What is Net-Net?
Net-net is a term used for a company with a market capitalization that is less than the difference between the company’s current assets and total liabilities. The equation does not consider long-term assets, such as property, plant, and equipment (PP&E), and intangibles.
Net-net investing is used with the underlying understanding that if the net-net (company) is sold, the current assets would be used to settle the obligations or liabilities, and the leftover amount (cash) will be worth more than the market capitalization of the company. In other words, the stock price is below the net current asset value (NCAV) of the company.
What is the Net Current Asset Value (NCAV)?
Net current asset value (NCAV) is the value of the current assets minus total liabilities, including preferred shares and off-balance sheet liabilities. NCAV is derived when you remove the long-term assets component from total assets, leaving a highly conservative estimate for a company’s value in case of liquidation. The NCAV strategy and net-net investing was founded in the 1930s by Benjamin Graham and was thought of as a good proxy to gauge a company’s real-world solvency value.
Price to NCAV of an Investment
A related concept is a multiple involving NCAV. P/NCAV can help investors and analysts determine whether a stock is under or overvalued. A low P/NCAV means the stock is undervalued. A company can alter its NCAV by buying back or issuing common shares.
Net-Net Investing: The Warren Buffet Perspective
The net-net strategy was used by Warren Buffet to grow his investments. He popularly referred to this as the “cigar-butt” investing technique. The strategy was taken from Graham, and Buffet came up with a simple rule to buy a stock. He said that if the stock price is less than 2/3 of the difference of the current assets and total liabilities, it is a net-net stock. The equation is given below:
Buffet stated that the only rule of thumb was the equation, and one does not need to analyze the company’s financial statements, conduct fundamental analysis, or make any qualitative or quantitative judgments. The strategy was a bit controversial, as most of the stocks trading as net-net stocks are not very sought after, and people avoid them as they are trading at ridiculously low prices. Moreover, people are scared to invest in companies that may undergo bankruptcy (although, there are instances of profit generation in such cases, too).
Success of Net-Net Investing Strategy
It is interesting to see that despite net-net being such a volatile strategy, the strategy yields positive returns. There are several factors as to why the net-net strategy is considered successful, including:
1. Riskiness of stocks
Looking at market data for a basket of net-net stocks, the stocks tend to show a beta (volatility) greater than 1, indicating that any movement in the markets will cause a larger impact on the change in the stock price of the stocks (indicating why such stocks might’ve historically outperformed relative to other average stocks).
2. Market liquidity
If a company’s stock is selling below its NVAC, it is normally a small company with illiquid stock. As the stock is hard to buy/sell, it will take time for the investor to react to any news that comes regarding the stock. Therefore, for such stocks, investors get a higher premium to compensate for the illiquid risk they are being exposed to.
3. Long-term reversal
A common concept in trading is that everything will eventually revert to the mean, and if anything’s previously been performing badly, it will perform well now. Studies indicate that net-net stocks performing well could be because they were not doing too well earlier (although this argument may seem flawed and biased).
4. Financial distress
Any company that is showing liquidity or solvency problems tends to garner a negative reaction from the market. The negative reaction often leads to the stock price falling way below the fair market price (making the company undervalued and, therefore, a potentially attractive investment).
Pitfalls of the Net-Net Investing Strategy
The net-net strategy comes with certain pitfalls, as not everyone can benefit from it. The investing technique does not always work, with certain investors demonstrating months of underperformance when employing the strategy. The strategy tends to do well if used for a longer time horizon (based on the success factors mentioned in the earlier section).
Another problem of the strategy arises if investors do not diversify and focus on one to two stocks to do the work. It is possible that not every net-net stock posts the gains expected, so it is very important to diversify and invest in a basket of net-net stocks. The net-net strategy works well for illiquid stocks, and as most investors are unable to purchase shares due to the thinly traded volume, they end up not benefitting from the strategy.
CFI offers the Certified Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: