Net-Net Investing is a type of value investing strategy that is an investment philosophy centred around 2 main points. 1.) Having a margin of safety 2.) Buying assets at liquidation value, relative to their market price
It is not limited to buying a discounted company, but rather, a philosophy that allows investors to purchase a whole range of products and services. Interestingly, it is most likely that you have already practised the art of value investing.
Remember shopping at outlet malls or sale expo events?
Buying the same product(that you love) that does the same function at a fraction of its cost(close to its expiry date, or dented packaging, etc). That is value investing. Of course, it’s more to it than that, but you get the point.
There are many ways of executing value investing strategies. Net-net investing is a specific type of value investing strategy that allows an investor to tangibly determine a company’s value based on its current assets and liabilities – thus profiting from it.
So then, how does one use Net-Net investing to identify undervalued stocks?
Read Also: Guide To Value Investing In Singapore
Net-Net Investing Identifies Beaten Down Companies That Have A Higher Asset Value Than Their Share Price
Specifically, Net-Net investing identifies businesses that are beaten down to a level so low, yet the business still has value in cash, inventories, accounts receivables, etc. Therefore, the market price does not justify its low prices (at least in theory).
There are many reasons why the market price does not reflect it. The main reasons often are: 1.) Bad news; such as government fines, lawsuit loss, or product recalls 2.) Poor consecutive earnings 3.) Being unpopular among investors, such as being in a boring industry or a company “hated” by the public due to acts of poor behaviour
These companies have their prices beaten down by investors that poorly reflect the actual value that the company has. The value could be hidden in cash, inventories, properties, stocks they own, and various other long-term assets.
Using Market Volatility And Bad News To Your Advantage
It might seem counterintuitive to go against the flow of things especially buying into a company that has been thrown into the gutter. Net-Net stocks are just that.
You will be looking into companies that have a one-time fine or are slapped with a slurry of bad news. However, their management and overall finances may turn out to be just fine, allowing you to scoop up a bargain.
Other reasons could be recently a slate of poor earnings, ousting or death of the CEO, the closure of multiple stores, or generally a huge one-time event that investors might see as a complete disaster for the company.
Net-Net stocks are beaten so far down due to all the bad news that any single sign of good news or profitability may shoot its stock price back up.
This “temporary” volatility misprices the stock price and that difference in arbitrage is where you come in and purchase the stock.
Read Also: S&P500 vs Straits Times Index: Which Is “Better” For Beginner Singapore Investors?
You Might Have Just Bought A Terrible Company
However, it isn’t all just rainbows and butterflies. You might just be caught in a value trap. A value trap is where an investor assumes that just because the company has way more assets than it has liabilities, the company is a worthy buy.
However, there is one factor that is a good determinant of a value trap – its burn rate.
The burn rate is how fast a company loses money (cash) due to being unprofitable. A slow burn rate is all right if the company can deliver profits once more, get bought out or has a change in management that reverses its fortunes.
If you are caught in a value trap, your stock price might get stuck for years or even be devalued even further. Thus, you might only end up with a couple of percentage gains after 3-5 years (in the best-case scenario) or you might probably have a company that runs into the ground.
An investor needs to thoroughly check on the management, business plan, and any contingent plan the company has and if management is diluting its stock.
Afterwards, determine if the actions taken are sound and any macro factors that might increase the probability of another disaster for the company. (Geopolitics, disruption in its supply chain)
How To Find Net-Net Type Stocks
Finding these beaten-down businesses takes time. With the power of the internet, you can scour the web for these companies with greater detail and precision (try FinViz or Yahoo Finance).
Albeit, with all this information available, it is still a difficult task. A beaten-down business can come from any industry, but it is better to stick to industries that you are familiar with and where your knowledge can give you an edge in sieving through all the information.
Once you have found a business whose share price has been beaten down badly, grab its financials and read its statements. The balance sheet is a good place to start. Of course, there are many things to look out for like retained earnings and how its debt is structured, etc.
You would want to look for the company’s total current assets, total liabilities, inventories and account receivables. Before you continue, you have to know two things. There are 2 types of Net-Net formulas:
- Net Current Asset Value (NCAV) – taking current assets – total liabilities.)
- Net-Net Working Capital (NWWC) – which is similar to NCAV, but with a twist. (Current assets + (0.75x account receivable) + (0.5 x inventories) – total liabilities)
Those numbers “0.75” and “0.5” are percentages to discount the items. The discount depends on the industry. If the company is going bust and needs to liquidate its assets, we assume its inventories are worth half of its initial selling price (a more niche industry has a higher discounted value) and 75% of its accounts receivable as some clients might not pay them back.
Using this number, divide the number by the total number of shares outstanding. Once you have a price per share, slash it by approximately half (50%) as a margin of safety.
Afterwards, you can look at their income statement to view their profit & loss, to see how they spent their resources. Followed by the cash flow statement, you can determine the amount of cash flow going through the company.
These two statements might further influence the price per share that you have previously calculated, and discount items that might seem too good to be true.
Obviously, there is more to it than this, but looking at the company’s 10-K and related news will benefit your overall due diligence.
Read Also: 4 Financial Ratios To Look Out For When Investing In Small & Mid-Cap Stocks
Is Net-Net Investing For Me?
Just like everything else in this world, there is no one-size-fits-all option. Depending on your stomach to handle volatility, your current financial position in life, and the ability to stick within your circle of competence and bet all in on the best investment idea that you have – you might have a different outlook on Net-Net investing.
A value trap is a real thing and investors do get stuck in it. There are ways to potentially spot a value trap like burn rate and looking at past market price fluctuations. It also takes time to search for net-net type stocks as well as the ability to read through its financial statements.
Buy the company, not its price. Net-net investing might not be perfect, but it might be for some. Whatever your appetite is, happy hunting.
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