Looking for value in the overlooked margins of the market.
Interview on the Benzinga PreMarket show
I was asked to be a guest on the Benzinga PreMarket show again, to which I happily agreed. You can find my segment below. I discussed the Citizens Bank (CFG) IPO, along with merger activity in small banks, and a European bank idea.
Portfolio Strategies: Liquidity
Liquidity for most investors can be measured in seconds, the amount of time it takes to open a portfolio and click 'sell'. The speed at which investors can change their minds has created a distorted environment where frantic buying and selling is the norm, and patience is old fashioned.
I want to examine what liquidity is, why you need it, and also reframe the discussion. I think sometimes discussions about liquidity are really discussions about symptoms, not the root cause.
What is liquidity? Liquidity is a measure that represents the ease at which something can be bought or sold in a market.
Almost all purchase or sale decisions outside the stock market involve friction in both buying and selling. Almost everything anyone buys is illiquid, yet this doesn't seem to bother consumers. For example consider a house purchase. A family decides they want a new house, they hire a realtor, tour houses and eventually find one they like. Then they place an offer and haggle back and forth with the seller. Once an agreement is reached financing needs to be arranged, documents need to be signed and a closing date is set. Often the closing date is a month or more in the future. If the buyers move in and decide they don't like the neighborhood they have to endure the same lengthly sales process they just went through before they can be rid of their purchase.
Consider another example of a smaller purchase, a dress shirt. To purchase a dress shirt you need to drive to the store, pick it out, then stand in line to purchase it. If you get home and decide you don't like it you need to make another trip to the store, stand in line again, and conduct the return.
Anything that's purchased out in the 'real world' involves friction in both buying and selling. Once something is purchased there's a hassle factor to returning the item and receiving your money back. I can't think of any purchases where one can buy something, immediately change their mind and within a few seconds have reversed the entire transaction. It's fair to say that illiquidity is part of any transaction when something is purchased.
Even cash, the golden standard of liquidity, is sometimes illiquid. When someone wants to move cash from a savings account to a checking account it takes three days for the money to post. Say the person changes their mind on the transaction and wants the money back in their savings account, another three days to transfer back. A full six days for cash to make a round trip between one account to another.
When consumers understand that a transaction has considerable friction or is hard to reverse they spend a lot of time up front to ensure they're making the right decision. I've heard people joke that many investors will spend dozens of hours researching which washing machine to buy and then spend 15m researching a stock purchase. On the face of it this is absurd, an investment is many times the value of the washing machine, so why the time differential? It's because the cost of making the wrong decision on the washing machine is much greater than the cost of making a poor investment decision. If one purchases the wrong washing machine it's not an easy task to return it. Whereas if the investment purchase is wrong it's just a few mouse clicks from a sale.
When an investor is considering either an extremely large purchase of a business, or purchasing a private business they spend a lot of time researching their decision. Large minority, or majority investors don't have the luxury of selling off their position anytime they want. Their sale could be interpreted as a signal to the market with the share price negatively reflecting this information. An investor buying a stake in a private business has to consider their decision carefully because they can't easily reverse it either.
Larger holders, and private company investors also have different investment objectives compared to the majority of private market buyers. They aren't looking to flip their shares quickly for a small gain, rather they're in the investment for the long term. They are looking for capital appreciation, or for the company to return a portion of their profits to them as dividends.
Dividends are under-rated, they provide liquidity in even the most illiquid situations. If a company is profitable and investors are paid out a portion of earnings as a dividend not many investors can be found complaining about the inability to sell shares. In fact the opposite is true. I know of a number of very illiquid unlisted stocks paying very high dividends and it's impossible to buy shares because no current holders are willing to sell!
The drive to own a liquid stock stems from two underlying reasons, the near term need for the cash, and for the optionality to change ones mind quickly after a purchase has been made.
In order to purchase more illiquid assets a strategy needs to be put in place. Here is how I structure my portfolio in a manner that allows me to own very illiquid assets. Money I need for near term events, which I define as five years or less I hold in a savings account. I never invest this money, and my liquidity on it is three days. Beyond my initial cash I own a number of stocks that are either very liquid, or moderately liquid. A moderately liquid stock is one where I could sell out of my position in a day or two, a very liquid one is where I could sell out of my position instantly.
The bulk of my portfolio consists of moderately liquid holdings. Some of these holdings pay dividends, but not all do. If the market provides an opportunity for an exit then I'm willing to forgo a dividend, although I prefer one if possible.
The last portion of my portfolio I invest in illiquid stocks. I view these in the same way I'd view purchasing a stake in a local business. I expect to be in these holdings for a very long time. Because of the time commitment I will only invest when these stocks trade at a significant discount, and I always want them to pay me a dividend. I have made one exception to the dividend rule, it was for a stock trading at 10-15% of BV and a few times earnings.
When I first realized the potential to dedicating a portion of my assets to illiquid securities I came across an article with a quote from Jack Norberg, the unlisted stock king. He suggested to the journalist that no more than 15-20% of one's portfolio be dedicated to illiquid securities. This seems like an accurate number to me as well, I personally have 18% of my portfolio in illiquid securities.
One question I haven't addressed that some readers might be asking is "what's the point of buying any illiquid stocks at all?" Let me answer the question this way. If a local businessperson approached you with the opportunity to buy shares in their successful business for 4x earnings and at 50% of book value that paid a 10% dividend would you consider that investment? I think many investors would, and investors don't need to find local businesses to invest in. There are many opportunities like that in the current market place found in stocks that don't attract a quote daily (or at times weekly). Its in these stocks that some of the most incredible bargains can be found.
I want to examine what liquidity is, why you need it, and also reframe the discussion. I think sometimes discussions about liquidity are really discussions about symptoms, not the root cause.
What is liquidity? Liquidity is a measure that represents the ease at which something can be bought or sold in a market.
Almost all purchase or sale decisions outside the stock market involve friction in both buying and selling. Almost everything anyone buys is illiquid, yet this doesn't seem to bother consumers. For example consider a house purchase. A family decides they want a new house, they hire a realtor, tour houses and eventually find one they like. Then they place an offer and haggle back and forth with the seller. Once an agreement is reached financing needs to be arranged, documents need to be signed and a closing date is set. Often the closing date is a month or more in the future. If the buyers move in and decide they don't like the neighborhood they have to endure the same lengthly sales process they just went through before they can be rid of their purchase.
Consider another example of a smaller purchase, a dress shirt. To purchase a dress shirt you need to drive to the store, pick it out, then stand in line to purchase it. If you get home and decide you don't like it you need to make another trip to the store, stand in line again, and conduct the return.
Anything that's purchased out in the 'real world' involves friction in both buying and selling. Once something is purchased there's a hassle factor to returning the item and receiving your money back. I can't think of any purchases where one can buy something, immediately change their mind and within a few seconds have reversed the entire transaction. It's fair to say that illiquidity is part of any transaction when something is purchased.
