Net-Net Stocks — Are they Really Free Money? — Value Stock Guide

In the lore of value investing, net-net stocks hold a special position. These are true, so-called free money stocks. To see why, consider the following hypothetical question:

Suppose there is a company that you can buy up for $100. Once you do, you can simply close up shop. You payoff everyone you owe in cash, and when all is said and done, you are left with $120 in cash plus a few odd buildings and machinery.

Will you do it?

I know I would. Ben Graham thought so as well. Ben Graham net-nets were quite common in those days. Today, these stocks are hard to find, but they do exist, and every now and then we come across a few examples. We have made some good money investing in the net-nets in the past.

Let’s dispense with the definition first.

What is Net Net?

On a very basic level, a net net is defined as a stock where the price is below the net current asset value.

You must recall that the net current asset value, or NCAV = Current Assets — Total Liabilities.

Current assets are assets that can be converted to cash in less than 12 months. These are close to the market value of these assets. Some examples include account receivables, and inventory.

If you are a conservative investor, you may want to adjust the current assets in the net net formula to discount the doubtful accounts and inventory spoilage

In fact, Ben Graham painted with broader strokes. He decided to give the NCAV a haircut of 30%-40% and insisted that the price paid for the stock be below this value. Margin of safety, as this is called, has remained the mainstay of value investing ever since.

If you run a net net screener and ask for a margin of safety of 30%-40% today, you will get very few results. But like they say, a value investor only needs to wait for a hittable pitch and swing hard when he gets it. This is a game of patience.

Net Net Screener — How to Find Net Net Stocks?

Most of the free stock screeners in the market, or even the ones offered by the brokers to their clients, are unable to calculate NCAV. As a result, you need to look for more sophisticated screeners that gives you more flexibility in defining your filter criteria. I use Stock Rover PremiumPlus screener, and it allows me to build the screening criteria by writing custom equations that are very powerful. Consider using Stock Rover, or a similarly capable screener to search for net-net stocks.

Possible Issues with Net Net Stocks

You have to keep in mind that the simple mathematical argument aside, these stocks represent companies that are still a going concern. The management may still be engaged in reversing the decline, or creating shareholder value by increasing revenue or profitability. Nevermind the fact that liquidation may be the most optimal outcome for the shareholders. Management does not get paid to liquidate and they are unlikely to take steps to fire themselves.

As a result, in a large number of net-nets, the management actually ends up in a futile attempt try to save the company, and as a result, the net current asset value declines over time. Shareholders’ hope is to find an activist investor to take control and do what management should be doing but would not do.

Other possibilities for a profitable investment exit include:

  1. The management taking the company private and paying a premium to the stock price, or,
  2. A competitor deciding that the price is too good to pass up and acquires the company

Most of the net-nets we owned in the past got acquired by competitors. American Greetings got bought out by the management. At least one company just returned money to the shareholders and closed down and we broke even on that investment. However, RELL bled value for many years until we sold and took a loss. Buying a net-net is not a ticket to guaranteed profits, but it does improve your odds of a profitable exit considerably. So don’t skimp on research just because a stock is a net-net.

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Originally published at https://valuestockguide.com on November 20, 2019.

Shailesh Kumar, MBA

Written by

Value Investor and Entrepreneur. Curious about the world. Founder of ValueStockGuide.com

Value Stock Guide

Looking for values in the global stock markets.

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