Imagine finding a company that is so undervalued that you can buy it for less than what it can fetch in a liquidation! Your worst case scenario is that the company is closed down, and you still make money. These are the net-net stocks and these are every value investor’s fantasy. Popularized by Benjamin Graham, the father of value investing, these deep value investing opportunities are rare but they can deliver outsized returns if you know how to find and evaluate them. In the guide below, I will take you through the essentials of identifying and profiting from net-net stocks.
What are Net-Net Stocks and How do You Find Them?
Net-net stocks are the stocks that trade below the net current asset value, or NCAV.
NCAV = Current Assets – Total Liabilities
Benjamin Graham was more conservative and calculated a net-net working capital instead of NCAV as follows
Net-net Working Capital = Adjusted Current Assets – Total Liabilities, where,
Adjusted Current Assets = Cash and Cash Equivalents + 75% of Accounts Receivable + 50% of Inventory
The basic premise is simple. Suppose you acquire the entire company by buying up all the stock in the open market at the current market price. If you do this for real, the market price will rise, but bear with me here. Once you bough the company, you can convert the current assets to cash by selling them off. Remember that the current assets are the assets that can quickly be converted to cash (in less than 12 months), and therefore are close to being valued at their market value.
Once you sell off all the current assets, you use the cash to pay of ALL liabilities. This means you will pay off all the creditors – short and long term.
Once this is done, you will have cash left over. The value of this cash is your NCAV. You will also have long term assets such as property and equipment left over as well.
Since you picked this stock because its market value was below the NCAV, the cash left over on the books now is more than what you paid for the entire company when you purchased it. If you pay yourself back the purchase price, you will still have some cash left over, along with the long term assets.
The remaining cash and the long term assets are your profit. In many cases, these can be substantial. In pretty much every case, the profits will accrue before one year is out.
Net-net stocks are more common during the time of Ben Graham when the markets are less crowded and less efficient. These were Graham’s favorite investments and he writes about these in Security Analysis. Today, these stocks are hard to find and if you find them, the undervaluation tends to disappear quickly. You can still find such stocks in “emerging” markets where the markets are likely to be less efficient.
Why Invest in Net-Net Stocks?
Why should you care? After all, these stocks have gone down for a reason!
The key to understanding the deep value appeal of the net-net stocks, is that the downside is very low at these valuation levels. There is solid hard cash or assets very easily and quickly convertible to cash supporting the stock price. The upside potential is significant. The risk-reward ratio is significantly asymmetric, skewed in the favor of outsized reward.
There are significant studies and research that conclude that net-net stock portfolios can return in excess of 20-30% annual returns.
When you buy a net-net stock, you expect the market to eventually realize its mistake and correct the stock’s valuation, thereby handing you a profit. The other way net-net stocks payoff is by the company getting acquired at a premium. This is a common scenario as other companies in the industry or even private equity are constantly looking to buy cheap assets to profit from – your minority stake in the company will benefit as the company stock gets revalued through corporate action.
Finally, net-net stocks are typically found amongst the small-cap and micro-cap stocks. This is the segment of the market where you do not find too many institutions or analyst coverage. As a result, the odds are NOT stacked against you and significant opportunities to profit still exist.
Characteristics of Net-Net Stocks
Let’s go back to the basics and take a look at the Balance Sheet equation that is the cornerstone of all accounting.
Assets = Liabilities + Stockholder’s Equity
This can be restated as
Current Assets + Long Term Assets – Liabilities = Book Value, or
NCAV + Long Term Assets = Book Value
Given that net-net stocks have share price < NCAV, we can deduce a few things from this:
- Price/Book Value = Price / (NCAV + Long Term Assets) < 1, and
- Current Ratio = Current Assets/Current Liabilities is very high as Current Assets is significantly greater than Total Liabilities
Therefore, net-net stocks exhibit very low price-to-book ratios and very high current ratio. Typically you will also find that net-net stock companies have very little to no debt. Given these characteristics, it is easy to see why these stocks tend to have very little downside risk.
