Source: Benjamin Graham's Net-Net Stock Strategy/ Harriman House
One of the most valuable, but least utilized, tools in investing is the investment checklist. A checklist is a list of items used to systematically approach a complex task. They have been tremendously valuable in all sorts of industries for reducing or eliminating human error. Pilots, for example, go through a pre-flight checklist to ensure an aircraft is safe and prepared for flight. Professionals such as Monish Pabrai have incorporated checklists into their investment process to make sure they don’t leave out critical pieces of information when researching a stock. Buffett and Munger are no different, though they call their checklist items filters. While it’s not possible to eliminate all human error, investors can go a long way towards reducing their mistakes and choosing better stocks by referencing a checklist during the research process. Background to a solid scorecard Temperament – Some investors feel more comfortable owning a lot of positions that are cheap and safe as judged by statistical measures, such as a very low price to NCAV, a small debt to equity figure, and solid balance sheet liquidity. Others will only feel secure if they own net-net investments that have a strong ‘story’. This necessitates more qualitative analysis and a more concentrated portfolio as a result. Investment skill – Newer investors lack the skill and experience needed to identify stronger investment candidates on qualitative grounds, so are better off sticking to a diversified portfolio selected on quantitative grounds. By contrast, some investors will have extensive stock picking skill and investment experience. These investors can leverage this skill and experience by identifying great prospects and concentrating on the better qualitative situations. Philosophy – Some investors feel that investments should only be selected by use of quantitative data. Jim Simons of Renaissance Technologies may fall into this camp. Other investors, such as Charlie Munger, feel that investments should be selected only if they also possess a very strong qualitative profile. Clearly money can be made with either approach and far be it for me to try to dissuade anyone from their natural leanings. My own approach is to select investments which satisfy both a strong quantitative and qualitative showing. Scorecard: Core Criteria Suitable average daily volume Investments that can’t be purchased have no utility, so investors should first assess whether a stock has enough volume to put together a decently sized position. Net-net firms are usually tiny businesses, which means their stock usually trades infrequently. This thin volume allows small investors to use the strategy but keeps larger investors out. Sometimes a stock trades so infrequently that even retail investors managing just a few thousand dollars have trouble buying. For that reason, volume assessment is a must. When assessing volume, we’re specifically after average daily dollar volume. Average daily dollar volume is the dollar amount of stock traded on average each day over the recent past. Note that this is different from average daily volume, which only looks at the number of shares traded on average per day, without calculating the value of stock being traded. To find the average daily dollar volume, simply multiply the average daily volume by the stock price. Minimum standards have to be set by investors’ portfolio size, and the size of the position they want to buy. Someone investing $100,000, for example, will have to look for much higher average daily dollar volume minimums than would someone investing $10,000. Because of this, all investors must arrive at a suitable standard for themselves. The $100,000 investor, if buying 20 equally sized positions, would benefit from an average daily dollar volume of at least $1,000. This would help ensure that the investor could build a full position over a reasonable length of time. The $10,000 investor could get away with a much lower average daily dollar volume, while an investor managing $1 million should look for a minimum of perhaps $10,000. Price to NCAV below 100% The defining characteristic of net-net investing is buying stocks below their NCAV, which Graham regarded as a rough real-world assessment of their liquidation value. While purists would scoff at buying net-nets without a sufficient one-third discount to NCAV, studies show that net-nets which trade at, or just over, NCAV can still work out beautifully. To balance Graham’s philosophy with academic findings, we simply limit the pool of candidates to those trading below NCAV. Part of the reason why net-nets without a minimum one-third discount work out so well may be due to the put-like nature of net-net investing. An ultra-conservative assessment of liquidation value acts as a rock-bottom minimum valuation when assessing failed businesses. But many firms will ultimately recover and a few will actually thrive. Those that do will be revalued based on a multiple of earnings, book value, and so on, providing enormous returns. This pattern is likely responsible for the excellent returns of more expensive net-nets. Demanding a more lenient discount has two major benefits. First, investors maintain a larger pool of stocks when the market is trading at higher valuations. This allows them to maintain a portfolio full of high-performance net-nets. Second, this tactic allows investors to pick the few exceptional buys that