Extreme value investing: screening for net nets

In a recent article, I explained how crises could provide opportunities for the patient value investor. Three such sharp sell-offs have occurred in my investing lifetime: 2008, 2020 and 2022. (Arguably, the 2016 Brexit result sell-off could be included here, but it was so brief it barely appears on a long-term chart.) In each case, the blow-up of widespread leveraged trading strategies added to the woes caused by the initial bad news and, with hindsight, took some equities significantly below a conservative assessment of their intrinsic value.

The problems with investing in times of crisis

The problem with investing during such crises is that they often appear during periods of extreme uncertainty. Take, for example, the 2020 sell-off in response to COVID-19. The background to the sell-off presented some significant challenges to investment decision-making:

• The future earnings expectations became highly uncertain for the majority of stocks. In many cases, brokers removed all forecasts from the market, meaning that investors had no idea what earnings and cash flow would be for many companies.

• Dividends were cancelled across the board, including in formerly recession-proof companies, such as cinema operators, for whom COVID-19 was an entirely unanticipated risk to consumer behaviour.

• Companies that were likely to benefit from the crisis, such as biotech or pharma businesses, were already on unattractive valuations and became more expensive.

• Even relatively stable investment metrics that many value investors use, such as tangible book value, became uncertain since the future value of long-term assets, such as property, plant, and equipment, came under question.

Faced with such an investing backdrop, it was very tricky for an investor to make an informed decision as to where to deploy their capital. However, amid this uncertainty, a type of investment opportunity became available that has been uncommon in recent years: some stocks became net nets.

Net nets

A net net is a type of deep value investing first made famous by Benjamin Graham, known as the father of value investing. His idea was to buy a stock so cheaply that it traded at a discount to the liquid assets it held on its balance sheet, such as cash, inventories or receivables, even after you netted off all the current and non-current liabilities. In making this assessment, no value is given to non-current assets, such as property or equipment. Graham gave various formulations in his writings of how to apply the discounts for this strategy, but the one I prefer applies specific discounts to current assets depending on how likely they are to be able to be rapidly turned into cash. Existing cash holdings are included at face value. However, inventories are discounted to 50% of their value in the accounts and receivables are discounted to 75% of the accounting figure. This reflects that, in extremis, not all customers are likely to pay, and a company may not receive full value for their inventory if they had to sell it rapidly.

Net Net Value = Cash + (50% x Inventories) + (75% x Receivables) - Current Labilities - Non-Current Liabilities

The idea is that a company could cease trading, sell all its assets, pay all its liabilities and still return more than the current market capitalisation in cash to shareholders. However, the returns from this strategy rarely come from such liquidations. Before liquidation is necessary to extract value, a business often improves, and the market realises how cheap it has become.

This is clearly a very extreme form of value investing, and the abundance of data and availability of analysis tools to the average investor means that markets have probably become more efficient. Benjamin Graham would have loved to have access to Stockopedia in his search for value opportunities. So, while these sorts of opportunities are rarer these days, they often appear in moments of crisis and during leveraged sell-offs. As this figure from a 2012 study by Tobias Carlisle, Sunil Mohanty, and Jeffrey Oxman shows, opportunities to invest in net nets are more prevalent in bear markets:

Does it work?

Ben Graham kept detailed records of the various investment strategies he developed. In a 1975 retrospective, he said:

At this point let me consider briefly an approach with which we were closely identified when managing the Graham-Newman fund. This was the purchase of shares at less than their working capital value. That gave such good results for us over a forty-year period of decision making that we eventually renounced all other common-stock choices based on the regular common stock procedures, and concentrated on these ‘sub-asset stocks.’

So, in the end, Graham found that the returns of net net strategy beat all the others and solely focussed on this for the latter part of his career.

In 1986, Henry Oppenheimer published a paper looking at the performance of the net net strategy for the 13-year period from 1970-82 period in the US. He found a compound annual growth rate of 28.5% vs the S&P 500 Total Return at 9.3%; an absolute outperformance of 19.2%.

The 2012 study by Carlisle, Mohanty, and Oxman updated this by examining the performance of net net stocks in the US market between 1984 and 2010. Despite having a higher corporate failure rate, 6% for the net net portfolio versus 2.5% for the general market, the net net portfolio delivered far higher returns. The net net portfolio outperformed the NYSE-AMEX Index by a phenomenal 22.4% per annum and the Small-Firm Index by 16.9% per annum.

Some critics have pointed out that being such small companies means that the quoted returns of this study may be optimistic due to large bid-offer spreads and may not be available to all investors. Still, the size of the outperformance is such that the returns to individual investors should still be great despite these challenges.

