The Net-Net Value Investing Strategy, developed by Benjamin Graham and Warren Buffett, evaluates a company’s stock by considering its net current assets per share after adjusting for doubtful accounts and inventory values. Let’s find out how the net-net strategy works.
The Net-Net Value Investing Strategy, created by Benjamin Graham, is a value-based method for evaluating a company’s stock. It focuses on the company’s net current assets per share (NCAVPS), taking into account cash and equivalents, adjusting for doubtful accounts and inventory values, and subtracting total liabilities. This approach aims to identify undervalued stocks and provide a margin of safety for investors.
In this post, we look at the Net-Net Value investing strategy. We end the article with a backtest and further research about the strategy.
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Net-Net Value Investing Strategy
The Net-Net Value Investing Strategy is an investment approach that focuses on buying value stocks using their net current assets per share (NCAVPS). According to Warren Buffett, those are stocks whose prices are less than 2/3rd of their NCAVPS.
Investors use this strategy as a means of identifying undervalued stocks in the market. They calculate a company’s net current assets per share (NCAVPS) by taking into account its cash and cash equivalents, making adjustments for doubtful accounts, and reducing inventories to liquidation values. The net-net value is then obtained by subtracting total liabilities from the adjusted current assets.
Investors using this strategy are looking for companies that are trading at a significant discount to their intrinsic value, as represented by their net-net value.
By buying these stocks, they aim to realize a profit over the long term as the market corrects and the stock price increases to its fair value. The Net-Net Value Investing Strategy provides a margin of safety for investors, as it focuses on current assets, which are considered to be more liquid and less risky.
Definition of Net-Net Value Investing
Net-Net Value Investing is a stock valuation and investment strategy developed by Benjamin Graham, an influential economist and investor.
The strategy focuses on evaluating a company’s stock based on its net current assets per share (NCAVPS), which is calculated by taking cash and cash equivalents at face value, reducing accounts receivable for doubtful accounts, and reducing inventories to liquidation values. The net-net value is then determined by subtracting the company’s total liabilities from its adjusted current assets.
This approach prioritizes current assets, providing a margin of safety for investors and aiming to identify undervalued stocks. The idea behind this strategy is to purchase stocks at a significant discount to their intrinsic value, expecting to realize a profit over the long term.
Benefits of Net-Net Value Investing
Net-Net Value Investing offers a lot of benefits for investors. These are some of them:
- It provides a margin of safety by prioritizing current assets which are considered to be more liquid and less risky.
- It helps investors identify undervalued stocks in the market.
- It offers the opportunity to purchase stocks at a lower price with the expectation of realizing a profit over the long term.
- It takes a systematic approach to stock evaluation, which eliminates biases and emotions from the investment decision-making process.
- You can automate the investment process.
- It provides a framework for stock valuation based on tangible, fundamental metrics.
Risks of Net-Net Value Investing
Like any investment strategy, Net-Net Value Investing also carries certain risks. One of the main risks is that the market may not correct as expected, and the stock price may not increase to its fair value, resulting in a loss for the investor. Time is not on your side (see more further down in the article).
Also, the companies that are being considered for investment may have issues such as declining sales, declining margins, or a challenging industry environment that may not be reflected in their financial statements. This can make it difficult for investors to accurately assess the intrinsic value of the company and its stock.
Furthermore, the Net-Net Value Investing strategy may result in a concentrated portfolio, as it only focuses on a small subset of companies. This increases the overall risk of the portfolio, as the performance of a single stock can have a significant impact on the overall portfolio returns.
How to Create a Net-Net Value Investing Portfolio
Here are the steps to take when creating a Net-Net Value Investing portfolio:
- Research: Research and identify companies that fit the criteria for Net-Net Value Investing. This involves reviewing financial statements and calculating the net current assets per share (NCAVPS).
- Evaluate: Evaluate the financial health and stability of the companies that meet the Net-Net criteria. Look for companies with a solid balance sheet and positive cash flows.