may not be trading at a minimum one-third discount. Some exceptional buys, such as growth stocks trading below NCAV, stocks with solid near-term catalysts, or firms with executives vacuuming up shares, can provide exceptional returns even if not trading with a minimum discount. When it comes to investing real money, there’s little value in hanging on to dogmatic beliefs. Market capitalization below $100 million While studies have shown that net-nets trading at or just above NCAV can still work out very well, the same is not true of larger firms trading below NCAV. In fact, studies that assess the relationship between net-net firm size and return show a significant negative correlation between the two. The larger the firm trading below NCAV, the lower the return. While there is no clear demarcation line, most net-net firms have market caps below $100 million. Returns drop gradually as market capitalizations tick upwards, so it’s unwise to buy larger net-net firms. Setting the cut-off here allows us to maintain a large pool of candidates while screening out a smaller number of statistically terrible buys. Market capitalization above $1 million Despite the negative correlation between firm size and stock returns, as market capitalizations drop, management quality becomes more questionable. Publicly traded companies with market capitalizations below $1 million are not likely to have the financial resources to attract reasonably competent managers and are therefore best avoided. It’s curious why these firms are publicly listed in the first place. Maintaining a listing can cost over $100,000, making it prohibitively expensive for them to maintain a public listing. Small, successful, private businesses will seldom seek a public listing, opting for a private sale if an owner wants to monetize his investment. While it’s true that some formerly profitable firms will stumble below NCAV and drop to a market cap of $1 million or less, it’s often also the case that a firm went public as a shaky start-up, and subsequently failed to grow. Firms with market capitalization below $1 million are probably best avoided by amateur investors unless they have a keen understanding of business and can assess management skill and integrity. Not a prohibited classification Exceptional buys can be found in all industries, but some investments make for particularly poor net-nets. When assessing net-net candidates, we want to avoid financial, regulated, real estate, resource exploration, early stage bio, and early stage pharmaceutical firms, as well as closed funds and ADRs. These categories are excluded in many academic studies, and therefore don’t have the same academic backing as other net-net firms. Each classification listed here poses unique problems that inhibit an investor’s ability to profit while running a net-net stock strategy. For example, financial firms require specialists to assess, since the range and nature of financial products have changed significantly over the last 50 years. Regulated firms, on the other hand, can face barriers to third-party takeovers and actions that could improve the business. Real estate firms, resource exploration firms, as well as early stage bio and pharma companies often rapidly destroy NCAV. Real estate firms in particular can see debt ratios balloon and cash evaporate when projects are started, while resource exploration, early stage bio, and early stage pharmaceutical firms spend cash trying to obtain a viable economic asset. Many fail, completely eroding shareholder value, and then come back to shareholders for more money. Firms operating in these industries perform very poorly in its proprietary back tests. No significant Chinese operations China is a rich and vibrant country with an enormous depth of culture and an incredibly interesting history. Its people are intelligent and seem poised to lead the world both politically and economically. But while tourists can gain a lot by venturing east, investors should stay clear of Chinese stocks. The short-selling firm Muddy Waters Research, headed by Carson Block, brought issues with Chinese reverse merger firms to public attention in the early 2010s. Since then, the firm has made a solid living shorting Western-listed Chinese firms that the firm thought were frauds. Muddy Waters cites the Chinese proverb “Muddy waters makes it easy to catch fish” to explain the attitude of some unscrupulous Chinese businessmen. According to the team, some Chinese firms take advantage of investors ignorant of Chinese culture, language, and business practices by publishing fraudulent financial statements. These financial reports grossly inflate asset values and reported earnings. Rather than act as a watchdog, Western auditors and regulators have largely abdicated their responsibility, leaving short sellers like Muddy Waters to uncover the scams. Unfortunately, many of these companies trade well below their claimed net asset values. Lured by a seemingly solid balance sheet, solid record of growth, and a dirt cheap valuation, many uninformed net-net investors scoop up shares only to lose most of their principal investment. There are serious bargains on offer in Chinese public companies, but small investors do not have the skill and experience to avoid the frauds. For that reason, avoiding listed Chinese firms is a must. Not selling shares Firms that sell shares below NCAV provide terrible investment returns, as a group. The reason is obvious: either management