What is the net-net strategy?
How do you decide what a company’s liquidation value is? According to Benjamin Graham, a reasonable estimation would be the net current asset value (NCAV), which is calculated as current assets minus total liabilities. The NCAV formula only assigns value to current assets such as cash and marketable securities, whilst non-current/fixed assets are ignored in their entirety. Since non-current assets are likely to have some value too, the NCAV formula is extremely conservative in its appraisal of liquidation value. That’s interesting, but why is the NCAV of concern to investors, who are not liquidators? Graham, who was the first to suggest that a company’s market value was distinct from its intrinsic value (its actual worth), devised a stock-picking strategy based on the NCAV formula – he purchased companies that were trading at no more than 2/3 of their NCAV.
“To Graham, who had been brought close to ruin in the 1929 stock market crash, the best estimate of intrinsic value was the most conservative one, and the most conservative estimate of intrinsic value was liquidation value. It was also the easiest to calculate, requiring little analysis beyond the application of a simple, quantitative rule.”Tobias Carlisle, Deep Value
Assuming that the NCAV represented liquidation value accurately, the 2/3 rule meant that Graham bought companies at a sizeable discount to what had to be their minimal intrinsic (actual) value. Therefore, stocks that met this criterion provided a wide margin of safety – the downside of the investment was limited relative to the potential upside. The margin of safety concept is axiomatic to value investing, and it suggests that a high reward can be had with low risk. This dual principle defies traditional finance theory where high risk equals high reward and vice-versa. The net-net strategy may be the ultimate example of traditional value investing, as a dollar (the NCAV/liquidation value) can truly be purchased for less than 67 cents (by means of the 2/3 rule). Why are stocks which fit Graham’s criterion called net-nets? I think of it this way: the NCAV represents current assets net of current liabilities, and net of non-current liabilities (there are two ‘nettings‘/subtractions).
Of course, companies that are worth more dead than alive are in serious trouble. Graham admitted that the “objection to buying these issues lies in the probability, or at least the possibility, that earnings will decline or losses continue, and that the resources will be dissipated and the intrinsic value ultimately become less than the price paid” (Graham & Dodd, Security Analysis). However, he also argued that while such outcomes may manifest in individual cases, generally, positive developments occurred, such as:
- The creation of an earning power commensurate with the company’s assets. This may result from: a) general improvement in the industry b) favourable change in the company’s operating policies, with or without a change in management. These changes include more efficient methods, new products, abandonment of unprofitable lines, etc.
- A sale or merger, because some other concern is able to utilise the resources to better advantage and hence can pay at least liquidating value for the assets.
- Complete or partial liquidation.
Performance check – U.S. net-nets
This all sounds good in theory, but how do net-nets actually perform? In an interview for the Financial Analysts Journal in 1976, Ben Graham stated that he and his partners had “used this [net-net] approach extensively in managing investment funds” and that over a “30-odd year period we [Graham et al.] must have earned an average of some 20 per cent per year from this source.”
“It always seemed, and still seems, ridiculously simple to say that if one can acquire a diversified group of common stocks at a price less than the applicable net current assets alone – after deducting all prior claims, and counting as zero the fixed and other assets – the results should be quite satisfactory.”Benjamin Graham, The Intelligent Investor
Although useful, it would be foolish to rely solely on Graham’s testimony, so we need to review academic studies and backtests. Robert Oppenheimer studied the returns of the net-net strategy over a 13-year period from December 31, 1970, to December 31, 1983. He assumed that all stocks were purchased on that date, held for a year, and then replaced by new net-nets. Over its life, the portfolio contained a minimum of 18 and maximum of 89 stocks. Oppenheimer reported that the net-net portfolio’s compounded annual return throughout this period was 29.4% versus 11.5% for the market – “quite satisfactory” indeed. Although these findings are revealing, we need to consider the constrained time period – 13-years still limits the conclusions we can draw. Fortunately, Carlisle, Mohanty, and Oxman (2010) extended Oppenheimer’s study through exploring the returns of net-nets between 1983-2009 (a 25-year period). Their results were similar. The net-net portfolio produced a return of 35.3%, outperforming the market by 22.4% annually, and a more comparable small-firm index by 16.9% on a compounded annual basis. The authors found the fewest net-nets in 1984 (13 stocks) and the most after the Dotcom bubble induced bear market in 2002 (152).
Performance check – international net-nets
How about international net-nets? James Montier, a behavioural finance expert, found that an equally-weighted portfolio of U.S., Japanese and European net-nets produced an astounding compounded return of 35.3% between 1985-2007 versus 17% for the market. Montier reported other interesting findings. First, there were differences between regions – net-nets produced a return in excess of the market of 18%, 15%, and 6% in the U.S., Japan, and Europe, respectively. Second, the average market cap of net-nets was only $124 million, suggesting that this strategy is ideal for investors with small portfolios. Third, more than half of net-nets in the portfolio in 2009 were Japanese, and finally, 5% of net-nets suffered a decline of >90% in a single year compared to 2% in the broader market – driving home the importance of diversification and paying attention to the entire portfolio’s performance instead of individual stocks. Again, the availability of net-nets was found to vary greatly: net-nets surface in bear markets and seem to disappear in bull markets, which is logical.
You can visualise the findings of the aforementioned studies below:
Overall, the net-net strategy has produced excellent returns, but you may ask yourself whether certain net-nets perform better than others. Oppenheimer divided the net-nets into quintiles (five groups) based on their discount to NCAV (price/NCAV). He found that the net-nets in quintile 1 (the cheapest net-nets) outperformed those in quintile 5 (the most expensive net-nets) by more than 10% annually. Another finding was more counterintuitive: loss-making net-nets were found to outperform net-nets with positive earnings. These trends were generally replicated by Carlisle, Mohanty & Oxman (2010), with one perplexing exception – the absolute cheapest group of net-nets had lower returns than the rest of the portfolio. Commenting on this finding in Deep Value, Carlisle stated the following: “It’s possible that the result is an outlier, and it’s worth bearing in mind, but it doesn’t change the finding that there is a positive relationship between the size of the discount and returns.”
Applying the strategy
The beauty of the net-net strategy is that it is so simple yet so powerful, and that in almost all market conditions, you should be able to find enough net-nets to construct a diversified portfolio of 20-30 stocks. However, although the prescription is clear, actual success depends entirely on the investor’s psychology, as is the case with all things investing.