- Select: Select the companies that are most attractive for investment based on their net-net value and financial stability. Focus on a diversified portfolio of at least 10-15 stocks to reduce risk.
- Monitor: Regularly monitor the portfolio and review the performance of the companies. Consider selling stocks that are no longer undervalued or that have reached their intrinsic value.
- Rebalance: Rebalance the portfolio periodically to ensure that it remains diversified and aligned with your investment goals. Time is important because you have most likely not invested in a “wonderful business”.
Analyzing Financial Statements for Net-Net Value Investing
Analyzing financial statements is an important aspect of Net-Net Value Investing. The primary focus is on the balance sheet, which provides information about a company’s current assets and liabilities. To determine the net current assets per share (NCAVPS), investors must take the following steps:
- Calculate the total current assets by adding up cash, cash equivalents, accounts receivable, and inventories.
- Adjust the accounts receivable for doubtful accounts and reduce inventories to liquidation values.
- Deduct the total liabilities from the adjusted current assets to arrive at the net current assets.
- Divide the net current assets by the number of shares outstanding to arrive at the NCAVPS.
- Compare the NCAVPS to the current market price of the stock to determine if the stock is undervalued. If the share price of the stock is less than or equal to 2/3rd the NCAVPS, the stock may be considered a potential investment opportunity.
The Value Investing Strategy of Benjamin Graham
Benjamin Graham was a pioneer of value investing. His book The Intelligent Investor is considered a classic in the field of value investing. The key principles of his value investing strategy are as follows:
- Focus on undervalued stocks: Graham believed in buying stocks that were undervalued relative to their intrinsic value. He would look for stocks that were selling at a discount to their net current assets per share (NCAVPS).
- Avoid overvalued stocks: Graham advocated avoiding overpriced stocks, even if they were in popular or high-growth industries.
- Emphasize safety: Graham stressed the importance of safety, recommending that investors focus on investing in well-established companies with strong financials. Always have a margin of safety (chapter 20 in The Intelligent Investor).
- Diversification: Graham believed in diversifying investments to minimize risk, and recommended holding a portfolio of at least 10-30 stocks.
- Long-term horizon: Graham was a proponent of long-term investing, advocating for a patient and disciplined approach to investing.
Investing in Distressed Companies with Net-Net Value
Investing in distressed companies using the net-net value strategy involves identifying somewhat strong companies that are in temporary financial distress and buying their stocks when they are undervalued. The goal is to profit from the eventual recovery of the company. To do this, investors must consider the following:
- Look for companies with a strong balance sheet and a history of stability.
- Analyze the company’s financial statements, including the balance sheet, income statement, and cash flow statement.
- Determine the net current assets per share (NCAVPS) to assess if the stock is undervalued.
- Consider the company’s management, market position, and future prospects to determine if a turnaround is likely.
- Be prepared for increased risk, as distressed companies often face significant challenges, including declining revenues, operational issues, and even potential bankruptcy.
Common Mistakes to Avoid When Investing with Net-Net Value
When investing with the Net-Net Value strategy, you should be aware of common mistakes that can lead to investment losses. Some common mistakes to avoid include:
- Overvaluing current assets: The net-net value calculation assumes that current assets are worth their full value, but this may not always be the case. You must adjust current assets to account for doubtful accounts and reduce inventories to liquidation values. Accounting is not a science.
- Underestimating the risk of distress: Distressed companies can face significant challenges, including declining revenues, operational issues, and potential bankruptcy. You have to be prepared for increased risk when investing in distressed companies.
- Not considering the company’s future prospects: Investors must evaluate the company’s management, market position, and future prospects to determine if a turnaround is likely.
- Failing to diversify: Investing in a single distressed company can result in significant losses. It is important to have a diversified portfolio when investing in distressed companies.
