Want High Net Net Stock Returns? Leave Your Emotions at the Door


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Guest Post

written by

Evan Bleker

I have a secret.

Whenever I invest in a net net stock I feel a little pang of anxiety. It doesn’t matter how optimistic I am about the investment, I still feel a little bit queasy when I look at the business.

This is what I call an investor’s gag reflex.

Plug Your Nose and Buy

Buying a net net stock can be scary. A lot of people new to these stocks feel uncomfortable buying and holding companies that are facing large problems, or have poor future prospects.

To add to the discomfort, in nearly all cases, these companies have just had a cataclysmic drop in price and it’s unclear when the price will quit dropping.

Most of the net net stock investors that I frequently talk to, and the most skilled value investors in the industry, have learned to control their gag reflex so they can invest in the most promising value stocks.

Being able to make cool rational decisions is a learned temperament that investors seeking to beat the market by a wide margin over the long term have to hone.

Still, investing in net net stocks for the first time can be scary, and holding a net net stock to maturity can be a roller-coaster of emotions. To smooth the transition I thought I’d give you a window into what owning one of these stocks is like.

Those of you who have signed up to receive free net net stock ideas each month will be well aware of my recent sale of InfoSonics (NASDAQ: IFON), a company that I’ve now held from extreme undervaluation to substantial profit twice.

InfoSonics originally made my shortlist of promising deep value investment opportunities back in 2011. I didn’t have much hope that the company would become a profitable growing business each time I purchased the stock.

Aside from some cost cutting, the only reasons I found to hold the stock was that it was extremely cheap and ranked well on my NCAV stock scorecard.

I ended up purchasing the stock in 2011 and holding on for just over a year. Let’s take a look:

IFON First Buy 2011

IFON First Buy 2011 | Click to Enlarge

Check the Story When Fear and Doubt Set In

This chart should give readers a good idea of what holding on to a net net stock can be like.

I have heard somewhere that the average stock moves 50%, from top tick to bottom tick, in any given year.

I’m not sure how true that is, but it can be emotionally trying to hold these stocks without much in the way of news or information to justify their leaps and drops.

In the above case, when I saw the stock price slowly erode for 7 months from my initial purchase I was constantly questioning the company’s suitability as a net net stock investment.

Without much negative news, the firm’s promise as an investment hadn’t seemed to have diminished but I was constantly calling my own judgments into question.

That can be a good thing since it forces you to revisit your analysis, but investors with a weaker emotional temperament or a less secure grounding in Benjamin Graham’s value investment philosophy would feel a far stronger pull to sell.

If nothing has changed in the story and the company still fits your original well thought-out checklist then averaging down can be extremely rewarding.

The price performance of InfoSonics had a similar pattern when I held it the second time from January to December 2013:

IFON Second Buy 2013

IFON Second Buy 2013 | Click to Enlarge

Patience is Needed… a Promising Outlook Is Not

The thing about buying net net stocks is that there’s little positive reasons to own them.

Sure, there’s the great track record of NCAV stocks in general and the conservative balance sheets that most NCAV stocks have, but there’s often little on the horizon to look forward to.

Much of the time these firms are in the midst of trying to solve massive business problems. Many are turnaround companies in the truest sense of the word and it’s unclear whether management will be successful in turning the business around or not.

Not that it matters.

The great thing about net net stocks is that the price of the company is so depressed in the market, and there is so much negative sentiment built into the stock price, that any change in the overwhelmingly negative perception of investors can send the stock surging.

This is what I like to call the Dead Cat Bounce.

While a great story can boost your net net stock returns, you don’t need one for it to lead to fantastic investment profits.

But price corrections don’t happen overnight. In the two periods in which I held InfoSonics it took just over a year for the market price to rise to reflect NCAV.

When I bought shares in the company again the second time it took just under a year. I consider this timeframe fairly short but a net net stock should surge in price within 3 years.