Even cash, the golden standard of liquidity, is sometimes illiquid. When someone wants to move cash from a savings account to a checking account it takes three days for the money to post. Say the person changes their mind on the transaction and wants the money back in their savings account, another three days to transfer back. A full six days for cash to make a round trip between one account to another.
When consumers understand that a transaction has considerable friction or is hard to reverse they spend a lot of time up front to ensure they're making the right decision. I've heard people joke that many investors will spend dozens of hours researching which washing machine to buy and then spend 15m researching a stock purchase. On the face of it this is absurd, an investment is many times the value of the washing machine, so why the time differential? It's because the cost of making the wrong decision on the washing machine is much greater than the cost of making a poor investment decision. If one purchases the wrong washing machine it's not an easy task to return it. Whereas if the investment purchase is wrong it's just a few mouse clicks from a sale.
When an investor is considering either an extremely large purchase of a business, or purchasing a private business they spend a lot of time researching their decision. Large minority, or majority investors don't have the luxury of selling off their position anytime they want. Their sale could be interpreted as a signal to the market with the share price negatively reflecting this information. An investor buying a stake in a private business has to consider their decision carefully because they can't easily reverse it either.
Larger holders, and private company investors also have different investment objectives compared to the majority of private market buyers. They aren't looking to flip their shares quickly for a small gain, rather they're in the investment for the long term. They are looking for capital appreciation, or for the company to return a portion of their profits to them as dividends.
Dividends are under-rated, they provide liquidity in even the most illiquid situations. If a company is profitable and investors are paid out a portion of earnings as a dividend not many investors can be found complaining about the inability to sell shares. In fact the opposite is true. I know of a number of very illiquid unlisted stocks paying very high dividends and it's impossible to buy shares because no current holders are willing to sell!
The drive to own a liquid stock stems from two underlying reasons, the near term need for the cash, and for the optionality to change ones mind quickly after a purchase has been made.
In order to purchase more illiquid assets a strategy needs to be put in place. Here is how I structure my portfolio in a manner that allows me to own very illiquid assets. Money I need for near term events, which I define as five years or less I hold in a savings account. I never invest this money, and my liquidity on it is three days. Beyond my initial cash I own a number of stocks that are either very liquid, or moderately liquid. A moderately liquid stock is one where I could sell out of my position in a day or two, a very liquid one is where I could sell out of my position instantly.
The bulk of my portfolio consists of moderately liquid holdings. Some of these holdings pay dividends, but not all do. If the market provides an opportunity for an exit then I'm willing to forgo a dividend, although I prefer one if possible.
The last portion of my portfolio I invest in illiquid stocks. I view these in the same way I'd view purchasing a stake in a local business. I expect to be in these holdings for a very long time. Because of the time commitment I will only invest when these stocks trade at a significant discount, and I always want them to pay me a dividend. I have made one exception to the dividend rule, it was for a stock trading at 10-15% of BV and a few times earnings.
When I first realized the potential to dedicating a portion of my assets to illiquid securities I came across an article with a quote from Jack Norberg, the unlisted stock king. He suggested to the journalist that no more than 15-20% of one's portfolio be dedicated to illiquid securities. This seems like an accurate number to me as well, I personally have 18% of my portfolio in illiquid securities.
One question I haven't addressed that some readers might be asking is "what's the point of buying any illiquid stocks at all?" Let me answer the question this way. If a local businessperson approached you with the opportunity to buy shares in their successful business for 4x earnings and at 50% of book value that paid a 10% dividend would you consider that investment? I think many investors would, and investors don't need to find local businesses to invest in. There are many opportunities like that in the current market place found in stocks that don't attract a quote daily (or at times weekly). Its in these stocks that some of the most incredible bargains can be found.
Reliance Bancshares, a turnaround that's actually turned around
A big secret in investing is that turnarounds usually don’t turn around. Companies in the midst of a seismic business change often don’t make it through to the other side. The reasons for this are numerous but one of the most important factors is management. The management of a company that falls into a mess is usually the wrong team to get a company out of a messy situation.
At times a company might realize that they are outside of their capacity regarding a turnaround and they bring in outside management. It’s in situations like this where things get very interesting, such as with Reliance Bancshares.
Reliance Bancshares (RLBS) is a holding company for Reliance Bank located in St. Louis, Missouri with two branches in Ft Meyers, Florida. They have a market cap of $154m, and have slightly over $1b in assets.
The financial crisis was not kind to Reliance Bancshares, the company’s results from 2009-2011 were horrible. The bank lost $21m, $31m, and $29m in 2009, 2010 and 2011 respectively. Non-current loans to loans rose from a pre-crisis .81% to a high of 15.33% in 2010. In 2011 they charged off 3.5% of their loans as they worked to clear out their troubled loan book.
As a result of their operational problems the bank was given a Cease and Desist order from the Office of Thrift Supervision (OTS), and later a Consent Order by the FDIC, the successor to the OTS. The orders directed the bank to cease dividend payments, cease share buybacks and improve their capital position.
The bank's management at the time realized that they were out of their element and brought in an outside banking consultant. The consultant was Thomas Brouster, a banking entrepreneur who had previously turned around 14 banks. The company's management eventually promoted Brouster to the position of CEO.
The Consent Order from the FDIC directed the bank to raise capital, which they did. They raised $31m in an equity offering led by Brouster. Brouster came away with a majority ownership position in the bank, and the bank ended up with $24m in capital, raising their Tier 1 ratio above 10%. The rest of the capital was held at the holding company.
Brouster did what he was known to do, he stemmed losses at the bank and returned it to profitability. He did this by reducing costs, lowering deposit costs and growing the bank's loan book.
The biggest drag on the bank's earnings has been their cost of deposits, the picture below show how much they were paying historically:
In 2010 the bank was paying 1.84% for their funding, a value that's dropped to .77% in the most recent quarter. High funding like this is a sign of a bank that uses costly brokered deposits. Reliance Bancshares was a pig at the trough with hot money going into the financial crisis. In 2008 they had $168m in brokered deposits and $808m in time deposits. As of the most recent quarter the bank has $8m in brokered deposits and $324m in time deposits.
Fast forward to the most recent quarter, the bank earned $2.08m pre-tax and $38m in net income. A difference like this merits further investigation. Their large one time gain was a result of a reversal of a valuation reserve against their deferred tax asset. As banks generate losses they book those losses into something called a deferred tax asset to be used at a future point to offset future gains. If it seems unlikely that a bank will be able to utilize this asset the auditors require the bank mark down this asset. The reversed valuation allowance amounted to $36m.
Along with expense reductions, and lowered deposit costs Brouster has also been at work growing the bank. In the second quarter loans grew 11%, and deposits grew 2.4%. Additionally the bank's non performing assets have continued to drop, and they've now had 28 months without a loan more than 30 days past due.
Reliance Bank is not only working on expanding their loan book, they're expanding their physical presence too. They recently closed on a piece of property in St. Louis proper, and are working on constructing another branch in the St. Louis suburbs. Both of these branches should result in increased deposits and lending.
