companies that have gone nowhere in the last ten years. Maybe these companies deserve it as well? I don't know, well I don't think Intel does since I own it, but I haven't looked at Microsoft or Dell.
Thanks for being a reader, your comments have added a lot of value to the discussion.
Well, some stocks -- tech stocks, for example, and even Walmart -- were overvalued ten years ago, which is why they've gone nowhere as unrealistic growth expectations have been slowly shed. Intel & Cisco might be undervalued today, however: the market is saying that their franchise will shrink slightly; I don't know enough about either business to be able to say, one way or the other.
ReplyDeleteI believe they were the net-nets with the longest history of continuous profits.
ReplyDeleteWhen you buy a net net, the main thesis is that you buy at a price that is so low that you have a significant margin of safety. You could liquidate these companies and still make a return.
ReplyDelete"It's interesting that the results are polarized, companies either went to zero, or recovered nicely. There are no companies on that list down 30% over the decade, if there were losses they were total losses. "
This observation makes me wonder. Do net net really offer a margin of safety with results so polarized like these? Doesn't that go against the core principle of a margin of safety:"never be exposed to a permanent loss of capital"?
Disclaimer: I am a big fan of this blog
This is a really good question, I'm covering it in my conclusion piece.
Delete