21st Century Net-Nets

One of the most enduring investment strategies for ‘deep value’ investors was defined by Ben Graham way back in (at least) the 1940’s.  The approach was to buy shares in companies where the market cap was less than the value of its current assets minus all of its liabilities.

This was a simplified rule-of-thumb guesstimate of liquidation value.  The assumption was that any haircut taken on current assets (like inventory) in an orderly liquidation would be more than offset, on average, by returns from the sale of fixed assets like property and equipment.

So why would anyone want to invest based on a guess of the liquidation value of a company?  Graham cited three key reasons:

1. Earnings power would rise in the future to the point where investors would value the company at a higher level.  Graham conjectured that this might occur because such a poor industry may see other firms exiting first, leaving more customers for those who can stick it out or; management find a way to generate sufficient earnings by dropping underperforming products, becoming more efficient or some other means.
2. A sale or merger in which the buyer would likely pay at least liquidation value.
3. The company is liquidated, fully or partially, and shareholders gain from the value released by selling off the company’s assets.

There have been many studies into these net-net stocks and as far as I know, they have all shown a high degree of outperformance, in the medium and long term.

But it isn’t an easy strategy to follow.

As I mentioned before in Merry Christmas 2011, I abandoned my own portfolio of low price-to-book stocks because I found it difficult to hold a large portion of my pension in a group of weak and economically underperforming companies.  Another problem is the tiny pool of stocks that fit the investment criteria.  It’s highly uncommon for any company other than a housebuilder to have enough current assets to pay off all current and non-current liabilities.  At the moment my net-net screen shows only 16 companies listed on the main FTSE indices (i.e. not the Alternative Investment Market, which typically can’t be held in an ISA) which are valued at less than their net-net value, and only 6 companies that are valued below 2/3rds of their net-net value, which was the most that Graham would pay.

When Graham’s investment company used net-nets as their main strategy for some 20 years or so, he typically held over 100 positions.  The reason for this high degree of diversification was the inherent uncertainty in any given net-net stock.  By being so diversified the volatility and returns of the overall portfolio were more acceptable to his clients.

So to reduce volatility to a level that could be lived with by most people Graham invested in over 100 companies at a time, but that’s going to be very difficult if there are only 6 available to select from.

Another problem with net-net stocks is the bid/ask spread.  Because many of these companies are small and unloved, they don’t attract much trading on the stock market.  This means that the difference between the bid and the ask price can be 10% or more.  That may not sound like much but if the average holding period is one year then a stock with a 10% spread needs to gain 10% just to break even.  Seeing as 10% is the average return from the stock market over time (including dividends) that’s a big handicap to carry.

Still, I have an enduring fascination with simple mechanical strategies and net-nets are one of the simplest and one of the best.  I think that with a few tweaks, the strategy could be usable for those who are interested, without having to hold only a handful of these highly volatile and often miserable stocks.

Buy liquid, unlevered companies

The first point to note is that there isn’t anything magic about having enough current assets to cover all liabilities.  The real point is that companies that do have that balance sheet structure are typically highly liquid (quick ratio over 1) with little leverage and very often have net cash.  The reason that good liquidity and low leverage are important is that it helps the company to survive whatever problems are currently causing the share price to be so low.  Turnarounds are a lot easier if the company has lots of cash and little debt.

Not only that, but in The Price To Book Effect In Stock Returns: Accounting For Leverage, Stephen Penman found that in some cases lower leverage leads to higher returns.

Buy low price-to-book companies

The second point is that net nets are trading well below book value and even tangible book value.  Low-price-to-book stocks are the standard academic definition of ‘value’ stocks and they have a history of outperformance in the long term.

Hold lots of companies for long periods

Another point of note is that several studies have looked at returns of net nets and low price-to-book stocks and found that they outperform the market, on average, for years after they are selected.  For example, in Testing Benjamin Graham’s Net Current Asset Value Strategy in London, Ying Xiao and Glen Arnold show that net nets beat the market by up to 19.7% a year, over 5 holding years.  In Tweedy, Browne’s What Has Worked In Investing, various studies show excess returns over 3 and 4 years.

By holding an investment for a longer period the average returns from each position are larger, which can help mitigate some of the negative effects of wide spreads.

So one possible interpretation of net nets for the 21st century would focus on low price-to-book, highly liquid, low-leverage companies, holding quite a large number of positions for multiple years.

I like to keep things simple so I came up with this list:

Net cash

Only invest in stocks that are net cash, i.e. they have enough assets that they can turn into cash within a ‘short’ period of time to cover all borrowings.  This is a measure of leverage, but it is also a reasonable indicator of liquidity.  If you look at companies that are net cash they tend to have quick ratios close to and usually over 1.

Low price to book

Very simple this one.  Low price-to-book stocks have a history of outperformance.  Net-nets are low price-to-book stocks so that’s what I’m after.  Sort the universe of stocks by price to book at the start with the lowest.

Price to sales ratio of less than 1

This is the only point where I really digress from the net-net spirit.  At these levels, you can pick up some funny companies, like pharmaceutical firms that don’t actually sell anything or just make losses every year… or house builders that aren’t doing anything or other firms that are in hibernation mode or other companies that are so inefficient they cannot even generate a fraction of their book value in sales.  I want the companies in the portfolio to be actual trading companies so a price to sales ratio of less than 1 is a simple rule of thumb to make sure that the company is actually doing something.

Hold 60 companies, equally balanced, for 5 years each

60 companies should give the investor enough distance from each individual company so that any horror stories (or even success stories) that emerge shouldn’t over-excite or over-depress.  A detached alertness is what is required and this many positions should help.

Holding each stock for 5 years is in line with previous studies and should allow the average to outperform the market while reducing trading costs from the more typical 1-year holding period.  For example, in Testing Benjamin Graham’s Net Current Asset Value Strategy in London, the average 60-month buy and hold return was 254% which would not be affected to a huge extent by a single 10% trading cost.  Compare that to flipping positions every year and even if your investment returns 30% a year it’s running uphill against a 10% or even 5% spread each year.  The difference over time is enormous.

Flip investments monthly

I like a fixed investment schedule as it helps me to avoid the delusion that I can time the market.  By investing on a fixed schedule it also mechanises the optimisation of the portfolio, calmly and gradually over the long term.  I’m not saying that any portfolio is optimal, but if you’re consistently moving a portfolio towards value then good things are more likely to happen.

So basically I’d buy say French Connection today and hold it until January 2017, at which point I’d sell it regardless of where it was or what happened in between and replace it with another of my 21st-century net-nets.

It may sound daft, but in the long term, these ‘blind watchmaker’ strategies seem to have a nasty habit of working.

Over the next 60 weeks I’ll be loading a new model portfolio up with these stocks, 1 a week plus a post on each one when possible; followed by a switch to monthly trading once it’s fully invested.

For those who love the unloved, this could be interesting.