The bank is clearly on the mend, they earned more this past quarter verses all of last year. If they can continue to decrease expenses and lower their deposit cost earnings will grow, even without loan growth.
The obvious question is what is this bank worth? That's where things get interesting. The bank isn't cheap on any classic valuation metrics. Their book value is $1.78 per share, and tangible book value is $1.22 per share. This past quarter they earned $.02 per share. Let's assume they can earn a similar amount over a year for $.08, they'd be trading with a P/E of 25.
A better way to model the bank is to look at what their ultimate earning potential is given their assets and work from there. If the bank can continue to reduce their expenses and deposit cost maybe they can earn 1% on their assets. Under that scenario they'd be earning $10m per year, or $.13 per share. A 10% reduction in expenses could lead to $2.1m in savings, a 25% reduction in expenses could lead to another $5m in savings. With the bank's substantial tax loss carry-forwards these savings would fall straight to the bottom line.
It's possible the bank will grow into their valuation. Maybe they can dramatically reduce expenses beyond my 10% estimate as well as increase lending with their new branches. Regardless, Reliance Bancshares isn't a typical value investment, but I can imagine a number of scenarios where if this bank can execute on their growth plans that one might consider this price cheap.
In the end this isn't an investment for me, but I'm sure this is something a few readers will be able to benefit from.
Disclosure: No position
At times a company might realize that they are outside of their capacity regarding a turnaround and they bring in outside management. It’s in situations like this where things get very interesting, such as with Reliance Bancshares.
Reliance Bancshares (RLBS) is a holding company for Reliance Bank located in St. Louis, Missouri with two branches in Ft Meyers, Florida. They have a market cap of $154m, and have slightly over $1b in assets.
The financial crisis was not kind to Reliance Bancshares, the company’s results from 2009-2011 were horrible. The bank lost $21m, $31m, and $29m in 2009, 2010 and 2011 respectively. Non-current loans to loans rose from a pre-crisis .81% to a high of 15.33% in 2010. In 2011 they charged off 3.5% of their loans as they worked to clear out their troubled loan book.
As a result of their operational problems the bank was given a Cease and Desist order from the Office of Thrift Supervision (OTS), and later a Consent Order by the FDIC, the successor to the OTS. The orders directed the bank to cease dividend payments, cease share buybacks and improve their capital position.
The bank's management at the time realized that they were out of their element and brought in an outside banking consultant. The consultant was Thomas Brouster, a banking entrepreneur who had previously turned around 14 banks. The company's management eventually promoted Brouster to the position of CEO.
The Consent Order from the FDIC directed the bank to raise capital, which they did. They raised $31m in an equity offering led by Brouster. Brouster came away with a majority ownership position in the bank, and the bank ended up with $24m in capital, raising their Tier 1 ratio above 10%. The rest of the capital was held at the holding company.
Brouster did what he was known to do, he stemmed losses at the bank and returned it to profitability. He did this by reducing costs, lowering deposit costs and growing the bank's loan book.
The biggest drag on the bank's earnings has been their cost of deposits, the picture below show how much they were paying historically:
In 2010 the bank was paying 1.84% for their funding, a value that's dropped to .77% in the most recent quarter. High funding like this is a sign of a bank that uses costly brokered deposits. Reliance Bancshares was a pig at the trough with hot money going into the financial crisis. In 2008 they had $168m in brokered deposits and $808m in time deposits. As of the most recent quarter the bank has $8m in brokered deposits and $324m in time deposits.
Fast forward to the most recent quarter, the bank earned $2.08m pre-tax and $38m in net income. A difference like this merits further investigation. Their large one time gain was a result of a reversal of a valuation reserve against their deferred tax asset. As banks generate losses they book those losses into something called a deferred tax asset to be used at a future point to offset future gains. If it seems unlikely that a bank will be able to utilize this asset the auditors require the bank mark down this asset. The reversed valuation allowance amounted to $36m.
Along with expense reductions, and lowered deposit costs Brouster has also been at work growing the bank. In the second quarter loans grew 11%, and deposits grew 2.4%. Additionally the bank's non performing assets have continued to drop, and they've now had 28 months without a loan more than 30 days past due.
Reliance Bank is not only working on expanding their loan book, they're expanding their physical presence too. They recently closed on a piece of property in St. Louis proper, and are working on constructing another branch in the St. Louis suburbs. Both of these branches should result in increased deposits and lending.
The bank is clearly on the mend, they earned more this past quarter verses all of last year. If they can continue to decrease expenses and lower their deposit cost earnings will grow, even without loan growth.
The obvious question is what is this bank worth? That's where things get interesting. The bank isn't cheap on any classic valuation metrics. Their book value is $1.78 per share, and tangible book value is $1.22 per share. This past quarter they earned $.02 per share. Let's assume they can earn a similar amount over a year for $.08, they'd be trading with a P/E of 25.
A better way to model the bank is to look at what their ultimate earning potential is given their assets and work from there. If the bank can continue to reduce their expenses and deposit cost maybe they can earn 1% on their assets. Under that scenario they'd be earning $10m per year, or $.13 per share. A 10% reduction in expenses could lead to $2.1m in savings, a 25% reduction in expenses could lead to another $5m in savings. With the bank's substantial tax loss carry-forwards these savings would fall straight to the bottom line.
It's possible the bank will grow into their valuation. Maybe they can dramatically reduce expenses beyond my 10% estimate as well as increase lending with their new branches. Regardless, Reliance Bancshares isn't a typical value investment, but I can imagine a number of scenarios where if this bank can execute on their growth plans that one might consider this price cheap.
In the end this isn't an investment for me, but I'm sure this is something a few readers will be able to benefit from.
Interested in learning more about banks? Buy my book The Bank Investor's Handbook (Kindle and paperback available)
Disclosure: No position
Portfolio Strategies: Value Traps
If defined by the popular media value investing is considered the practice of buying turnarounds and companies that have entered a state of perpetual decline with the hope they eventually recover. In many circles value investing itself is seen as a bit of a trap. Buying cheap companies with no growth doesn't seem like a way to grow a portfolio.
If one were to look at the investing universe from a cold and calculating seat in an ivory tower it might resemble a giant system that continually reverts to a mean. Stocks that go up too much eventually fall back down. Stocks that fall too much eventually rise back up. But why do companies do this?
Behind the bid/ask, constant stream of quotes, and ad-naseum discussions about abstract financial figures are businesses trying to sell products that solve customer problems. These businesses are run by people who are worried about keeping their jobs and keeping their customers. If margins slip some mythical shareholder might be angry, but if a key customer isn't given a deal an employee might hear about it at t-ball practice all week. In situations like this who do you think employees will favor, the faceless shareholders behind computer monitors, or those they interact with daily?
These real companies ebb and flow with the business cycle. Maybe a company creates a fantastic product that customers love and they're rewarded with sizable profits for a few years. Or maybe a once successful business decides to rest on their laurels for a decade too long and slips behind the competition. Either way the company's results are driven by their operations, whatever they are doing to satisfy their customers needs.
