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
.
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.