For Paulson Capital Corp., a tiny investment/brokerage firm that Google Finance mistakenly seems to think is owned by famed investor John Paulson, the eventual pop in price took over 28 months:

PLCC-Buy-2011

PLCC-Buy-2011 | Click to Enlarge

Fear and Doubt Lead Me to Revisit Paulson Capital Corp.

I originally bought Paulson Capital Corp. because they seemed to be grossly undervalued on a net current asset value basis. I was right — but I didn’t spend enough time originally reflecting on the fact that the firm was a financial company.

All investors should constantly strive to improve and this is a mistake I’ve corrected in my selection process.

When I revisited my thesis near the end of 2011, I decided to be cautious.

I wasn’t exactly sure what further risks the firm faced, essentially being an investment bank, but I spent a considerable amount of time looking at the short term assets of the company.

After rechecking the firm’s fundamentals, I judged that, while not perfectly safe, there didn’t seem to be a substantial risk in holding the firm.

Put another way, I couldn’t see a reason to either buy or sell the stock after it had fallen in price so I decided to hold on to the firm until its share price reached its NCAV per share value or time (my 3 year holding cap) forced me to sell.

One thing that soon boosted my confidence in the investment was the large cash position the firm gained from selling its retail division.

While I wasn’t sure just how much the company received for the division, the size of the retail operations in relation to the firm’s total sales suggested that it was a lot.

At any rate, seeing as most takeovers occur at a price reflecting a company’s NCAV or more, I bet that the purchase price exceeded the division’s share of net current assets.

Keep a Fundamental, By-The-Numbers, Perspective and Wait

Net net stocks aren’t riskier than the average stock.

They just look ugly.

Most companies are facing huge business problems, have a questionable future, and are at the tail end of a massive drop in market price.

Investors who look past the negative points to actual business fundamentals and keeping in mind the great track record net net stocks have shown, can see surprisingly good investment results.

As Benjamin Graham wrote in the Intelligent Investor;

It always seemed, and still seems, ridiculously simple to say that if one can acquire a diversified group of stocks at a price less than the applicable net current assets alone…the results should be quite satisfactory.

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5 responses to “Want High Net Net Stock Returns? Leave Your Emotions at the Door”

  1. Viet Nguyen says:

    Great insight on owning a net-net. But my question is: how much research are you doing on it? Are you still pouring through 10-K’s and looking at competitive “moats”? Something that could end up being a buying opportunity? debt? other fundamentals? Its hard for me to turn off all those things and simply look at just price.

    The question is, then: what is the difference between a deep value net-net and a penny stock?

  2. No, definitely not.

    Companies that have been hammered down like this don’t have moats, almost by definition. They have very troubled business operations or problems that need addressing. By investing in these I’m betting that the situation will improve, the company will liquidate, or there will be a buyout. One of these three usually seems to happen within 3 years.

    I typically drill down into the 10ks and 10qs but how much research you want to do will depend on how you want to use the strategy. It is very possible to just take a mechanical approach and do well.

    http://www.netnethunter.com/the-bucket-approach-to-net-net-stock-investing/

    Price is just one of the factors that go into the selection process. It’s very unwise to select stocks on price alone. I’ve written a lot about how I assess net net stocks and this is a really good overview:

    http://www.netnethunter.com/my-ncav-investment-scorecard/

    Penny stock is a derogatory name for a.stock selling below $1. Really, it’s pretty meaningless. Any of these companies could just do a reverse split and have shares trading at $100 each.

    Small companies are supposedly more prone to manipulation and scams. That might be true but I haven’t had much in the way of problems and John Templeton, claimed by some to be the best international value investor who ever lived, famously bought buckets of penny stocks.

    What differs a penny stock from a net net is just that the net net meets the statistical definition of a net net: (current assets less all liabilities and preferred shares) > market cap.

    I understand where you’re coming from writing the comment. I was there, as well, a few years back. What convinced me was Graham’s comments in the Intelligent Investor, Security Analysis, but most of all reading through all the academic studies about net net stocks. Despite how bad these firms look, they definitely do very well as a group.

    Thanks a lot for the compliment on the article. Let me know if you have any other questions.