Investors are an emotional bunch. They get excited at the announcement of a new product and drive a stock senselessly higher. Or they panic because a company hasn't issued a press release in a few days and wonder if they are even still in business, or worse yet a fraud. The supply and demand dynamics of the market, along with fickle investor interest drive stock prices higher and lower than business fundamentals.
Eventually stock prices do tend to settle around a businesses fundamentals. This is mean reversion, the concept that eventually the price of a stock will trade close to the fundamental value of a business. If an investor buys at a point of pessimism and holds long enough they will be rewarded with a gain. If an investor buys into hype and holds long enough they will probably lose money.
A value trap is what happens when a company never reverts to the mean. The company never reverts because there is no mean to revert to, the company's business fundamentals have changed for the worse and the market is quick to reflecting it.
I think that retail provides the easiest examples of value traps. This is because popular opinion changes quickly in retail and what was hot one summer can be cold the next. Retail also exhibits significant operating leverage. There are certain fixed cost that needs to be covered at each store. The marginal sales above fixed cost fall almost straight to the bottom line. More sales equals more profits and better margins. Retail is a volume business.
Near us there is a plan to redevelop an old shopping center into a new Wal-Mart. Residents are against it claiming that Wal-Mart will drive all of our local companies out of business leaving us with chain stores and generic suburbs. I could argue that these residents don't realize that this generic utopia is exactly what Americans seem to want. Every exurb in the US looks the same, from the fake town square down to the same Costco, Chipotle, and Whole Foods. And the exurbs are growing fast as Americans trade their small character-laden residences for large faceless McMansions in McSuburbs that are all one of the 10 Best Places to Raise a Family.
The fact that Americans are enamored with cookie cutter living spaces isn't my point, it's that I have no sympathy for a business that Wal-mart closes. The argument against Wal-mart is that they shut down small companies who can't compete. Rephrased it's that Wal-Mart's prices are lower, and customers only care about price. It's true that most local businesses can't compete with Wal-Mart on price, but if a business is small and their competitive advantage (in their eyes) is low cost they have a problem. A company that has a niche, or offers something of value to customers beyond price alone will retain customers. People know the quality of goods that Wal-Mart sells. If I am looking to purchase something more or less disposable I don't mind buying it cheaply at Wal-Mart, but that's my expectation, it's cheap and will break.
What does this discussion of a local Wal-Mart have to do with value traps? Everything. The local Wal-Mart changes the local market business dynamics. Small companies who had a price advantage no longer hold one. The dynamic has changed forever. A local store that was a price leader will need to either change their business, or go out of business. There is no reversion to the mean for them, the dynamics have changed.
The residential outcry against the Wal-Mart has filled the news here with town hall meetings. My wife pointed out something that I thought was interesting. She noticed that almost everyone at the town hall meetings is in their 50s, 60s or older. Now this could be because residents in their 20s and 30s don't care about local issues, or it could be something else.
She followed this observation with the point that younger generations don't care about Wal-Mart because Amazon.com lives in our pockets. Why even go to a Wal-Mart when you can buy from anyone anywhere in the world with a simple click? For most items you can have them two days later. If a person is able to plan ahead slightly there aren't many regular purchases one needs faster than two days in the future.
While local residents are worried that the local Wal-Mart is going to put small companies out of business the younger generation is using a tool that has Wal-Mart worried. The life cycle in retail is short, who knows what might happen to Amazon. Maybe one day I'll be watching the news as they discuss what to do with the empty shell of an abandoned Wal-Mart.
A value trap is when a company begins to trade lower due to these structural shifts. Many investors ignore the shift, or discount it and claim shares are cheap. The structural shifts are important because most businesses have significant operating leverage. This means slight decreases in sales can translate into large losses. A business that's built to sell $5b worth of parts a year will struggle to slim down to a $500m a year business. Operational infrastructure in business is built with one thing in mind, growth. No one building a company thinks "if my sales were to drop 50% from a new invention how would I react, how do I build an organization to handle that?"
If a structural change is what causes a value trap then it seems like it should be easy to avoid them. Just avoid companies in the midst of an industry upheaval. That's easier said than done, companies with perfect earnings and great growth don't usually trade for low valuations. But companies in struggling industries do trade for low valuations.
One approach to investing in tumultuous industries is to follow the methodology set out by Benjamin Graham in Security Analysis. He recommended buying the leading company in a depressed industry. The rationale was that the industry leader almost always came through a crisis intact, and while they might not trade as low as other companies they would still be low enough that investors could make money. This is a very safe and sane approach.
What does one do when the situation isn't as clear cut? I think the best way to avoid a value trap is to ask yourself the question "under what condition would this company never revert to the mean?" The perfect investment is one where the company is fundamentally sound, but investors have a negative impression. All that needs to happen is investor psychology needs to change, and investors are fickle and quick to change, so it won't be long. If the answer to the question is long and involved it's possible you're dealing with a value trap. Q:"What needs to happen for RadioShack to revert to the mean?" A:"Ham radio, flip phones, Tandy computers and remote control cars need to become popular again." The likelihood of any of those things happening, or a completely company transformation happening are long shots.
You've probably noticed I haven't spent any time discussing financials up to this point. That's because I don't believe you can identify a value trap from a company's financials alone. One needs to look at the industry and the structural shifts first. Then secondly look at the company's financials. If a company is caught in the midst of an industry shift the best margins and best balance sheet won't mean anything except that the company will endure the misery longer than their competitors.
If one were to look at the investing universe from a cold and calculating seat in an ivory tower it might resemble a giant system that continually reverts to a mean. Stocks that go up too much eventually fall back down. Stocks that fall too much eventually rise back up. But why do companies do this?
Behind the bid/ask, constant stream of quotes, and ad-naseum discussions about abstract financial figures are businesses trying to sell products that solve customer problems. These businesses are run by people who are worried about keeping their jobs and keeping their customers. If margins slip some mythical shareholder might be angry, but if a key customer isn't given a deal an employee might hear about it at t-ball practice all week. In situations like this who do you think employees will favor, the faceless shareholders behind computer monitors, or those they interact with daily?
These real companies ebb and flow with the business cycle. Maybe a company creates a fantastic product that customers love and they're rewarded with sizable profits for a few years. Or maybe a once successful business decides to rest on their laurels for a decade too long and slips behind the competition. Either way the company's results are driven by their operations, whatever they are doing to satisfy their customers needs.
Investors are an emotional bunch. They get excited at the announcement of a new product and drive a stock senselessly higher. Or they panic because a company hasn't issued a press release in a few days and wonder if they are even still in business, or worse yet a fraud. The supply and demand dynamics of the market, along with fickle investor interest drive stock prices higher and lower than business fundamentals.