- Not considering market conditions: Market conditions can impact all stocks. In a bearish market, almost all stocks decline, regardless of whether they were already trading at a discount.
- Time is not on your side: You have most likely invested in a mediocre business that is undervalued, and time is not on your side.
- Arbed away? Computer power means you can find net-net companies at relative ease. Thus, competition from other investors is fierce.
Finding Good Investment Opportunities with Net-Net Value
Finding good investment opportunities using the net-net value strategy requires careful analysis and research. Here are some tips:
- Screen for companies with a strong balance sheet and a history of stability.
- Analyze the company’s financial statements, including the balance sheet, income statement, and cash flow statement.
- Find out the net current assets per share (NCAVPS) to ascertain if the stock is undervalued.
- Research the company’s management, market position, and future prospects to determine if a turnaround is likely.
- Consider market conditions, as bearish markets can affect the ability of Net-Net Value stocks to turn around.
- Consider seeking the advice of a financial advisor or investment professional with expertise in the net-net value strategy.
What is the Difference Between Value Investing and Net-Net Value Investing?
Value investing and net-net value investing are both investment strategies that seek to buy stocks that are undervalued compared to their intrinsic value.
However, value investing is a broader investment strategy that considers a range of factors to determine a company’s intrinsic value, including earnings, revenue, assets, and growth potential.
On the other hand, net-net value investing focuses solely on a company’s current assets, taking into account only cash and cash equivalents, accounts receivable, and inventories. Net-net value investing is a sub-set of value investing used to identify companies that are deeply undervalued and may be distressed.
What are the Advantages of Investing in Net-Net Value Companies?
Investing in net-net value companies has several advantages, including:
- High margin of safety: By focusing on a company’s current assets, investors can buy stocks that potentially have a large margin of safety, reducing the risk of loss in case of a downturn in the market. However, research shows that this might not be the case. They do very well in a bear market, but tend to underperform in a bear market.
- Potential for high returns: Companies that are deeply undervalued may have the potential for high returns if they can turn their business around and return to profitability.
- Less competition: Net-net value investing is a niche strategy, so there may be less competition from other investors, increasing the potential for finding undervalued companies.
- Identifying companies with a strong balance sheet: Companies with strong balance sheets are more likely to weather economic downturns, making them a safer investment option.
What Types of Companies are Suitable for Net-Net Value Investing?
Net-net value investing is suitable for companies that have a strong balance sheet, with a high proportion of current assets relative to total liabilities. These companies are typically in temporary financial distress, with low earnings and a history of underperforming the market. Examples of companies that are suitable for net-net value investing include:
- Small-cap companies: Small companies may be overlooked by larger investors, making them more likely to be undervalued.
- Cyclical companies: Companies that operate in industries that are sensitive to economic cycles may present opportunities for net-net value investing during economic downturns.
How Can Investors Assess the True Value of a Net-Net Value Company?
Investors can assess the true value of a net-net value company by:
- Reviewing the company’s financial statements to assess its liquidity, profitability, and solvency
- Considering the company’s position within its industry and how changes in the industry may affect its future performance
- Evaluating the experience and track record of the company’s management team
- Analyzing the company’s competition, including its market share, growth rate, and profitability
- Considering the company’s future prospects, including its growth plans, product pipeline, and expected earnings
- Looking for events or developments that may trigger a revaluation of the company’s stock price.
Net-Net Value Investing Strategy – Backtest, Returns And Performance
Before we go on to look at backtests and empirical findings, we briefly mention Benjam Graham’s books called The Intelligent Investor and Security Analysis. We recommend reading both of them, even if you’re a short-term trader. They contain valuable insights no matter the time frame you are trading.
Benjamin Graham’s net-net strategy has been researched and backtested plenty of times. Let’s look at some of the findings and empirical evidence:
Net-Net Value Investing Strategy backtest 1
The first research paper we look at is Ben Graham’s Net-nets: Seventy-Five Years Old and Outperforming by Tobias Carlisle, Sunil Mohanty, and Jeffrey Oxman. They looked at and backtested the net-net strategy for over 24 years, from 1984 to 2008, with annual rebalancing.