disregards shareholder value, or the firm’s very survival is in question. Nothing is worse than a management team that disregards shareholder value so much that they give away the firm at a price below liquidation value. As Graham said nearly 100 years ago, if a firm trades below liquidation value, management should liquidate the company or work to correct the issue. Because the voluntary sale of shares below liquidation value destroys shareholder value, it is likely to be a breach of fiduciary duty. In situations where the firm lacks liquidity to meet near-term obligations, share sales may be the last resort. In these cases, management may suspect that the liquid assets they have on hand are not of sufficient quality to cover near-term liabilities, so they will attempt to raise cash through a share sale. In other cases, management may feel that the firm’s business issues are serious enough to warrant raising capital while they can to survive the coming storm. Whatever the case, selling shares below NCAV is a clear red flag, and investors should act accordingly. Firms that trade below NCAV and have sold shares have performed particularly badly. Current ratio above 1.5× Current ratios assess a company’s ability to meet its short-term obligations. They’re measured by dividing a company’s current assets by its current liabilities. Distressed firms should have ample current assets to cover any liability that has to be paid over the near term. Failing to meet these obligations could lead to a range of sanctions, from suppliers refusing to sell to the company to the firm filing for bankruptcy. While current ratios can be neatly stated as a mathematical formula, their composition and implication is messier. Strong firms such as Wal-Mart often have current ratios below 1×, as they’re able to demand favorable payment terms from suppliers. But distressed firms with current ratios near 1× are typically in serious trouble, since they lack the earnings or cash flow needed to cover near-term obligations. While net-net investors should favor large current ratios, setting a limit is necessarily arbitrary. Graham’s opinion regarding a specific standard shifted markedly over the course of his career. In mid-career, he explained that hurdles differ based on industry and investor taste, but he offered no clear means of determining an ideal minimum.204 Towards the end of his life, he favored the simple rule that a company should own twice what it owes. My hurdle rate is more lenient. When assessing net-nets, we want to focus on companies that have current assets at least 1.5× their current liabilities. This provides investors with a one-third margin of safety, as current assets can shrink by one-third before the company runs into problems. Luckily, few companies fail this standard in practice. Reasonable burn rate Burn rate refers to the rate of shrink in NCAV between two reporting periods. If the firm reported a NCAV of 100 in the previous quarter, and a NCAV of 90 in the most recent quarter, it has a −10% quarter-over-quarter burn rate. From a qualitative point of view, it makes sense to demand a stable NCAV. All value investors base their investment decision on referencing some source of value, whether earnings, cash flow, or a firm’s private market value. Net-net investors reference NCAV, and a discount below this value provides the investor with both safety of principle and profit potential. When a firm’s NCAV shrinks, so does an investor’s margin of safety and profit potential. In core criteria, we demand that firms have not shed NCAV by more than −25% over the most recent quarter or most recent 12 months. Debt to equity below 50% By definition, net-net stocks require a strong balance sheet due to their excess of current assets over total liabilities. In theory, this excess liquidity renders the firm safe as an investment. But real-world asset values can differ remarkably from their stated balance-sheet figures. If receivables prove uncollectible, or inventory unsaleable, the firm may not have enough cash to fund near-term debt obligations or cover interest payments. Net-net firms are also clear takeover targets, and takeovers are often funded with debt. But if a target company already has a large debt burden, a potential acquirer may not be able to use the debt to fund the purchase. This ultimately reduces the likelihood of a takeover. To add to the mess, since interest rates were at near-historic lows in 2019, many firms carried debt they could not afford under normal economic conditions. This suggests the presence of many publicly traded zombie firms: undead firms that will bite the dust as interest rates rise. What could be worse than owning a money-losing firm with eroding sales and a large debt load during a period of rising interest rates? No NYSE NYSE net-nets have been associated with some of the lowest returns on offer in the net-net universe. Identifying the best net-nets, then, requires us to pass on any company that has a NYSE listing. American net-net investors may be dismayed by this rule. Given the poor performance that NYSE net-nets have shown, though, we’ve elected to designate this a core, rather than a ranking, criterion. Quantitative ranking criteria While all firms must meet every check in the core criteria, ranking criteria is optional. The first set of ranking criteria, quantitative ranking criteria, focuses on factors that provide a statistical boost in returns. The more of these criteria a stock meets, the better it is as a statistical bet. Investors who aim to select the best performing net-nets on a statistical basis should focus on firms that meet as many of these criteria as possible. Share buy-backs One of the best ways for net-net investors to boost returns is by selecting firms that are buying back shares. Share buy-backs are beneficial for two reasons. First, buy-backs communicate management’s belief that the firm is financially healthy and its problem temporary. Management teams that fear for the survival of their company will not waste cash on buy-backs if they feel that the firm may require significant funds to stay in business. They’re also less likely to buy back shares if they assume that the firm’s problems will be drawn out. If management spends cash on buy-backs when the business faces a drawn-out business problem, less cash will be on hand to maintain operations. Money spent on buy-backs therefore represents money that management feel they can spend without jeopardizing the survival of the firm. Buy-backs are also beneficial because they increase per-share value by increasing the ownership percentage that each share represents. When shares are undervalued, management may use company funds to repurchase shares in order to reward remaining shareholders. When management buy back shares while they trade below NCAV, they significantly boost shareholder value. We’re specifically looking for companies that spend a material amount on share repurchases, since the more money spent on buy-backs, the more the remaining shareholders benefit. No dividends As highlighted in the discussion of net-net stock studies, dividends have a powerfully negative effect on net-net stock returns. Net-nets that pay a dividend provide much lower average yearly returns than their non-dividend-paying peers. It only makes sense, then, to avoid dividend payers if we’re aiming to buy the highest returning net-net stocks possible. If dividends pull down returns so much, why not move this requirement to core criteria? We prefer to keep this criterion optional simply because some investors prefer to receive dividends to fund everyday expenses. Income investors should be aware of the trade-off they make in order to receive dividends. Insider buys Insider buying is a powerful indicator. The term insider usually refers to a member of a firm’s upper management team or board of directors. Insiders often have the best understanding about their firm and are in the best position to render judgement on the firm’s prospects. Insiders almost always buy shares to profit through capital gains. When insiders buy, they communicate a strong conviction that the company’s stock is a solid investment. Given their detailed understanding of the firm’s operations, financial health, and prospects, insider buying is a much stronger vote of confidence than anything Wall Street can produce. The more cash spent on share purchases, and the more insiders who are buying, the better the company looks as an investment. Market capitalization below $50 Million In the core criteria, we demand a market capitalization below $100 million, claiming that larger net-net firms are poor investment candidates. When setting the limit, we need to strike a balance between statistical returns and stock availability. To help identify the best picks, however, our ranking criterion demands a much tougher standard: a market cap below $50 million. Smaller firms perform much better as a group, so focusing on them makes sense. Imposing a $50 million cut-off ensures that the stocks we select are tiny and are therefore grouped among some of the highest-returning net-nets available. Debt to equity below 20% Debt is a problem for troubled firms in a rising interest rate environment, as discussed in core criteria. Not only does debt reduce a company’s attractiveness as an acquisition target but failure to meet debt requirements could push the firm into bankruptcy protection. And as interest rates rise, so do interest payments, making the firm’s debt load more of a burden. Tweedy, Browne’s study revealed the performance boost that a debt-free balance sheet provides. Net-nets with debt to equity ratios below 20% see a significant increase, on average. Focusing on the best net-nets from a statistical point of view means avoiding firms with a meaningful amount of debt. Trading at less than 50% of NCAV Net-net studies over the last 40 years highlight a relationship between a portfolio’s discount to NCAV and average returns. The deeper the discount, the larger the return. As discussed, the relationship is not as strong as true-blue value investors would like it to be, which is why we demanded a smaller hurdle in core criteria. Still, focusing on the best performing net-nets means investing in firms that have deeper discounts, ideally as deep as possible. We demand a much stricter standard in ranking criteria than we did in core criteria. Rather than simply trading below NCAV, we want to see a discount of 50% or greater. Qualitative ranking criteria Investors who want to focus on strong quantitative criteria now have the tools needed to make smart investment decisions. By focusing on a group of net-nets that meet both the core and quantitative ranking criteria, investors can put together a strong portfolio which should provide great market-beating returns over the long run. But not all investors are satisfied with maintaining a quantitative stance. Without looking deeper into a firm’s