Eventually stock prices do tend to settle around a businesses fundamentals. This is mean reversion, the concept that eventually the price of a stock will trade close to the fundamental value of a business. If an investor buys at a point of pessimism and holds long enough they will be rewarded with a gain. If an investor buys into hype and holds long enough they will probably lose money.
A value trap is what happens when a company never reverts to the mean. The company never reverts because there is no mean to revert to, the company's business fundamentals have changed for the worse and the market is quick to reflecting it.
I think that retail provides the easiest examples of value traps. This is because popular opinion changes quickly in retail and what was hot one summer can be cold the next. Retail also exhibits significant operating leverage. There are certain fixed cost that needs to be covered at each store. The marginal sales above fixed cost fall almost straight to the bottom line. More sales equals more profits and better margins. Retail is a volume business.
Near us there is a plan to redevelop an old shopping center into a new Wal-Mart. Residents are against it claiming that Wal-Mart will drive all of our local companies out of business leaving us with chain stores and generic suburbs. I could argue that these residents don't realize that this generic utopia is exactly what Americans seem to want. Every exurb in the US looks the same, from the fake town square down to the same Costco, Chipotle, and Whole Foods. And the exurbs are growing fast as Americans trade their small character-laden residences for large faceless McMansions in McSuburbs that are all one of the 10 Best Places to Raise a Family.
The fact that Americans are enamored with cookie cutter living spaces isn't my point, it's that I have no sympathy for a business that Wal-mart closes. The argument against Wal-mart is that they shut down small companies who can't compete. Rephrased it's that Wal-Mart's prices are lower, and customers only care about price. It's true that most local businesses can't compete with Wal-Mart on price, but if a business is small and their competitive advantage (in their eyes) is low cost they have a problem. A company that has a niche, or offers something of value to customers beyond price alone will retain customers. People know the quality of goods that Wal-Mart sells. If I am looking to purchase something more or less disposable I don't mind buying it cheaply at Wal-Mart, but that's my expectation, it's cheap and will break.
What does this discussion of a local Wal-Mart have to do with value traps? Everything. The local Wal-Mart changes the local market business dynamics. Small companies who had a price advantage no longer hold one. The dynamic has changed forever. A local store that was a price leader will need to either change their business, or go out of business. There is no reversion to the mean for them, the dynamics have changed.
The residential outcry against the Wal-Mart has filled the news here with town hall meetings. My wife pointed out something that I thought was interesting. She noticed that almost everyone at the town hall meetings is in their 50s, 60s or older. Now this could be because residents in their 20s and 30s don't care about local issues, or it could be something else.
She followed this observation with the point that younger generations don't care about Wal-Mart because Amazon.com lives in our pockets. Why even go to a Wal-Mart when you can buy from anyone anywhere in the world with a simple click? For most items you can have them two days later. If a person is able to plan ahead slightly there aren't many regular purchases one needs faster than two days in the future.
While local residents are worried that the local Wal-Mart is going to put small companies out of business the younger generation is using a tool that has Wal-Mart worried. The life cycle in retail is short, who knows what might happen to Amazon. Maybe one day I'll be watching the news as they discuss what to do with the empty shell of an abandoned Wal-Mart.
A value trap is when a company begins to trade lower due to these structural shifts. Many investors ignore the shift, or discount it and claim shares are cheap. The structural shifts are important because most businesses have significant operating leverage. This means slight decreases in sales can translate into large losses. A business that's built to sell $5b worth of parts a year will struggle to slim down to a $500m a year business. Operational infrastructure in business is built with one thing in mind, growth. No one building a company thinks "if my sales were to drop 50% from a new invention how would I react, how do I build an organization to handle that?"
If a structural change is what causes a value trap then it seems like it should be easy to avoid them. Just avoid companies in the midst of an industry upheaval. That's easier said than done, companies with perfect earnings and great growth don't usually trade for low valuations. But companies in struggling industries do trade for low valuations.
One approach to investing in tumultuous industries is to follow the methodology set out by Benjamin Graham in Security Analysis. He recommended buying the leading company in a depressed industry. The rationale was that the industry leader almost always came through a crisis intact, and while they might not trade as low as other companies they would still be low enough that investors could make money. This is a very safe and sane approach.
What does one do when the situation isn't as clear cut? I think the best way to avoid a value trap is to ask yourself the question "under what condition would this company never revert to the mean?" The perfect investment is one where the company is fundamentally sound, but investors have a negative impression. All that needs to happen is investor psychology needs to change, and investors are fickle and quick to change, so it won't be long. If the answer to the question is long and involved it's possible you're dealing with a value trap. Q:"What needs to happen for RadioShack to revert to the mean?" A:"Ham radio, flip phones, Tandy computers and remote control cars need to become popular again." The likelihood of any of those things happening, or a completely company transformation happening are long shots.
You've probably noticed I haven't spent any time discussing financials up to this point. That's because I don't believe you can identify a value trap from a company's financials alone. One needs to look at the industry and the structural shifts first. Then secondly look at the company's financials. If a company is caught in the midst of an industry shift the best margins and best balance sheet won't mean anything except that the company will endure the misery longer than their competitors.
Portfolio strategies: The definitive guide to net-nets
This is hopefully the first post in a small series detailing my thoughts on a few different types of value investing strategies. If you've been reading this blog for a while this post might not contain much new, but it's a summation of my thoughts on a subject in one place.
Net-net: A company whose market cap is less than the value of their current assets minus all of their liabilities. Formula: (Current Assets - All Liabilities) > Market Capitalization
When a company's NCAV (the aforementioned current assets minus all liabilities) is more than a company's market value it's theoretically possible that the company could be liquidated and result in a gain for shareholders. For an asset to be classified as current a company must have the intent to sell or use the asset in the period of a year or less.
The market is driven by emotions, fear, greed, and is rarely rational. On the whole it gets things right over time, but in the short term anything can happen. Some try to use this as an explanation as to why a company can sell below NCAV for any period of time. The market is just irrational and net-nets are a sort of market fluke.
I don't believe much in life is a fluke. Before I started this blog and met a large number of investors I would have believed in the net-net fluke theory. But after meeting a lot of investors I've come to the conclusion that not many people view stocks the same way. For most investors the balance sheet is a financial statement that holds almost no value. If a company isn't generating satisfying earnings, cash flow, free cash flow or growth it doesn't matter what the balance sheet says, the company doesn't hold much value.
Net-nets exist because what the market values is different from what a subset of value investors find attractive. In my latest issue of the Oddball Stocks newsletter I discussed the idea that all value stocks have some sort of flaw. If a stock is perfect and it's cheap then something is wrong, look harder. A flaw might be something that many market participants find unattractive for a variety of reasons and overweight when evaluating the stock.
An investor should always try to identify why a company is selling for less than NCAV. Once this has been identified the investor should then determine of the discount for the given flaw is appropriate. Not all net-nets are good investments, some have gone to zero for a variety of good reasons.
Are they riskier?