    Evan

  3. Hi Viet,

    No moats here. Net net stocks don’t become net nets if they have moats.

    I typically read back 3 or 4 years to get a sense of the business and the business problems its facing. I don’t know how much that helps, to be honest. These companies are terrible and there’s often little positive to justify a purchase — yet they work out very well as a group.

    I have a bunch of criteria I use to assess whether the stock is worth a purchase or not. I wrote out most of them here:

    http://www.netnethunter.com/my-ncav-investment-scorecard/

    A “Penny Stock” is a pejorative name for a stock trading below $1. A net net stock is a stock that fits a certain statistical criteria: (current assets less all liabilities & preferred shares) > market cap. It may or may not be trading below $1.

    Cheers,
    Evan

  4. Viet Nguyen says:

    Thanks again for the insight. But it seems too “easy;” that is to say that all you’d need to do is pull up a couple balance sheets, throw them into a spreadsheet, then buy if its x% of bookvalue, right?

    I’m just trying to wrap my ahead around the exact scope of research we’re supposed to do. I’m assuming we’d still have to pour through the 10-K’s and do the whole “circle of competence” thing, too.

    I know that there’s no “moat” per se, but there’s gotta be some sort of “diamond in the rough” quality to it. Like for example, I bought a small position of Sprint when it was around 2.50 a share. Not exactly a net-net, but Sprint also owned a lot of spectrum, so I figure if nothing else it would be a buy-out target for a bigger telecom. And after 2 years, voila, it became a multi bagger for me when it got bought out by Softbank.

    But what if it just happens to be a crap company, for example a dying restaurant. i’m assuming the risk here is that the business takes on a bunch of debt, becomes insolvent and goes bankrupt.

    I’m assuming the downside risk is minimal, but still, don’t these companies have a habit of going bankrupt or whatnot?

    I’m definitely intrigued, as the large caps are *more* efficiently priced. But I do believe that the small caps and/or the net-nets are largely ignored by the market and you can find some value in the net-nets. Maybe I’lll test out my skills and make a portfolio called “ben graham” and buy a “bucket” of net-nets and I’ll have to see how it goes.

  5. Hi Viet,

    No problem.

    You’re right, I don’t think it’s quite as easy as you described. That being said, I think that fundamental research only helps up until a point.

    The bare minimum that you should be doing is looking through the 10Qs to make sure the company is actually a net net and not just a net net on the screener (screeners have errors and there are off balance sheet items that can lead to nixing the stock). If you put together a portfolio of these kinds of companies — companies that match the statistical definition — then you should do alright. Graham thought so, anyways. It would also require a fair amount of diversification.

    You can definitely add value by doing a marginal amount of research. This is basically what I do — I try to screen based on the criteria I wrote in the above link. Basically, I’m looking for subsets of NCAV stocks that outperform the population of NCAV stocks as a whole.

    I don’t think deep analytical research is always worthwhile because of how these firms tend to workout, though. The question you have to ask is — how likely is it that my analysis will be right often enough to provide returns over and above what could be achieved by just applying additional statistical factors that have shown to outperform? I think deep fundamental analysis by the average retail investor rarely adds value so I put my money on increasing the probabilities of payoff — basically, just what I wrote about in the link above.

    I haven’t had any of mine go bankrupt but one has sunk 75%. That’s fine by me, the rest more than made up for that stock. I think the fear of bankruptcy is over-rated. Even if the bankruptcy rate was double what it is for the average publicly traded company the capital gains front he winners are more than enough to make up for any losses you would suffer. If that wasn’t the case then the population returns would be shown to be much different.

    If you put a basket together, keep in mind:

    1. These stocks work out very well as a group over a decently long period of time. That means,

    2. like any strategy there will be periods of underperformance, so

    3. you would have to judge results in, ideally, a 3 year stretch or more.

    http://www.netnethunter.com/to-beat-the-market-you-have-to-underperform/

    A better idea would be to look at academic studies that dive into net net stock portfolios. That’s what I did before I started and what eventually sold me on the strategy.

    Cheers,
    Evan

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