Experiences with Net Net Stock Investments

On the heels of my recent breakdown of “net-net” value play ARCW, I wanted to write a bit more about my experiences investing in net-net stocks.

As a value investor in the Ben Graham school of thought, a net-net is sort of a dream scenario.

When you read Security Analysis for the first time you almost wish you lived back in the days where you could see some of the opportunities Graham did. I believe it is unlikely that as many net-net opportunities arise as they did 60-70 years ago. Technology and the rapid dissemination of information make it more difficult to find egregious mis-pricing of stocks to such a degree that millions of dollars in cash are completely unaccounted for in the market price (but it still does happen).

Formally, a ‘net-net’ stock is one which is trading in the market for less then you would receive if you were to use working capital to pay all liabilities and write yourself a check for the difference.

Current assets – total liabilities = net working capital.

There are various percentage handicaps which are applied to the working capital figure (to account for obsolescence of inventory and uncollectability in receivables as well as the nebulous benefit of some other current assets like pre-paid insurance and rent) to arrive at the sum used to deduct liabilities from and arrive at the proper current asset figure used in the equation.

For practical purposes, if you had a widget making business with $50 million in cash, no other current assets and $25 million in total (on and off balance sheet) liabilities, you would have $25 million in “net working capital.’ And if the market cap for this company was $15 million, you’d have a $10 million surplus in working capital over market cap. Theoretically, if you owned 100% of the stock, you could liquidate the company immediately and make $10 million (before costs _ taxes). And if there’s any earning power at all left in the business, taking a long position in a company like this would mean you  would not liquidate it, but would instead get $10 million in net cash and widget making business for free.

So this is the big attraction to these situations. You can get an ongoing, profitable business for free. You aren’t paying an premium in the stock price at all for the earning power you acquire with ownership in the company.

Ok, let’s press on…

In the past, I’ve invested in net-net’s with varying degrees of success. Admittedly, I have not been able to find the ‘Sanborn Map’ type values that made Warren Buffett famous in his early days, but the investments I have made contributed positively to my portfolio.

The net-net’s I had success with from 2009-2010 (when I first found some worth taking positions in) were due to the market pricing the company as having zero earning power or even negative earning power. This is what the case is with a net net. If a company is trading for less than it’s liquidation value, it’s a good bet the market thinks the company is worth more dead than alive.

This can be an area of opportunity and also one of extreme disappointment.

One of my best successes with a ‘net-net’ investment was Flexsteel Industries (FLXS). Trading at a discount to it’s net working capital in June 2009, I entered this position at $7.23/share. My intrinsic value estimate at the time was $14-$16 per share. Essentially, the market thought this furniture maker was basically ‘done-for’. My evaluation was the company would continue in business and continue making money  (perhaps even at depressed levels), but still maintain profits at which an owner would be pleased to have. The market was simply ringing the death knell which was just not there. FLXS had also shown shareholder friendly trends, like paying a dividend and they were taking corrective courses of action to manage inventories and receivables.

FLXS subsequently advanced to $16/share in March of 2010. This was the high end of the intrinsic value range, so I exited my position. FLXS did advance even further, peaking at a little over $18 in Jan. 2011. Total gain: 121%.

Other ‘net-net’s did not play out as well as this one.

Mathstar (MATH), was a semiconductor company I took a long position in in May 2009. The company had a surplus of cash over total liabilities of about $3 million ($1.34/share) or so. But…there was zero earning power left in the company, save for the pie-in-the-sky possibility the board was entertaining at the time of licensing it’s semiconductor technology to another firm. The only way to profit from owning a part of this company was to realize the value disparity between net working capital and market price. There was one good puff left in this soggy cigar butt.

When I took the position, I was confident in my margin of safety, along with possible catalysts. I went long in MATH at $1.01/share on May 21, 2009.

Shortly after I took my position, MATH shareholders received a tender offer from Tiberius Capital for $1.15/share (later upped to $1.25/share and then $1.35 and then $1.45). The stock price then rallied to $1.21/share after the first tender offer of $1.15/share. Even after this catalyst type event, the stock was still trading for less than it’s liquidation value, I was considering holding on but then…

The board of MATH recommended rejecting the tender offer (they subsequently got a slap from the SEC for the way the communicated their recommendation to reject the tender). The board did not even try to play ball with the investment firm (Tiberius). The board of MATH became outright hostile. In addition, the board also consistently rejected other ideas presented to it for unlocking shareholder value.