For many investors net-nets are viewed as riskier investments due to their low price. Think about this for a minute, it's a self-reinforcing notion. Someone looks at a net-net and notices how cheap it is, and because it is cheap avoids it. Without liquidity the stock becomes cheaper, all because it's already cheap in the first place. Once a stock becomes undervalued it can become a self-fulfilling valuation trap. Professional investors dump the stock for liquidity reasons, individuals dump it for lack of earnings or lack of growth, or a low price. Companies caught in the valuation trap can languish for years before they either post numbers investors like, or become so cheap they attract interest from asset based investors.
If a net-net's assets aren't extremely specialized and the company isn't burning through their assets then a net-net should be less risky than other stocks. David Merkel of the Aleph Blog wrote an analogy years ago discussing two types of stability, table stability and bicycle stability. A bike is stable as long as it's moving forward, once stopped it's extremely unstable. A table is very stable at rest, but is hard to move.
A lot of companies have bicycle stability, as long as everything is moving the company is stable. But if sales were to drastically shrink, or the company lose a strategic supplier operations could become unstable quickly. Many Net-nets exhibit the type of stability found in a table. The company might have lackluster operations, but the company has a balance sheet that can support the lackluster operations for decades without change. As David says "..only a severe event will upend a large table."
It's important to invest in net-nets that have a table stability rather than bicycle stability. Many net-nets are smaller and are prone to sudden business upheavals.
Fraud risk
A newer risk related to net-nets is that investors worry they're fraudulent companies. This risk is related to the number of Chinese reverse merger companies that had both fantastic numbers, and incredibly low valuations that turned out to be fraudulent. Outside of the Chinese companies I don't believe net-nets hold any more risk for fraud compared to other areas of the market.
In general my thoughts on fraud are this; if something looks too good to be true it probably is. Always investigate further, and if you spot serious red flags it's not worth the risk, move on.
Profits or no profits?
One debate between those who invest and research net-nets is whether to invest in ones that are losing money, or only invest in profitable net-nets. The research suggests that unprofitable net-nets might result in higher investment returns. The theory is that at a money losing company management has been pushed to their limit and must either take drastic action to save the company or find an alternate outcome through a merger or sale.
It makes sense that unprofitable companies could ultimate make better investments. But sometimes what the research says needs to be reconciled with investor psychology and emotions. Most net-nets are average or below average companies to begin with. Purchasing an unprofitable net-net tests even the strongest investor stomach. An unprofitable net-net is a potentially bad company that is losing money with no end in sight. This is a recipe for emotional disaster.
I personally prefer to purchase profitable net-nets even though I know I am sabotaging my potential returns. The reason for this is I know emotionally I am able to hold a portfolio of net-nets through thick and thin if I know my holdings aren't destroying asset value and will be operating in three or five years. I know myself and I know that holding a company constantly on the cusp of disaster would test my ability to hold, and I'd probably end up selling at the first opportunity I had to get out of the situation. I'd rather implement a strategy with slightly lower returns that I know I can stick to rather than shoot for the moon with a strategy that I'm likely to abandon.
Overweight real estate?
A signature feature of many net-nets, and value companies in general are significant real estate holdings. At times these real estate holdings can be extremely valuable, and sometimes a source of hidden value. I have owned many companies where management sold an undervalued real estate holding that resulted in a bonanza for shareholders.
Land can be valuable, if you own the only empty plot in Midtown Manhattan you're sitting on a fortune. But those cases are rare. More likely for a net-net is a company owns a plot of land in Altoona, PA or Eaton, OH where land is in ample supply. For readers who live on the coasts and and are under the impression that the US is overpopulated I'd encourage you to drive across the country. The United States is a vastly empty place with a few tiny hubs of human activity. Anyone who's driven across South Dakota, Iowa, Ohio, or Montana would agree. There is so much empty land it's almost incredible. In many small towns there is no premium to land. To build a new facility outside of the city limits would cost as much as getting an existing facility up to code.
Unless a company has a unique real estate holding I don't give a company's real estate much weight. At times some real estate can be resold for book value, but that's only in certain circumstances.
The curse of real estate is that to sell incurs a high transaction cost and takes a long time. It's hard to unload a lot of real estate quickly at market rates. If a seller tries to liquidate their real estate holdings quickly it's likely they'll only realize fire sale values.
Inventory, inventory, inventory
The biggest concern I hear investors voicing about net-nets is that many of them have high levels of inventory and that makes investors uncomfortable. The problem with inventory is investors think about how quickly it could be liquidated, which I believe is the wrong attitude.
If a company is operating and isn't writing down their inventory it's a sign that the inventory has some value in the market place. As long as the net-net continues to operate, and isn't constantly writing down inventory it should be valued at something reasonably close to fair value. The caveat to this is if the company is losing money. If a company is losing money this means they are unable to sell their goods for more than their cost. A company that's losing money might merit a discount to the value of their inventory. Or a discount might be merited if the company has stated that some of their inventory is collecting dust in the back of a warehouse somewhere.
Of all the net-nets that trade in the market only a few will ever progress to a liquidation. Liquidations are extremely rare. They're costly, and take a long time. When Graham first discussed net-nets in Security Analysis he spends a lot of time discussing how a net-net could potentially be liquidated for more than their market value. He goes through a lengthly analysis of how certain accounts should be discounted to take into account liquidation values. Many investors seem to get hung up on the prospect of a company liquidating and what accounts receivable, inventory or the real estate should theoretically be marked down to in a liquidation. Almost no net-nets ever liquidate, and I think fixating on a theoretically liquidation is wasted mental energy. If a company declares a liquidation it's time to focus on their liquidation value, but until then it's wasted energy. Graham's point in my view was to emphasize the absurdity of the value these companies were trading with.
Are they bad companies?
Many investors are looking for companies that return 15% a year no matter the market and will make shareholders rich no matter the price purchased at. These are not net-nets. It's not uncommon to find a net-net earning a few percent on equity. Some net-net require a magnifying glass to see their return on equity, it's there, but it's just that small.
A lot of net-nets are under utilizing both their assets and intellectual capital. Under a different management team, or under different market conditions these companies can earn significant returns. The reason many of these companies are selling so cheaply is because the management team, or market conditions are not ideal. Market conditions can always change, and a company that has been left for dead can find itself in an ideal environment and losses can turn to gains.
Keep in mind when you're evaluating net-nets that you're not trying to find a great business at an average price that you can buy and hold, but rather you're investing in an average company at a bargain price.
Think of a net-net investor as someone who's buying reprint paintings at TJ Maxx for $20 and reselling them online for $40. The Buffett buy and hold value investor is looking for a Van Gogh that they can buy at any price and resell at some point in the future for more. They know because they own a rare Van Gogh that the painting will always be worth more in the future compared to today's price. The person buying paintings at TJ Maxx makes their money at the purchase.
Their role in a portfolio?
Net-nets should play a strong supporting role in any value investor portfolio. A supporting role means that a portfolio isn't concentrated in them entirely, but they're also not so small of a position that they don't have a meaningful impact on the portfolio's returns.