situation, some investors feel a lack of safety and control. This makes it tougher to start quantitative investing in the first place or stick to it over the long term. Math, in terms of historic performance and statistical expectations, does little to comfort an investor when a strategy fails to perform over a period of time. To address these problems, almost all investors employ qualitative checks. But adopting a qualitative assessment doesn’t just make investing easier from an emotional point of view; qualitative investing can boost returns when done well. This means identifying solid qualitative criteria, and maintaining strict standards when assessing a firm. The qualitative ranking criteria pulls together some of the factors I consider particularly fruitful when applying qualitative checks. While there is a nearly infinite number of factors that an investor could use when assessing a firm’s qualitative situation, I’ve focused on the few that seem to have the biggest impact on my own investing. Rather than develop this set of criteria from scratch, I lifted all of it from the writings of outstanding investors such as Buffett, Graham, Seth Klarman, and Peter Lynch. It makes sense to adopt the criteria espoused by gifted investors when those criteria are relevant to net-nets. Catalyst When selecting net-nets, one of my favourite criteria is a solid catalyst. The term catalyst refers to a probable event on the horizon that would likely lift a company’s stock price. Situations in which management shop around for a buyer for the company, a grossly unfavourable contract will soon end, or a commodity price rises rapidly are all catalysts and would likely have a positive impact on a firm’s stock price. When a net-net firm is put up for sale, transactions typically take place at or near NCAV, which has a direct impact on the stock price. The elimination of an unfair contract can have a positive impact on the firm’s bottom line, which can boost the stock price. Similarly, if a firm’s business benefits from a rise (or a fall) in a specific commodity price, a large move in that commodity’s price will impact the firm’s profitability, moving the stock price. Catalysts are only probable events, never certain. There is always doubt as to what the future holds, so it’s never wise to expect a future event with 100% certainty. Instead, we’re simply looking for events that are likely to happen and would probably have a big impact on the firm’s stock price. The more certain the event is and the larger the impact it would have on the firm’s stock price, however, the better. High-quality growth While growth is a catalyst, it’s so important that it deserves to be separated as a specific criterion. As Buffett pointed out, growth is a source of value. Investors lucky enough to find a sub-liquidation value firm that’s growing its earnings, revenue, equity, or NCAV may have stumbled onto a truly exceptional buy. Growth in NCAV increases a net-net investor’s profit potential and margin of safety. Even if growth slows or stops after an investor purchases the stock, the investor will still benefit from any increased NCAV gained after purchase. High-quality earnings growth is more lucrative than a mere bump up in price to reflect full NCAV. Continued profit growth can cause investors to shift from seeing the firm as a mere net-net to seeing it as a growth company. Investors smart enough to buy early and hang on as the scenario unfolds stumble onto a Shelby Davis double play. As earnings growth continues, investors revalue the stock to reflect a market multiple of earnings and increase the multiple they’re willing to pay. This results in fantastically large stock price appreciation. But smart investors also demand an equally rapid increase in free cash flow to help management fund operations, and they avoid firms with weak customer credit standards. Sometimes growth in revenue and shrinking losses highlight an exceptional buy. As revenue increases, the firm finds it easier to cover fixed costs, which eventually leads to rapidly growing profits. Firms that shift from net-net to growth stock are as rare as they are profitable. More often than not a firm will seem attractive from a growth perspective only to see that growth fizzle out. Especially attractive to small investors are cyclical stocks that seem to have rapidly growing earnings and a low PE ratio. But rather than benefiting from this positive trend, investors can be left with heavy losses as the cycle begins its downturn. Low PE Joel Greenblatt highlighted the benefits of low PE ratios applied to net-net investing in his 1980s study. My own back tests, however, failed to replicate Greenblatt’s findings. To complicate matters, a low PE ratio does not necessarily signify a cheap market value. Earnings can be inflated for a number of reasons. One-time gains on asset sales, for example, can artificially inflate earnings and make an otherwise expensive firm appear cheap. But investors who can get past the noise to identify firms with high-quality earnings, and a low PE can really benefit. If growth picks up, or ongoing profits seem likely, investors may revalue the net-net on an earnings basis, leading to a significant boost in stock price. Significant past earnings In mid-career, Graham favored net-net firms that had significant past earnings. The more the company made, the better. The utility of this check is in assessing whether a profitable company has simply stumbled and may regain