Red Flags to Avoid
Given all these positives, what could go wrong? There are 2 red flags you should keep your eye on
- Bad or fraudulent management: Often in smaller companies you may find a management team that treats the company as their own ATM. It is possible that a management team may work hard to line their own pockets from this ample value instead of sharing it with the shareholders. Other cases may not involve fraud, but simply an inept management that can erode the value over time with bad decisions all the while resisting acquisition offers or other ways of unlocking value.
- Declining Industries: Some industries may be facing a structural decline and the companies shrink over time as the new opportunities are not there. This can erode the value in the stock.
There are normally signs that will tell you if any of this is true.
How to Find and Evaluate Net-Net Stocks?
Some screeners like Stock Rover allow you to write your own equations to filter. For example, to screen for net-net stocks, a screening criteria would be
Price < Current Assets – Total Liabilities
This is easily done in Stock Rover if you are subscribed to the Premium Plus plan by using their equation writer.
If you are using a less capable screener, you can search for stocks with low P/B ratio, high Current Ratio and low debt. Once you have a list of stocks that meet this criteria, you will then need to calculate the NCAV for each of these stocks and compare it to the market price yourself.
Net-net stocks are rare in the developed markets such as US as these markets tend to be more efficient. If looking for US traded stocks, you will have more success if you screen for small-cap or micro-cap stocks, or potentially even OTC stocks. Alternatively you can look for less efficient markets such as emerging markets.
Another possibility is to look for cyclical sectors that are undergoing temporary downturns. You may find a number of stocks that have been brutally sold off and some of them may be touching the net-net threshold.
Please note that Benjamin Graham’s version calculated the net-net working capital by discounting the Accounts Receivable and the Inventory by 25% and 50% discount each. You can certainly do this to be more conservative. You may alternatively choose to discount the standard NCAV by 30% or 50% before you compare it with the market price. This adds significant margin of safety to your valuation.
Risks and Challenges of Investing in Net-Net Stocks
While net-net stocks can be highly profitable, investing in them is not simple. First of all, net-net stocks are rare and can be hard to find. This is especially true in bull markets. If you are looking for net-net stocks, you may have to turn over more stones than you normally would. The rewards of course, are worth it.
There are two more challenges I will point out:
- Lack of liquidity in the stock: These stocks are so deeply undervalued because there is very little investor interest in them and very likely no institutional following. Additionally, these may be very small companies. All this makes for very low liquidity in the stock. You cannot just place a market order and buy the stock. You will have to use different strategies to mitigate the liquidity risk.
- Management/Governance Risk: You also need to be aware of the possibility of financial statement manipulation or other management tricks to reward themselves at the expense of the shareholders. We talked about this earlier but it is worth repeating.
Keep these in mind and buy net-net stocks within the context of a diversified portfolio, and you should be fine.
Final Thoughts
I once found a stock where the company was in the process of winding down its operations. They had zero operating activity, zero debt, and zero assets, except for a significant sum of cash sitting on their books which they had accumulated as they sold off their assets and patent portfolio. They had no earnings and their expenses were minimal – just a couple of employees doing the winddown. The stock price, curiously enough, was much lower than the cash per share on the books. Perhaps the investors saw the precipitous decline in earnings and sold, not bothering to look one level deeper. Strangely, there were many articles panning the stock due to its drop in EPS – most financial media do not actually do any basic stock research.
This was as risk-free investment as you can get and it was happily resolved in a profitable manner for me.
Net-net stocks may be rare in today’s markets, but for patient, disciplined investors, they offer a pathway to outsized returns. By focusing on these deep-value opportunities, you can build a portfolio with a strong margin of safety and the potential for significant appreciation. As with any investment strategy, success comes down to thorough research, risk management, and a willingness to go against the crowd.
You know now what to do and how to find these pots of gold. Now go get them.