Net net investing in modern times

Fund manager Jeroen Bos describes his success investing in such Net Nets in more recent times in his 2013 book, Deep Value Investing: Finding bargain shares with big potential. Bos prefers cyclical services businesses that are low on fixed assets and high on liquid assets. Typically, these are service companies such as recruiters, financial services and consultants. The cyclical nature of these businesses means that their earnings are periodically weak from time to time. The market’s tendency to value companies on short-term earnings may lead to them trading on a discount to current asset value during periods of poor trading. When trading recovers, excess inventories turn to cash, making the company cheap on both assets and earnings and driving a significant re-rating.

The type of companies that end up as net nets always appear to have something wrong with them. Such is the relative cheapness that high-quality, profitable companies with great products in growing markets are unlikely to be net nets. Net nets are invariably loss-making, in declining industries, or have other significant issues with their business. However, since the net net metric is a balance sheet one, they are often conservatively financed, giving them considerable time and flexibility to reverse their fortunes. The power of capitalism works to force such companies to shut down unprofitable business lines, cut costs and increase sales activities. Over time they show significant reversion to the mean. However, they can remain significantly loss-making, even as their share price recovers. Here are some personal examples of employing this strategy:

Xaar (LON:XAR)

Xaar Plc, which makes industrial print heads, remained loss-making, both on a reported and forward basis, from when I bought at around 20p per share in March 2020 until I sold roughly six months later at 130p per share. This re-rating occurred not due to a return to profitability but a change in the direction of travel: from increasingly loss-making to decreasingly loss-making. Combined with a significant shift in market sentiment, this drove a substantial stock price recovery. The company is now just becoming profitable three years later, and the share price is approaching 200p.

Hunting (LON:HTG)

Oil field services company Hunting became a net net a bit later in 2020. Although it fell in March 2020, it didn’t become a net net until later that year. Its 2019 Annual Report showed $536.8m of current assets and just $48m of non-current liabilities, which compared favourably to a c.$270m market cap at the time. Applying the Graham formula showed that the company became a net net at its nadir of £1.27. The subsequent recovery in trading took the share price over £3.

Hunting is finally expected to be profitable again in 2023.

What else should net net investors consider?

When buying companies this cheaply, time spent analysing industry trends or the quality of their products is almost always unnecessary. The additional information gained is likely to make investors overconfident in picking the winners. In this case, more research may cause investors to find reasons not to invest in such stocks. There are always factors that may persuade investors not to invest in such ‘dogs’, and despite investing in Xaar, I fell for this mistake with several other stocks. Of the dozen or so UK-listed stocks that became net nets between March and September 2020, a number of them subsequently generated over 500% returns. However, I didn’t invest in many of these short-term winners because I was concerned about their cash-burn rate or the quality of their products. This oversight was to the detriment of my returns during this period.

That quality factors lack predictive power when it comes to extremely cheap stocks perhaps shouldn’t have been a surprise. Oppenheimer found that unprofitable net nets outperformed profitable ones. Carlisle found that non-dividend-paying net nets beat the dividend payers.

Screening for Net Nets

This is one of the easiest screens for me to come up with since Stockopedia has Graham’s net net formula as a screening criterion. I can simply screen for Price to Net Net Working Capital of less than one:

It is tempting for me to leave it there. As the research into net nets has shown, applying too many criteria detracts from returns to the strategy, not enhances them. However, the results contain a lot of investment funds and VCTs. While large fund discounts may represent good value, these are not the kind of net nets I am looking for. It is easy to ignore them. However, adding this additional screening criterion removes them from the list:

There are currently 20 companies that meet these criteria, which shows how extreme this is as a value strategy:

A couple of things stand out from this list. The first is that net nets are often tiny companies. The largest here is less than £100m market cap. This means that the strategy won’t be actionable for every investor. Second, this isn’t a list to blindly buy all the companies that feature in the screen results. For example, since this is a balance sheet test at a point in time, investors need to be careful of post-balance-sheet events, such as a return of capital, changing the underlying state of the business. While investors can fall into the trap of doing too much research and excluding businesses that appear poor quality (with net nets this is likely to be true but already in the price), some additional research is necessary.

This is why I like to screen for near net nets as well as current ones. If I widen the criteria to P/NNWC <2, this broadens the number of companies to 67. These are still cheap, but not yet net nets. This wider selection yields more companies that I would consider investing in. I can research these at my leisure and build a watchlist ready to strike when the next time of crisis appears.