its footing. In other cases, the firm’s industry may turn the corner, allowing it to earn large profits yet again. When assessing net-nets based on this criterion, investors should look for firms that were significantly profitable in the recent past, ideally no more than ten years prior. The larger these profits were, relative to the company’s current size, the better. Investors should also prefer firms that have retained their ability to produce this level of profit. Companies that sold the divisions responsible for that profit, or profited on the back of a fad, such as a hit toy (Cabbage Patch dolls, Beanie Babies, Pogs, etc.), should be immediately suspect. While investors cannot profit from past earnings, the past record may provide a hint at what’s in store for the business. Past price above NCAV Value investors are rightfully skeptical of the impact past prices have on their ability to profit in the future. The main tenet of value investing, after all, is that stock prices tend to come back to fair value eventually. Past stock price behavior seems to have little to do with value investing. Rather than try to predict the future from past price behavior, my criterion mainly aims to sidestep a common net-net pitfall. Not all managers act as trustworthy stewards of shareholder value. Firms with lackluster or disinterested management typically trade at depressed prices as investors expect the situation to drag on indefinitely. While a newly minted net-net may slip into this pattern, a chronically depressed stock is strong evidence that management either do not care or do not have the skill needed to right the situation. But the historic record can also help pinpoint stocks with large, fast swings in price. Some issues contain more speculative enthusiasm (investor sentiment that shifts rapidly) than others. This rapid shift in enthusiasm can help investors unload shares bought well below fair value as the stock price surges. A speculative shift isn’t the only reason for rapid price advancements, however. Investors can also benefit from a speculative capital structure or tiny public float. Companies that have, for example, a large issue of preferred shares relative to their common stock may see extreme and rapid movements in their common stock price. Similarly, a small number of investors rushing to buy stock in a company that is mostly held by insiders or institutions can rapidly boost the stock price, allowing a deep value investor to exit with a large profit. Insider ownership Insider ownership refers to share ownership by management or directors. Rather than assess a holding size relative to the size of the company or number of shares outstanding, look for an ownership amount that would be meaningful on a personal level. Much is made of insiders having majority control of a company. While this certainly plays a role in the success of an investment, less has been said about the personal stake that management have in the company’s future. When assessing insider ownership, I look for a dollar amount that would provide insiders with a meaningful personal stake in the success or failure of the business. If business failure would have a powerfully negative impact on the insider’s net worth, that insider will work harder to avoid disaster. Likewise, if an increase in market value for the firm has a large impact on the insider’s personal fortune, that insider will be more likely to take the steps needed to improve the performance of the company. But while a material personal stake acts like a motivating factor, insiders with majority ownership may take advantage of their position to benefit family members or treat the company as their own personal piggy bank. Majority control also prevents activist investors from pressuring managers to make needed changes and steer the company in a more promising direction. Insider ownership is likely more effective when insiders own large personal stakes but do not have a majority control of the company. Reasonable insider pay Management and directors of net-net firms often don’t deserve even average salaries, typically having led the firm into catastrophe in the first place. But the focus here is on identifying insiders who draw unusually large salaries. Sometimes management and directors will have a firm grip on the company, resulting in uncomfortably large salaries. This is a clear case of insiders taking advantage of their position to profit. The practice amounts to hovering up shareholder value and shows a clear disregard for shareholders’ welfare. In these situations, management may not be interested in improving the business so long as they can maintain their large salaries. Contrast this to the board of Si2i, Ltd. operating in Singapore. When shareholders voiced dissatisfaction with their company’s languishing stock price, directors vowed to receive a salary of $1 per year until the firm regained profitability. Actions like these communicate a clear signal: insiders have genuine concern for shareholder welfare, have taken responsibility for company performance, and will work feverishly to right the business. Minority shareholders essentially elect to partner with insiders, retaining ownership but allowing these professional managers to run the company. Typical retail investors have little to no say in how a company is managed, but can spot shady practices before buying shares. If top management are busy raiding the store, they’re not likely to care about shareholder value.