Net-Net

What Is Net-Net?

The term "net-net" refers to the idea that, in the worst-case scenario, an investor could liquidate a company's current assets and still make a profit after paying off all its liabilities.

By investing in net-net stocks, investors hope to achieve high returns by capitalizing on market inefficiencies.

Net-Net is an investment strategy developed by the renowned value investor Benjamin Graham. It focuses on identifying deeply undervalued stocks based on a company's net current asset value (NCAV) in relation to its market capitalization.

This approach aims to uncover opportunities where the stock price is trading at a significant discount to its underlying assets, providing a potential margin of safety for investors.

The concept of net-net investing revolves around the belief that the market sometimes undervalues companies with strong financial positions.

This is based on the principle that a company's liquid assets, such as cash and receivables, are more valuable than its illiquid assets.

Key Components of Net-Net

Net Current Asset Value (NCAV)

Net Current Asset Value (NCAV) is the primary metric used in the net-net investing strategy. It represents the difference between a company's current assets and its total liabilities. NCAV is calculated as follows:

NCAV = Current Assets - Total Liabilities

Current assets include cash, marketable securities, accounts receivable, and inventory. Total liabilities encompass both short-term and long-term obligations, such as debt, accounts payable, and other outstanding financial obligations.

By focusing on NCAV, net-net investors aim to identify companies with strong liquid assets relative to their liabilities, signaling a robust financial position that could potentially lead to higher stock valuations in the future.

Market Capitalization

Market capitalization, often referred to as "market cap," is the total market value of a company's outstanding shares of stock. It is calculated by multiplying the stock's current price by the total number of outstanding shares.

Market capitalization is an essential component in the net-net investing strategy, as it helps investors compare a company's stock price to its net current asset value.

The goal of net-net investing is to find stocks with a market capitalization that is lower than their NCAV, indicating that the stock is undervalued and may offer a potential investment opportunity.

Calculating the Net-Net Value

To determine if a stock meets the criteria for a net-net investment, investors must compare its market capitalization to its net current asset value. If the market capitalization is lower than the NCAV, the stock may be considered a net-net investment.

Calculating the net-net value involves the following steps:

1. Determine the company's current assets and total liabilities.

2. Calculate the net current asset value (NCAV) by subtracting total liabilities from current assets.

3. Calculate the company's market capitalization by multiplying the stock price by the total number of outstanding shares.

4. Compare the market capitalization to the NCAV. If the market cap is lower than the NCAV, the stock may be considered a net-net investment.

Importance of the Net-Net Investing Strategy

Historical Performance

The net-net investing strategy has a long history of delivering strong returns for value investors. Benjamin Graham, the father of value investing, popularized the approach and used it to achieve impressive investment results throughout his career.

Historical performance demonstrates that, over the long term, net-net stocks have the potential to outperform the market.

This success is attributed to the fact that net-net investments capitalize on market inefficiencies and focus on stocks that are significantly undervalued.

Value Investing Approach

Net-net investing is a subset of the broader value investing philosophy, which emphasizes buying stocks at a discount to their intrinsic value.

By identifying undervalued stocks, value investors aim to profit from eventual price appreciation when the market corrects the mispricing.

The net-net strategy is an extreme form of value investing, as it focuses on companies with the most significant discounts to their liquid assets. This approach can be particularly appealing to investors who are willing to take on higher levels of risk in search of potentially higher returns.

Advantages of the Net-Net Strategy

Potential for High Returns

By investing in deeply undervalued stocks, net-net investors can capitalize on market inefficiencies and profit from the eventual price appreciation as the market recognizes the true value of the underlying assets.

Historical performance of net-net stocks has demonstrated that, over the long term, this strategy can produce impressive returns that outpace the broader market.

Margin of Safety

Another advantage of the net-net strategy is the built-in margin of safety. By investing in stocks trading below their net current asset value, investors are essentially buying a company's assets at a discount.

This margin of safety provides a cushion against potential losses, as the stock price would need to fall further before the investment becomes unprofitable.

In the worst-case scenario, even if a company's stock price declines, the net-net investor still has the underlying assets as a form of protection.

Focus on Undervalued Stocks

The net-net strategy forces investors to focus on undervalued stocks, which can be an effective way to identify investment opportunities that might be overlooked by the broader market.

Net-net investors can uncover hidden gems that offer the potential for substantial returns by concentrating on companies with strong financial positions and significant discounts to their liquid assets.

Risks and Challenges of Net-Net Investing

Illiquid Stocks

One of the challenges of net-net investing is that many stocks meeting the net-net criteria tend to be illiquid. This means that they have low trading volumes and can be difficult to buy or sell without impacting the stock price.

Illiquid stocks can be challenging to manage within a portfolio, as they may not be easily converted to cash when needed.

Investors considering the net-net strategy should be aware of the liquidity risks and be prepared to hold their investments for longer periods to achieve the desired returns.

Potential for Value Traps

Another risk associated with net-net investing is the potential for value traps. A value trap occurs when a stock appears to be undervalued based on its financial metrics, but its price remains stagnant or continues to decline due to underlying issues with the company or its industry.

Net-net investors must be diligent in their research and analysis to avoid falling into value traps by considering other factors, such as the company's competitive position, management team, and industry trends.

Limited Company Information

Net-net stocks are often small-cap or micro-cap companies, which can result in limited information available to investors.

This lack of information can make it challenging to conduct thorough research and analysis, increasing the risk of making poor investment decisions.

To mitigate this risk, net-net investors should seek out reliable sources of information and consider using additional financial metrics and ratios to support their investment decisions.

Examples of Net-Net Stocks

Case Study 1

Company ABC is a small-cap company in the manufacturing industry. Its current assets are valued at $10 million, and its total liabilities amount to $4 million.

This results in a net current asset value (NCAV) of $6 million. The company's stock price is $5, and it has 1 million outstanding shares, giving it a market capitalization of $5 million.

Since the market capitalization ($5 million) is lower than the NCAV ($6 million), Company ABC is considered a net-net stock, and it could be an attractive investment opportunity for net-net investors seeking undervalued stocks with a margin of safety.

Case Study 2

Company XYZ is a micro-cap company in the technology sector. It has current assets of $8 million and total liabilities of $2 million, resulting in a net current asset value (NCAV) of $6 million.

The company's stock price is $3, with 1.5 million outstanding shares, which gives it a market capitalization of $4.5 million.

In this case, Company XYZ also meets the criteria for a net-net investment, as its market capitalization ($4.5 million) is lower than its NCAV ($6 million).

This stock may appeal to net-net investors searching for undervalued investment opportunities with potential for significant returns.

The Bottom Line

Net-Net is an investment strategy that focuses on identifying deeply undervalued stocks based on their net current asset value (NCAV) in relation to their market capitalization.

The key components of the net-net investing strategy include net current asset value (NCAV), market capitalization, and the calculation of net-net value.

By comparing a company's market capitalization to its NCAV, investors can identify potential net-net investment opportunities that offer a margin of safety.

The net-net strategy offers several advantages, such as the potential for high returns, a built-in margin of safety, and a focus on undervalued stocks.

However, this approach also comes with risks and challenges, including illiquid stocks, potential value traps, and limited company information.

Investors considering the net-net strategy should be aware of these risks and conduct thorough research and analysis to make informed investment decisions.