The reason investors shouldn't concentrate in net-nets is because as the market rises higher there are fewer and fewer opportunities to invest in. At multiple points in the past there have been less than a half dozen net-nets in the US. When there are few net-nets the quality plummets, it wouldn't be wise to have a portfolio concentrated in three money losing companies selling obsolete products.
A net-net position should be diversified as well. There's no sense trying to pick the 'best' net-net. No one knows which companies will strike gold, and which ones will strike out. It's better to spread a portfolio's best across a variety of net-nets. Even though these companies trade below NCAV that's no guarantee against any of them eventually going bust, they have been known to do that at times.
Can a bank or financial company be a net-net?
For a reason unknown to myself financial companies are usually lumped into a "too hard pile" for 90% of the market. Investors would rather ignore financials over spending a little time learning the specialized industry. Because of this financials are always excluded from lists of net-nets and deep value stocks.
It's possible to have a bank or a financial services company trading below liquidation value. There are specific liquidation value calculations for banks and insurance companies that differ from the standard net-net formula. While the formula is different the idea is the same. At a certain point investing in a company that's trading for less than liquidation value makes sense because the worst case scenario is better than the current one.
Why don't more investors invest in them?
I think most investors avoid net-nets because they're too simple and too boring. Juan Matienzo discusses this during his interview with the Manual of Ideas. Too many investors view net-nets as simplistic and investments for value investing beginners. A lot of investors want to be like Buffett finding great companies with moats and durable advantages. In their quest to own these great companies they avoid simple areas of the market that offer great returns.
My portfolio isn't build to impress anyone. I don't find my value in the stocks I own. My portfolio serves one purpose, to generate returns on my capital. If I do that via net-nets or via great companies with moats I don't care. I want to invest in whatever will give me the greatest safe returns. Too many investors are trying to impress their peers with fancy shareholder letters, or by discussing their investments at cocktail parties. Your friends might be impressed that you hold all the value stocks du jour, but they'll be more impressed by your returns if you hold net-nets.
A second reason many investors don't invest in net-nets is because a lot of them are too small. Many of these stocks are considered uninvestable by Wall Street. It's hard for a fund managing $500m to build $50m worth of positions in net-net stocks, especially if the market is higher. If a fund were to look globally it's possible they'd find enough opportunities, but managing the large number of investments could time consuming. Only at the market bottom does one find enough large net-nets that a large fund could build a position.
When to sell
The time to sell a net-net is when the stock pops near fair value. These are not buy and hold investments, they are buy and sell quick investments. Sell when you are given the first opportunity, a second opportunity might not exist.
But portfolio management is only one part of a complete investing system. I outline my full strategy here.
Net-net: A company whose market cap is less than the value of their current assets minus all of their liabilities. Formula: (Current Assets - All Liabilities) > Market Capitalization
When a company's NCAV (the aforementioned current assets minus all liabilities) is more than a company's market value it's theoretically possible that the company could be liquidated and result in a gain for shareholders. For an asset to be classified as current a company must have the intent to sell or use the asset in the period of a year or less.
The market is driven by emotions, fear, greed, and is rarely rational. On the whole it gets things right over time, but in the short term anything can happen. Some try to use this as an explanation as to why a company can sell below NCAV for any period of time. The market is just irrational and net-nets are a sort of market fluke.
I don't believe much in life is a fluke. Before I started this blog and met a large number of investors I would have believed in the net-net fluke theory. But after meeting a lot of investors I've come to the conclusion that not many people view stocks the same way. For most investors the balance sheet is a financial statement that holds almost no value. If a company isn't generating satisfying earnings, cash flow, free cash flow or growth it doesn't matter what the balance sheet says, the company doesn't hold much value.
Net-nets exist because what the market values is different from what a subset of value investors find attractive. In my latest issue of the Oddball Stocks newsletter I discussed the idea that all value stocks have some sort of flaw. If a stock is perfect and it's cheap then something is wrong, look harder. A flaw might be something that many market participants find unattractive for a variety of reasons and overweight when evaluating the stock.
An investor should always try to identify why a company is selling for less than NCAV. Once this has been identified the investor should then determine of the discount for the given flaw is appropriate. Not all net-nets are good investments, some have gone to zero for a variety of good reasons.
Are they riskier?
For many investors net-nets are viewed as riskier investments due to their low price. Think about this for a minute, it's a self-reinforcing notion. Someone looks at a net-net and notices how cheap it is, and because it is cheap avoids it. Without liquidity the stock becomes cheaper, all because it's already cheap in the first place. Once a stock becomes undervalued it can become a self-fulfilling valuation trap. Professional investors dump the stock for liquidity reasons, individuals dump it for lack of earnings or lack of growth, or a low price. Companies caught in the valuation trap can languish for years before they either post numbers investors like, or become so cheap they attract interest from asset based investors.
If a net-net's assets aren't extremely specialized and the company isn't burning through their assets then a net-net should be less risky than other stocks. David Merkel of the Aleph Blog wrote an analogy years ago discussing two types of stability, table stability and bicycle stability. A bike is stable as long as it's moving forward, once stopped it's extremely unstable. A table is very stable at rest, but is hard to move.
A lot of companies have bicycle stability, as long as everything is moving the company is stable. But if sales were to drastically shrink, or the company lose a strategic supplier operations could become unstable quickly. Many Net-nets exhibit the type of stability found in a table. The company might have lackluster operations, but the company has a balance sheet that can support the lackluster operations for decades without change. As David says "..only a severe event will upend a large table."
It's important to invest in net-nets that have a table stability rather than bicycle stability. Many net-nets are smaller and are prone to sudden business upheavals.
Fraud risk
A newer risk related to net-nets is that investors worry they're fraudulent companies. This risk is related to the number of Chinese reverse merger companies that had both fantastic numbers, and incredibly low valuations that turned out to be fraudulent. Outside of the Chinese companies I don't believe net-nets hold any more risk for fraud compared to other areas of the market.
In general my thoughts on fraud are this; if something looks too good to be true it probably is. Always investigate further, and if you spot serious red flags it's not worth the risk, move on.
Profits or no profits?
One debate between those who invest and research net-nets is whether to invest in ones that are losing money, or only invest in profitable net-nets. The research suggests that unprofitable net-nets might result in higher investment returns. The theory is that at a money losing company management has been pushed to their limit and must either take drastic action to save the company or find an alternate outcome through a merger or sale.
It makes sense that unprofitable companies could ultimate make better investments. But sometimes what the research says needs to be reconciled with investor psychology and emotions. Most net-nets are average or below average companies to begin with. Purchasing an unprofitable net-net tests even the strongest investor stomach. An unprofitable net-net is a potentially bad company that is losing money with no end in sight. This is a recipe for emotional disaster.
