How to Avoid Value-Traps with Net-Net Stocks

(This is a guest post by Aaron J. Saunders of ValueHeadz. The author’s views are entirely his or her own and may not always reflect the views of Fat Pitch Financials.)

Summary:

Net-net stocks are those which sell below liquidation value and are major bargains. Avoid being a victim of value traps by only investing in net-nets which:

  1. Generate revenue
  2. Experience NCAV Burn of less than 25% annually
  3. Aren’t based in China or if you are risk averse, aren’t Chinese
  4. Have sold at a price above the current NCAV in the past 5 years
  5. Are not issuing shares
  6. May experience an event in the near future if it is an asset-shell

For those of you who don’t know, you can get excellent returns investing in bad, bad businesses. Warren Buffett, who advocates investing in businesses with a competitive advantage which generate high returns on invested capital, once said that “my cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performance.”

His cigar-butt strategy involves the purchase of net-net stocks- businesses selling below their liquidation value as found using the following equation:

Net Current Asset Value = (Current Assets – (Total Liabilities + Preferred Stock))/Total Shares Outstanding

 The Net Current Asset Value (NCAV) calculates the value of a firm’s cash, inventory, and receivables less all liabilities and preferred stock which is treated as debt. It is thus the firm’s lowest possible liquidation value, and a value below which no firm should ever be sold. Any stock selling at a price below 66% of its NCAV (Price < 0.66*NCAV) is called a net-net stock and is a major bargain. When you buy a net-net stock, you get $1 in net current assets and pay 0.66c or less for it. Some even sell for less than their net cash value, so you pay $1 and immediately own more than that in cash alone! As you can surmise, they are businesses struggling to such an extent that investors forget completely about the firm’s net asset value and are willing to sell them for an irrationally low price.

I would like to draw a quick analogy to help explain why such stocks should not exist. Imagine you run a lemonade stand which owns $7 of lemons, $3 of sugar, $5 in cash, and has sold lemonade on credit to which you are owed $7, so your current assets total $22. Your lemonade stand only has one liability which is that it owes the sugar factory $7. If you paid this liability you would have $15 worth of lemons, sugar, cash, and receivables, all of which you could quickly turn into cash. If someone offered to buy this lemonade stand for anything less than $15 the offer would sound ridiculous and be swiftly denied. This is because even if you assume that you couldn’t make another cent selling lemonade, you could end the business and leave with $15. For some reason, this logic does not transfer to the domain of public stock ownership, possibly because this aspect of asset ownership is not taken into account.

Every academic study on net-net stocks shows long-run annual returns in the range of 20-40% vs. the 10% historical return of the S&P 500, so the logic displayed above clearly translates to investment returns. See here for this evidence and to what extent net-nets dominate the market.

So far so good. I’m sure right now you are asking why these opportunities haven’t been taken advantage of and why they still exist. There are a variety of reasons why net-nets exist, such as the fact that large and institutional investors cannot invest in net-nets as they are very small businesses, or that academic theory contradicts the existence of net-nets, or that investors can be emotional, etc.

I would like to focus on one issue that many investors have with net-nets in particular and one which gives us value investors nightmares- this is the fear that the bargain you found is a value trap and that unbeknownst to you there are logical reasons as to why it is underpriced. I have experienced this feeling myself a number of times which led me to question if I was missing something crucial in the valuation. It turned out that I wasn’t missing anything and most of those situations turned out quite well. To help relieve your anxiety at this stage, I would like to inform you that many times there is no good reason as to why a stock is undervalued, especially when looking at businesses such as net-nets. Investors generally avoid poor stocks and don’t like the idea of investing in a business which is currently incapable of generating sufficient earnings or which has a limited future. Of course, value traps are real and can ruin portfolio performance, but if you know what to look for this concern can be mitigated.

Generally speaking, value traps are undervalued stocks which stay this way for prolonged periods and in some cases, they never return to their ‘intrinsic value’. When looking at net-net stocks there are a few quick ways to spot value-traps and knowing them will help you avoid most trap situations.

