Have you heard about net-net stocks, and now you’re wondering whether it’s the right investment strategy for you?
Net-net is a term for companies with a market capitalization that is less than the difference between current assets and total liabilities. It’s an investing technique developed by Benjamin Graham wherein a company is valued alone on its net current assets. But, take note that the equation doesn’t include long-term assets like property, equipment, intangibles.
Net-nets focus on current assets, which means they take cash and cash equivalents at full value, then reduce accounts receivable for doubtful accounts and inventories to liquidation values. This is because the net-net value is calculated by subtracting total liabilities from the company’s adjusted current assets.
An investor who wants to go for this type of strategy understands that if the net-net (company) gets sold, its current assets will be used to settle liabilities or obligations, and the leftover cash will have more worth than the market capitalization of the company. This simply means that the stock price is way below the company’s net current asset value (NCAV).
Understanding What is Net Current Asset Value or NCAV
Net current asset value or NCAV is the value of the current assets less total liabilities (inclusive of preferred shares and off-balance sheet liabilities). This is derived when you remove the long-term assets component from the total assets, leaving behind a conservative estimate of a company’s value in case of liquidation.
Benjamin Graham’s thoughts behind net current asset value were to know what a company’s worth would be in liquidation. NCAV values only the company’s current assets and ignores all fixed or intangible assets like buildings, goodwill, machinery, etc.
The Warren Buffet Perspective
Warren Buffet used the net-net strategy to grow various investments. He refers to it as a “cigar-butt” investing technique. Although this strategy was taken from Graham, Buffet came up with his own simple rule to buy a stock. According to Buffet, if the stock price is less than two-thirds of the difference of current assets minus total liabilities, then, it’s a net-net stock.
Net-Net Strategy = Stock Price < ⅔ x (Current Assets – Total Liabilities / Number of Shares)
Buffet stated that the equation was a rule of thumb, and you no longer need to evaluate financial statements, conduct fundamental analysis, or make qualitative or quantitative judgments.
This made the strategy quite controversial since most stocks trading as net-net stocks are not sought after by people. Investors avoid them because they’re trading at low prices, and people usually get scared to invest in companies that may go bankrupt even if these companies may have instances of profit generation.
Although net-net investing seems to be an unstable strategy, you can’t forego the fact that it yields positive returns. Here are several pros as to why the net-net strategy is considered successful:
Net-net stocks are offered at a huge discount, in general. For this reason, returns can be relatively more prominent than blue-chip companies. Moreover, their huge discount makes net stocks an attractive takeover target.
A company’s stock sold below its NVAC is usually a small business with illiquid stock. As the illiquid stock is hard to buy or sell, it will take time for investors to react to any news regarding the stock. Often, this means you can still sell or trade stocks but only with a significant discount compared to the potential value it may bring.
Therefore, for net-nets, investors can get a higher premium to offset the illiquid risk they are being exposed to.
There are common pitfalls of Net Net stock investing as not everybody can benefit from it. Just like any other investment, this technique is a risk and doesn’t always work. Here are the cons to consider when it comes to net-net investing:
Net-net’s small cap nature makes it difficult to scale as a strategy as your portfolio grows. In general, small caps tend to have more volatile swings because of their illiquid nature. It’s definitely not an investment strategy for the faint-hearted.
Net-net companies usually don’t pay any dividends. In other words, your return will be entirely capital gain.
Look From an Objective Perspective
The key is to view net-net stocks from an objective angle. Although these may not be great companies, they may just be selling for the wrong prices. Sometimes, you can find a great company that only stumbled due to temporary hard times. In most cases, these companies don’t even deserve their undervaluation.
The problem of this strategy arises if you, as an investor, don’t diversify your portfolio and only focus on one to two stocks to do the work. Not every net-net stock will post the gains you expected, so it’s crucial that you diversify and invest in a basket of stocks.
Deciding which net-net stocks to invest in to gain profits is a complicated matter that needs an expert’s advice. But at the end of the day, it really comes down to weighing the risk vs. reward.