And it was with my position in MATH when I really got hit with a ton of bricks over the head about what I consider to be the biggest problem with investing in net-net stocks: outright arrogant, illogical and nonsensical stubbornness of management to accept reality and take corrective courses of action to unlock shareholder value. The principal agent problem, basically.

(sometimes you learn about stuff in college and it pops back in your head at weird times)

There are no limits to how long and how hard management and a board of directors will dig their heels in and watch millions (and sometimes billions) of dollars in shareholder value be washed away like a mudslide.

I’m not saying every net-net trading company should liquidate. And I’m not saying every one should carry on and try to “stick it out.” But usually it’s easy to know what to do. It is the doing of it that is the problem.

Face it…if your business has been public for 10 years and you’ve never made a profit, you’ve never had more than a few hundred thousand a year in sales and you’ve repeatedly had to raise more and more capital only to watch it burn up…well, then it’s time to give whatever is left of their money back to the shareholders.

But if your business is still making a profit (or temporarily fell into the red), if you have an order backlog, if you have stable profit margins, if you don’t have ballooning off-balance sheet liabilities…well, then it’s a good idea to stay the course and keep making money. Let the market beat your stock up all it wants for all the wrong reasons. Buy back your shares.

As soon as it was evident that MATHs board was going to probably piss away the entire margin of safety for my purchase and then even erode more value, my decision was made.

I sold MATH at $1.21 on 7/11. This made a profit of $.20/share and a gain of 20% in about 6 weeks. Not bad. But nothing to write home about.

But then things got even more interesting…

The day before the company’s annual meeting (and when things were getting heated up with the Tiberius tender offer), their CEO resigned AND he resigned because MATH announced it was in merger talks with another company called Sajan.  In the CEO’s words:

“I do not believe the proposed Sajan acquisition is in the best interest of MathStar shareholders. I do not believe that Sajan, or the advisors hired to do the due diligence, have presented a business plan that warrants committing over $13 million of cash, nearly half of which will not remain in the combined company but will be distributed to the current Sajan shareholders. In addition the newly issued shares will result in nearly a 50% dilution of the equity currently held by MathStar shareholders.”

Hmm…it’s pretty bad when your CEO resigns in protest.

The tender offer (up to $1.45/share!) died in September of 2009. The share price declined subsequently and then the Sajan merger happened. Given the merger terms, a quick calculation reveals that MATH shareholders have not made out as well as they would have if the board had simply recommended the higher tender offer.

And so it goes with net-net’s….

You have to really know which type of situation you are getting into. If it’s a “liquidation and sell everything that isn’t nailed down” scenario, you must know how you stand to get your money back out. Chances are you may have to be your own catalyst (surprise the CEO with a phone call or have a Gordon Gekko type moment at the annual meeting!). You may have to watch carefully for signs a bigger investor might buy shares and agitate for change.  The company may also be a buyout candidate.

On the other hand, if it’s a scenario where the company has been beaten like a rented mule by the market for reasons of bad quarterly earnings, an overblown lawsuit or something along those lines, then as long as you are confident in management not completely blowing it you can see your value realized when the earning power of the company is properly priced into the stock. And…worst case…if you buy a good company at an insane bargain price, you’ll still have a good store of value and realize profits in the form of dividends and non-dilutive buy backs.

One important thing Ben Graham did recommend was holding a basket of net-net stocks. He knew – as we should know – that even though all the stars line up on a stock it still may not ever realize the price/value gap differential for profiting. Graham recommended 18-20 stocks and I think that is, of course, sound advice.

But it’s hard to find even 2 net-net’s that really make sense at any given point in time. Far too many companies have negative or severely diminished earning power as well as liabilities like long term lease obligations and retiree benefits (which seem to always be calculated using actuarial “fuzzy math” that assumes unrealistic growth rates in assets as well as unreasonable costs of health care benefits and the like) which gobble up any excess working capital.

By the time you have found a second or third net-net stock that works, you have to exit your position and realize profits in the other ones…thus not achieving a true basket.

The adjustment I make on this is to take smaller portfolio positions and try to buy cheap insurance (e.g. options) whenever possible.

This is not withstanding the event of an armageddon type market, where Wall Street bankers are jumping out of high-rise windows in droves (or maybe pushed?)…then, perhaps a gaggle of net-nets will become available.

If you want to dig into net-net’s, you must be prepared to be hard nosed and take a realistic view of the possibility and probability of catalysts. As humans, we are all very good at lying to ourselves. It’s easy to fudge a number or decimal point here or there. But the money is made at the margins. The extra diligence you do up front can be the difference between profits and “waiting forever to get a percentage of your principal back” with net-net stock investing.

 

 

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