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Rajveer Rawlin received his MBA in finance from the Cardiff Metropolitan University, Wales, UK. He is an avid market watcher having followed capital markets in the US and India since 1993. His research interests includes areas of Capital Markets, Banking, Investment Analysis and Portfolio Management and has over 20 years of experience in the above areas covering the US and Indian Markets. He has several publications in the above areas. The views expressed here are his own and should not be construed as advice to buy or sell securities.

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Wednesday, 9 March 2016

Net-Net Stocks and Karnalyte the Cash Cow

Guest Post: By: Aaron J. Saunders OwnerValueHeadz.com

Would you rather invest in a good or bad business? I bet if you asked all of your friends and family they would reply that they of course would rather invest in a good business. When shopping for consumer products, people understand that both quality and price matter, so a very cheap but lower quality product can be just as good a purchase as a better product for a much higher price. 

For some reason this doesn’t easily translate to the world of investment. As a small investor, you can generate awesome returns by taking advantage of the fact that most investors shun low-quality businesses although they may be bargains. I would like to illustrate the potential benefits to you by comparing two investors.

The first investor is Warren Buffett as we know him today. He advocates buying good businesses which generate high returns on invested capital, have a sustainable competitive advantage and which he would be comfortable holding forever. The other investor is young Warren Buffett, who was quite the opposite, investing in poor and downtrodden businesses at bargain prices. He focused on purchasing assets as opposed to future earnings and held stocks for much shorter periods.

From 1967 to now, Berkshire Hathaway has averaged 21.6% annually vs. 9.9% of the S&P 500, a fantastic return. In the original partnership he managed from 1957 to 1967, young Warren Buffett achieved a compounded annual return of 31.6% per year vs. 9.6% of the Dow- an absolutely insane return. While they both beat the market, young Buffett beat old Buffett by 10% annually, an enormous margin when considering the effects of compounding.
      
The strategy young Buffett used is to invest in net-net stocks. These are stocks so troubled and neglected that they are irrationally and ridiculously cheap. Instead of looking at earnings, this method uses the net current asset value- a basic liquidation value which is the absolute minimum a company can be worth, according to the basic equation below:
NCAV = Current Assets – (Total Liabilities + Preferred Stock)
 You would take this NCAV and divide it by the number of outstanding shares to find the NCAV per share. Make sure the stock price is only 66% or less of the NCAV to include a nice margin of safety (P/NCAV < 0.66) and if it is, you have yourself a bargain.
      
To be clear, current assets are the company’s assets which are used in the short-term, such as cash, inventory, and receivables. This liquidation value is thus the value of these current assets which can be turned into cash quickly, less ALL liabilities and the preferred stock which is treated as debt. The NCAV is what the company would own as cash, inventory and receivables, all of which can likely be turned into cash soon after it paid all of its debts. 

This liquidation value does not even include the value of the firm’s fixed assets such as buildings, land or equipment. (If a liquidation were to actually occur, the inventory and receivables would be marked down to some extent and the fixed assets would play a role, making up for that markdown. This leaves NCAV as a very accurate measure of real liquidation value according to Benjamin Graham, Buffett’s mentor). 

Since a net-net is any firm selling for less than its NCAV, the net-net strategy is a search for stocks selling at huge discounts to intrinsic value. If a firm is selling for less than its NCAV, you are paying $1 and getting more than that value in cash, inventory, and receivables alone.
      
The empirical evidence shows that a diversified portfolio of randomly chosen net-net stocks outperforms the market in the long-run and if you want to put in a bit of effort to include qualitative factors as well (such as earnings, competitive position, business potential, etc.), you can achieve anywhere from 20-40% annually. 

Benjamin Graham, the founder of this method, apparently became bored with the stock market after he found out he could get returns of 20% annually with little to no effort by investing in a diversified list of net-nets. To see the studies which show net-nets beating the S&P 500, go here to find them in a free eBook – www.valueheadz.com
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Of course, to take on the net-net strategy, you have to accept the fact that you are investing in businesses which are struggling to such an extent that most people would rather avoid or even short the business than buy it at this fire sale price. It is up to you as the contrarian value investor to invest where others will not; that is how extraordinary returns are made.
      
To give you a taste of net-net investing, I’ll share one of my successful net-nets in 2015, why I bought it and what happened to it. Karnalyte Resources Inc. (KRN) is a Canadian subsurface minerals company listed on the Toronto Stock Exchange which owns two operations in Canada which mine for potash and magnesium.

When I was looking at it in July of 2015, their total current assets were $32.27 million, with only $2.22 in total liabilities and no preferred stock. There were 27.48 million shares outstanding, so the NCAV at the time was:
     
NCAV = (32.27-2.22)/27.48 = $1.09 per share

When I bought it on July 10, 2015 it was selling for $0.71 which was 65% of its NCAV. It was selling very cheap for a few reasons. Firstly, it was mining for potash and magnesium but not selling it whatsoever, so it had no revenues or profits- in the vast majority of cases I would never invest in a business without revenues. Secondly, in April of 2013 it had a $59 million write off on one of its projects, plunging the share price and making investors completely disillusioned with the stock:


With relatively stable current assets and $32.02 million of its $32.27 in current assets being cash, it was selling at a major discount to its net cash on hand. This stock was selling for $0.71 and if you bought it you would own $1.08 in cash- awesome. The only issue is whether the business would spend this cash and leave me with a worthless stock. 

There were a few reasons why I felt comfortable adding this stock to my portfolio. Firstly, any stock selling at a major discount to cash is paying you to buy it. Secondly, the former CEO pulled a mutiny as a large shareholder and reclaimed his title as CEO in June 2015, citing the need for action and redirection. Thirdly, they were sitting on major potash and magnesium reserves with continued financing coming from various major firms who were highly invested and interested in the prospects of Karnalyte. Lastly, it was burning cash at a relatively low rate so my investment would be safe for at least a few years.

In October 2015, the stock jumped to $1.25 per share and I was able to sell out at $1.11, a 56% return over 4 months- quite a nice profit I would say. I sold at nearly exactly the NCAV of $1.09 that I calculated 4 months prior:


For those of you who would rather have a closely held portfolio of high quality net-nets, I would discourage an investment in a firm not generating revenues as it is very difficult to know exactly what will happen. I had to stay level headed when a lot of weird events occurred during the time I held the stock- I felt okay the whole time knowing my cash ownership per share didn’t change much. If you hold a larger portfolio then you may feel safe taking the bet if a catalyst seems imminent which will help the stock price revert to its NCAV. Be safe out there everybody.

Finding the best net-nets can be very difficult and the U.S. is filled with many poor quality net-nets which can negatively impact your returns. This is why I have launched www.valueheadz.com which will offer a database of the top 300 net-net stocks worldwide along with a short list for members. 

About Aaron J. Saunders:
Owner of the Valueheadz net-net stock database and obsessive investor, 
entrepreneur and businessperson. Bachelor of Economics from Union 
College, NY and Master of Business Economics from K.U. Leuven, 
Belgium. Aaron is currently focused on exposing the wonders of net-net 
stocks to the investor-universe but is interested in a variety of 
investment strategies, including those in wonderful businesses.

1 comment:

  1. If you have any questions, feel free to ask here or email me at aaron@valueheadz.com for further clarification!

    - Aaron

    ReplyDelete

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