Something which may be completely obvious is that you should not invest in any net-net stock, however undervalued, if it is not generating revenues and does not have ongoing operations. Many net-nets are in the process of developing highly technological products or pharmaceuticals, or they may be searching for rare minerals or fossil fuels. They may have significant current assets- likely almost all of it cash, and few liabilities, causing them to be net-nets. The issue is that most of these firms will waste away, reducing NCAV per share over time by spending cash and issuing shares to remain solvent, leading to a slow, long and painful drop in the stock price over time. Avoid any firm without revenues and operations.

Related to this point is that there are many net-nets out there which are asset shells- while they sell for less than their net current assets or even net cash, their operations and earnings are waning while they spend cash to sustain the business. This of course reduces NCAV over time and makes investors wonder how much longer their undervalued stock can drop in price. You can do very well on these asset-shell type net-nets, but only if there is an understanding within management or activist shareholders that things need to change. If management seems content to be paid their salaries as the firm wastes away, you can get burned. These net-nets are riskier but if some event such as a liquidation or buyout seems likely it can pay off. Better yet, if the waning earnings are caused by a temporary business or industry issue, then when the issue is resolved you will profit greatly. Avoid net-nets which are wasting away and unlikely to change course in the near future.

In most cases the net-net firms which waste shareholder value are easy to spot, even without considering qualitative business factors. They are the ones which burn NCAV at a high rate each year. Avoid the net-net if its NCAV has decreased by 25% or more in the past year and go for those which are growing their NCAV naturally without issuing shares. If I had to guess, most of the value traps in net-net investing are those businesses burning NCAV at a rate of 25% or worse year in and year out. Of course, by using this measure you may exclude those few net-nets which only experienced one bad year of NCAV reduction, but the majority of value traps will be immediately rejected.

Another quick measure is to check whether the stock has sold above its current NCAV in the past 5 years. If not, I would reject it immediately unless there are some extraordinary factors making the stock great in every other way. Most of the net-nets which have not sold above NCAV in the past 5 years experience a long decline in their stock price and the potential investor will likely never see the stock revert to NCAV. Such stocks are likely the same ones burning their NCAV rapidly or those which have dramatically impaired operations.

Be very, very careful when analyzing stocks selling under $1 or selling OTC or on Pink Sheets. Many of these have display the issues discussed above, along with potentially fraudulent financial statements or operations, and an absence of fiduciary duty to stockholders. Many of these cheap stocks are selling under 1 cent per share and at price to earnings ratios of less than one. I would bet that most of these have major issues and are not prime for investment. I would not immediately reject a net-net stock exhibiting an abnormally low P/E or price, but it should make you extra cautious in your analysis.

Apologies to my Chinese friends out there, but to avoid as many value-traps as possible I would also reject investment in any net-net stock headquartered in China. Unfortunately the management of many Chinese firms do not act as fiduciaries to their shareholders and the rate of corporate fraud is significantly higher than in many other developed nations. This makes it difficult to ascertain whether the financial statements are accurate or not, even if audited. Many Chinese firms stay undervalued for incredible periods due to the fear of fraud, as the bad apples affect the market sentiment for all other Chinese firms. This means that even if you are certain of the integrity of the business, other investors are not and this can make it very difficult for the undervalued Chinese firm to rise to NCAV. I sometimes invest in Chinese firms headquartered in the U.S. or elsewhere if they are listed on a major exchange, but I would advise caution and to invest in Chinese net-nets at your own discretion.

There are some other factors that can hint at the quality of the stock. If the firm is issuing shares to raise cash, it is a bad sign. If a firm is truly undervalued, management would be purchasing shares in abundance- selling shares signals either a lack of confidence or the inability to generate cash through operations, both of which are negative. Although you should look for net-nets growing their NCAVs, if it is done through issuing shares it is not a good sign.

There are a few other potential issues, such as the potential of off the balance sheet liabilities, hidden long-term lease or contract obligations, or receivables which are not actually receivable. Some firms which sell very unique inventory may not be able to liquidate it in the event of bankruptcy, leading NCAV to be lower than you originally thought.

These last few particulars are generally minor issues in the universe of net-nets. Focus on the big issues such as making sure the firm generates revenue, has a low or positive NCAV burn rate, isn’t based in China, isn’t generating NCAV through selling shares and has sold above NCAV in the past 5 years. If it is an asset-shell, try to determine whether the firm may experience a potential event or change of course in the near future. If you create a portfolio with net-nets fulfilling these requirements, you will experience excellent returns and avoid most all value-traps.

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