I personally prefer to purchase profitable net-nets even though I know I am sabotaging my potential returns. The reason for this is I know emotionally I am able to hold a portfolio of net-nets through thick and thin if I know my holdings aren't destroying asset value and will be operating in three or five years. I know myself and I know that holding a company constantly on the cusp of disaster would test my ability to hold, and I'd probably end up selling at the first opportunity I had to get out of the situation. I'd rather implement a strategy with slightly lower returns that I know I can stick to rather than shoot for the moon with a strategy that I'm likely to abandon.
Overweight real estate?
A signature feature of many net-nets, and value companies in general are significant real estate holdings. At times these real estate holdings can be extremely valuable, and sometimes a source of hidden value. I have owned many companies where management sold an undervalued real estate holding that resulted in a bonanza for shareholders.
Land can be valuable, if you own the only empty plot in Midtown Manhattan you're sitting on a fortune. But those cases are rare. More likely for a net-net is a company owns a plot of land in Altoona, PA or Eaton, OH where land is in ample supply. For readers who live on the coasts and and are under the impression that the US is overpopulated I'd encourage you to drive across the country. The United States is a vastly empty place with a few tiny hubs of human activity. Anyone who's driven across South Dakota, Iowa, Ohio, or Montana would agree. There is so much empty land it's almost incredible. In many small towns there is no premium to land. To build a new facility outside of the city limits would cost as much as getting an existing facility up to code.
Unless a company has a unique real estate holding I don't give a company's real estate much weight. At times some real estate can be resold for book value, but that's only in certain circumstances.
The curse of real estate is that to sell incurs a high transaction cost and takes a long time. It's hard to unload a lot of real estate quickly at market rates. If a seller tries to liquidate their real estate holdings quickly it's likely they'll only realize fire sale values.
Inventory, inventory, inventory
The biggest concern I hear investors voicing about net-nets is that many of them have high levels of inventory and that makes investors uncomfortable. The problem with inventory is investors think about how quickly it could be liquidated, which I believe is the wrong attitude.
If a company is operating and isn't writing down their inventory it's a sign that the inventory has some value in the market place. As long as the net-net continues to operate, and isn't constantly writing down inventory it should be valued at something reasonably close to fair value. The caveat to this is if the company is losing money. If a company is losing money this means they are unable to sell their goods for more than their cost. A company that's losing money might merit a discount to the value of their inventory. Or a discount might be merited if the company has stated that some of their inventory is collecting dust in the back of a warehouse somewhere.
Of all the net-nets that trade in the market only a few will ever progress to a liquidation. Liquidations are extremely rare. They're costly, and take a long time. When Graham first discussed net-nets in Security Analysis he spends a lot of time discussing how a net-net could potentially be liquidated for more than their market value. He goes through a lengthly analysis of how certain accounts should be discounted to take into account liquidation values. Many investors seem to get hung up on the prospect of a company liquidating and what accounts receivable, inventory or the real estate should theoretically be marked down to in a liquidation. Almost no net-nets ever liquidate, and I think fixating on a theoretically liquidation is wasted mental energy. If a company declares a liquidation it's time to focus on their liquidation value, but until then it's wasted energy. Graham's point in my view was to emphasize the absurdity of the value these companies were trading with.
Are they bad companies?
Many investors are looking for companies that return 15% a year no matter the market and will make shareholders rich no matter the price purchased at. These are not net-nets. It's not uncommon to find a net-net earning a few percent on equity. Some net-net require a magnifying glass to see their return on equity, it's there, but it's just that small.
A lot of net-nets are under utilizing both their assets and intellectual capital. Under a different management team, or under different market conditions these companies can earn significant returns. The reason many of these companies are selling so cheaply is because the management team, or market conditions are not ideal. Market conditions can always change, and a company that has been left for dead can find itself in an ideal environment and losses can turn to gains.
Keep in mind when you're evaluating net-nets that you're not trying to find a great business at an average price that you can buy and hold, but rather you're investing in an average company at a bargain price.
Think of a net-net investor as someone who's buying reprint paintings at TJ Maxx for $20 and reselling them online for $40. The Buffett buy and hold value investor is looking for a Van Gogh that they can buy at any price and resell at some point in the future for more. They know because they own a rare Van Gogh that the painting will always be worth more in the future compared to today's price. The person buying paintings at TJ Maxx makes their money at the purchase.
Their role in a portfolio?
Net-nets should play a strong supporting role in any value investor portfolio. A supporting role means that a portfolio isn't concentrated in them entirely, but they're also not so small of a position that they don't have a meaningful impact on the portfolio's returns.
The reason investors shouldn't concentrate in net-nets is because as the market rises higher there are fewer and fewer opportunities to invest in. At multiple points in the past there have been less than a half dozen net-nets in the US. When there are few net-nets the quality plummets, it wouldn't be wise to have a portfolio concentrated in three money losing companies selling obsolete products.
A net-net position should be diversified as well. There's no sense trying to pick the 'best' net-net. No one knows which companies will strike gold, and which ones will strike out. It's better to spread a portfolio's best across a variety of net-nets. Even though these companies trade below NCAV that's no guarantee against any of them eventually going bust, they have been known to do that at times.
Can a bank or financial company be a net-net?
For a reason unknown to myself financial companies are usually lumped into a "too hard pile" for 90% of the market. Investors would rather ignore financials over spending a little time learning the specialized industry. Because of this financials are always excluded from lists of net-nets and deep value stocks.
It's possible to have a bank or a financial services company trading below liquidation value. There are specific liquidation value calculations for banks and insurance companies that differ from the standard net-net formula. While the formula is different the idea is the same. At a certain point investing in a company that's trading for less than liquidation value makes sense because the worst case scenario is better than the current one.
Why don't more investors invest in them?
I think most investors avoid net-nets because they're too simple and too boring. Juan Matienzo discusses this during his interview with the Manual of Ideas. Too many investors view net-nets as simplistic and investments for value investing beginners. A lot of investors want to be like Buffett finding great companies with moats and durable advantages. In their quest to own these great companies they avoid simple areas of the market that offer great returns.
My portfolio isn't build to impress anyone. I don't find my value in the stocks I own. My portfolio serves one purpose, to generate returns on my capital. If I do that via net-nets or via great companies with moats I don't care. I want to invest in whatever will give me the greatest safe returns. Too many investors are trying to impress their peers with fancy shareholder letters, or by discussing their investments at cocktail parties. Your friends might be impressed that you hold all the value stocks du jour, but they'll be more impressed by your returns if you hold net-nets.
A second reason many investors don't invest in net-nets is because a lot of them are too small. Many of these stocks are considered uninvestable by Wall Street. It's hard for a fund managing $500m to build $50m worth of positions in net-net stocks, especially if the market is higher. If a fund were to look globally it's possible they'd find enough opportunities, but managing the large number of investments could time consuming. Only at the market bottom does one find enough large net-nets that a large fund could build a position.
When to sell
The time to sell a net-net is when the stock pops near fair value. These are not buy and hold investments, they are buy and sell quick investments. Sell when you are given the first opportunity, a second opportunity might not exist.
But portfolio management is only one part of a complete investing system. I outline my full strategy here.