Within the vast spectrum of investment strategies lies an intriguing concept promoted by Benjamin Graham, often termed the “father of value investing”: Net-Net Stocks. Based on the principles laid out in his classic work, “The Intelligent Investor,” this strategy targets companies priced significantly below their net current asset value. Deeply rooted in value investing principles, this approach offers investors a potential pathway to companies trading at deeply undervalued prices.
Understanding Net-Net Stocks
Net-Net Stocks, a term ingrained in value investing, derive their name from the balance sheet’s net current asset value. If a stock is trading below this figure, it may suggest a compelling opportunity for investors. Theoretically, if such a company were to liquidate all its current assets and clear its liabilities, shareholders would be left with a value that exceeds the current market price of the stock.
A company’s market price may trade below its net current asset value due to various reasons. Often, this can be attributed to negative market sentiment or subpar company performance. Skepticism about a company’s future or present operational and financial challenges can weigh down its stock price.
Benjamin Graham's Perspective
Benjamin Graham, often considered the father of value investing, elucidated this concept:
“The idea here was to acquire as many issues as possible at a cost for each of less than their book value in terms of net-current-assets alone — i.e., giving no value to the plant account and other assets. Our purchases were made typically at two-thirds or less of such stripped-down asset value. In most years we carried a wide diversification here — at least 100 different issues.”
To Graham, this wasn’t just a mathematical strategy. It embodied an investment philosophy anchored in the pursuit of tangible, intrinsic value. The strategy is primarily rooted in identifying glaring mispricings by the market, providing an avenue for investors to acquire assets at significant discounts.
Deciphering the Net-Net Metrics
Graham's Net-Net strategy hinges on three pivotal metrics aimed at identifying undervalued companies:
- Net Current Asset Value (NCAV): NCAV = Current Assets — Total Liabilities
- Net Cash: Net Cash = Cash and Short-term Investments — Total Liabilities
- Net-Net Working Capital (NNWC): NNWC = Cash and Short-term Investments + (0.75 * Accounts Receivable) + (0.5 * Inventory) — Total Liabilities
For Graham, undervalued opportunities were marked by:
- Stocks priced below two-thirds of their NNWC.
- Firms generating positive operating cash flows in the past year.
- Companies fortified by a strong cash stance in contrast to minimal debt.
Graham sounded a note of caution. Due to economic uncertainties, some of these firms might not prevail. Hence, he underscored the importance of holding a diversified portfolio of these Net-Net stocks to cushion against unforeseen downturns.
Performance of Net-Net Stocks
Graham’s “net current asset value” approach wasn’t just theoretical; it yielded substantial returns. Research from 1970 through 1983 highlighted that portfolios formed using this strategy, when reconstituted annually, yielded an average return of 29.4 percent over 13 years. In comparison, the S&P 500 Index returned only 11.5 percent. The resilience and consistency of this investment methodology became especially evident during volatile market periods. Similar impressive outcomes have been noted in other evaluations of the strategy.
Strengths and Pitfalls of the Net-Net Strategy
The Net-Net strategy has several strengths and pitfalls that investors should be aware of:
Strengths
- Margin of safety: Investing in stocks trading below their net current asset value offers an inherent margin of safety. When a stock trades below its net current asset value, the market is potentially misvaluing the company’s long-term assets and potential earning power, even though these assets might still hold substantial worth.
- Historical outperformance: As evidenced by the study between 1970 and 1983, and other similar studies, the net-net strategy has historically outperformed broader market indices. Such consistent overperformance underscores its potential as a value-driven approach in diversified portfolios.
- Simple valuation: The strategy provides a straightforward valuation metric, making it easier for investors to screen for potential investments. This simplicity can expedite the selection process, enabling investors to act swiftly when opportunities arise.
Pitfalls
- Scarce opportunities: Especially in developed markets with sophisticated investors and efficient market dynamics, genuine net-net opportunities have become increasingly rare. This scarcity demands even more thorough research and patience from the investor.
- Risk of value traps: Just because a stock is trading below its net current asset value doesn’t mean it’s a good investment. Some companies may face insurmountable challenges, making them value traps rather than genuine opportunities.
- Lack of dividends: Many net-net stocks don’t pay dividends, which means investors are primarily relying on capital appreciation for returns. As a result, those seeking consistent income might find this strategy less appealing.
- Liquidity concerns: Some net-net stocks might be thinly traded, leading to challenges in building or exiting positions without affecting the stock price. Such stocks often have wider bid-ask spreads, which can result in investors buying at a higher price or selling at a lower price than desired.
Relevance of Net-Net Stocks in Today's Market
As markets have matured and grown more efficient, the prevalence of genuinely undervalued Net-Net Stocks has dwindled, particularly in developed markets. Modern tools such as screeners and greater access to information play a role in uncovering these undervalued assets faster than before. These hidden gems, once more accessible, now require investors to exhibit increased patience and diligence in their pursuit. Additionally, the increasing global nature of markets means investors might have to cast a wider net, potentially exploring lesser-known markets or sectors.
Conclusion
Benjamin Graham’s Net-Net Stock strategy offers a time-tested approach for investors seeking undervalued opportunities. With its focus on tangible assets and a built-in margin of safety, this method offers a systematic framework for assessing companies, aiming for potentially attractive returns while managing associated risks. With modern tools and screeners aligning with Graham’s principles, today’s investor is well-positioned to tap into the potential of this time-honored strategy.
