Net-net investing is a distinctive value investing strategy pioneered by renowned economist Benjamin Graham, often regarded as the father of value investing. This technique involves evaluating a company's stock based solely on its net current assets per share (NCAVPS), focusing primarily on current assets while ignoring long-term liabilities and assets.
The Concept of Net-Net Investing
The essential premise of net-net investing is to identify stocks that are trading below their net current assets, implying that the current assets of a company—cash, receivables, and liquidatable inventory—are worth more than its market price. The calculation of net-net value is based on the following formula:
Net Current Asset Value Per Share (NCAVPS) Formula
[ \text{NCAVPS} = \frac{\text{Current Assets} - (\text{Total Liabilities} + \text{Preferred Stock})}{\text{Shares Outstanding}} ]
Investors employing this strategy typically seek companies whose stock prices are no more than 67% of their NCAVPS. This threshold offers a margin of safety, which is a critical concept in value investing that helps mitigate risks.
Key Considerations
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Current Assets: Under the net-net approach, current assets encompass cash, cash equivalents, accounts receivable (adjusted for doubtful accounts), and inventory (valued at liquidation prices). These are the assets that can be converted into cash within 12 months.
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Current Liabilities: The net-net value considers only current liabilities such as accounts payable. Long-term assets and liabilities are excluded, which simplifies the analysis but also raises questions about the sustainability of the business model.
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Short-term Focus: This approach leads to a strategy that is typically more effective in the short term. Investors that identify potential net-nets often see a correction in the stock price as the market reassesses the company’s value based on its ability to generate cash from current assets.
Historical Context and Effectiveness
Benjamin Graham utilized this method during a time when financial information was scarce and the market inefficiencies allowed net-nets to be a more reliable valuation model. According to a study conducted by the State University of New York over the period of 1970 to 1983, investors who followed Graham's criteria could achieve an average return of 29.4% annually by investing in stocks that qualified as net-nets.
Graham emphasized diversification in net-net investing. He advocated for investors to hold at least 30 different stocks to spread risk.
Special Considerations
Cash Conversion and Business Viability
Graham's philosophy emphasized the liquidity of current assets as the true value proposition of a business. As businesses sell inventory and collect payments from customers, they improve their cash flow and can enhance their working capital position. The ability to efficiently convert current assets to cash underpins their valuation in the net-net approach.
Criticisms of Net-Net Investing
While the net-net strategy is lauded for its approach to undervalued stocks, it has its share of criticisms:
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Management and Operational Hurdles: Critics argue that net-net stocks may reflect underlying challenges. A poorly managed company may not effectively utilize its current assets or may face long-term declines, such as rising competition or industry disruption. For instance, the rise of e-commerce giants like Amazon has led traditional retailers into net-net territories with short-lived rebounds.
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Poor Long-term Prospects: Companies positioned as net-nets can indicate that the market has already identified potential long-term issues. Liquidation of assets is typically not the primary aim of a company, meaning management may not act to unlock value immediately.
The Difference from Double Net Lease
It's crucial to note that net-net investing should not be confused with a double net lease, a commercial rental agreement wherein the tenant is responsible for both property taxes and insurance premiums on the property, focusing on property investment rather than corporate valuation.
Conclusion
Net-net investing remains an enduring concept in the world of value investing, embodying Graham’s principles of diligent analysis and finding value where others don't see it. While beneficial for short-term gains, investors must be cautious of the inherent risks and perform thorough due diligence before engaging in this strategy. Despite its challenges, understanding net-net investing can provide valuable insights into market inefficiencies and bolster an investor's strategy toward portfolio diversification and risk management.