What did they find out? We quote from the abstract:
We find that monthly returns amount to 2.55%, and excess returns using a simple market model amount to 1.66%. Monthly returns to the NYSE-AMEX and a small-firm index amount to 0.85% and 1.24% during the same time period.
According to the authors, this could not be explained by potential other factors like small-cap premium, momentum, etc.
The results indicate a massive annual outperformance.
The authors updated the research in 2010, but the conclusion remains.
Net-Net Value Investing Strategy backtest 2
Graham and most of the other researchers have looked at US stocks. Does it work outside the US?
Ying Xiao and Glen Arnold looked at stocks in the UK from 1981 to 2005 in a research paper called Testing Benjamin Graham’s Net Current Asset Value Strategy in London. We quote from the abstract:
Examining stocks listed on the London Stock Exchange for the period 1981 to 2005 we observe that those with an NCAV/MV greater than 1.5 display significantly positive market-adjusted returns (annualized return up to 19.7% per year) over five holding years.
The authors rebalanced annually in July based on accounting from December last year. They defined a net-net company as having a liquidation value that was 50% higher than the market value. If the company had to liquidate, it could sell for more than 50% of the market value.
Net-Net Value Investing Strategy backtest 3
The most recent performance we have seen for net-net stocks is a report by Chongsoo An, John Chen, and Il-woon Kim called Testing Benjamin Graham’s net current asset value model.
They investigated the NCAV model from 1999 until 2012, and not surprisingly, they concluded positively:
We used all stocks in Portfolio123 whose raw data were supplied by Compustat, Standard & Poors, Capital IQ, and Reuters for the period of January 2, 1999 to August 31, 2012. The overall results show that the firms with high net current asset values outperform the market. These results are strong in the up market. It can be argued that the firms with a high NCAV/MV ratio are likely to move toward their fundamental value and generate high excess return because its stock prices are now undervalued.
Net-Net Value Investing Strategy backtest 4
The last report we found is Graham’s Net-Nets: Outdated or Outstanding? by James Montier (2009) in Value Investing. He not only looked at the US markets but also at International markets. The table below summarizes the results:
However, the results are arithmetic means and not geometric means. This matters (see link below), and thus the credibility of the backtest is somewhat ruined.
What’s the downside on the net-net value investing strategy?
Annual returns still seem to be good for net-net stocks. But what about risk? How do they perform in bear markets?
The backtests we looked at show that net-net stocks underperform in bear markets. For example, the table below is taken from quantinvesting,com and its article called Why and how to implement a net-net investment strategy world-wide:
As you can see, portfolio 1-3, which are groups of net-net stocks, perform significantly worse than S&P 500 when markets go down. This is probably because these companies are struggling in their day-to-day business. In the long run, such companies are probably poor investments, even though the strategy shows splendid results.
Why is that? We need to understand the difference between good and bad companies:
Warren Buffet’s wisdom about “bad companies”
Time is the friend of the wonderful business, the enemy of the mediocre.
Warren Buffett used to invest in types of net-net stocks when he was starting his career. He referred to them as cigar butts. They were dying companies, but they had one last puff in them.
Later the influence of Charlie Munger made him realize that it was better to invest in quality companies that throw off a lot of cash. Net-net stocks are more likely to be in a cyclical business. If you own a quality company, you can just sit on your ass and do nothing while compounding.
Many of the net-net stocks are poor businesses. Thus, you are unlikely to do well if you own them for a long time (years). There’s a reason they are value plays and not growth plays. Please read our take on quality vs. non quality:
- How Much Can You Pay For A Quality Company And Still Make High Returns?
- Does Valuation Matter? Less Than You Think If You Buy Quality
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