If the company goes bankrupt, you win. If it recovers, you win. Investing in Net Net Stocks is a win-win investment strategy and it’s surprisingly simple! Warren Buffett calls these “cigarette butt stocks” and used this strategy when he was younger and when the size of his capital still allowed him to invest in smaller companies. He claimed that he was able to easily get consistently high returns whilst investing in these companies and YOU can do it too!
“My cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performance.” – Warren Buffett, Berkshire Hathaway 2014 Shareholder Letter
What exactly are Net-Net stocks? Net-Net stocks or cigarette butts are, as its name suggests, really cheap companies that are worth “taking one last puff” from. They are stocks that you buy that are below liquidation value. It is the ultimate form of “Value Investing”! (ok, maybe I’m hyping it up a bit too much but you get my point) So for you that are not familiar with the term, liquidation value is the value that is left after all the debts are repaid and all the assets are sold. Basically, if the company goes broke, it will first sell everything, then pay back everything it owes and then redistributes all the remaining money to the investors. So if you buy a Net-Net stock, where the liquidation value of the company is above the share price, then if the company goes bankrupt. You are almost 100% going to make a profit. Alternatively, if the company doesn’t go bankrupt and recovers, the share price is most likely going to increase and you’re in the green. By doing this, you greatly reduce the amount of risk that you have to take on.
How do you check if a stock is a Net-Net stock?
The essence of Net-Net investing is to buy a company below liquidation value. So first you need to calculate how much the company would be worth if the company goes broke and has to sell everything and pay back all its debt. How do you do this? The easiest method is trying to find out what the company’s net current asset value is called Net Current Asset Value or NCAV for short. It is Current Assets – Total Liabilities. What you then want to do is to divide the result by the number of shares to obtain NCAV per share and subsequently compare it to the share price. Benjamin Graham, the father of value investing, recommended that the minimum requirement to buying a net net stock is when its price is at least 66.67% of the NCAV to ensure that you have a sufficient margin of safety on your investment. You may be wondering what happened to all the non current assets in this approach. Why is it not included? Well, this approach calculates what can be converted into cash in as short a period of time as possible and long term assets are either quite illiquid (property, plants, equipment) or intangible (goodwill).
The second method is an upgraded and more precise version of the previous example. It’s called Net Net Working Capital (NNWC). It is basically a discounted version of NCAV. It is as follows:
Net Net Working Capital = Cash and short-term investments + (75% x Accounts Receivable) + (50% x Total Inventory ) – Total Liabilities
You take the whole of Cash and Short Term Investments because it is basically cash or guaranteed cash at any point of time.
Accounts Receivable (money owed to a company by its debtors and will be paid back) is multiplied by 0.75 because you can expect most of the money owed to you to be paid and the other 25% is for the possibility that not all of the money owed to you will be paid back.
Only 50% of Total inventory is counted because as a company you can’t expect to liquidate the value of your whole inventory. You would either have to sell it at deeply discounted prices or not be able to sell all of them
Then you subtract all the debt and just like NCAV you can compare it to the market capitalisation (Share Price x Number of Shares) or you can divide it by the number of shares and compare it directly to the share price.
In my personal experience, this strategy seems to work quite well. Here is an example, one of the Net-Net Stocks that I bought was called Gencor Industries (GENC). Gencor is a manufacturer of heavy machinery used in the production of highway construction materials, synthetic fuels and environmental control equipment.
I bought it at $7.90 at the beginning of 2014. At that point of time, the company had more cash than its stock price! (A real bargain) It had $92.67m in cash and short-term investments, $1.2m in Accounts Receivable, $14.13m in Total Inventory and $7.64m of liabilities. So the Net-Net Working Capital was:
NNWC = 92.67m + (0.75 x 1.2m) + (0.5 x 14.3m) – 7.64 = $93.08m
At that point of time, the Market Capitalisation was around $60m + (Can’t remember the exact figure) giving a sufficient margin of safety and a juicy bargain. Unfortunately, I did sell too early at around $12-13 and missed out on the huge jump after that. (Need to work on my own exit strategy)
An important thing to note is to PLEASE don’t only use this as the only indicator to buy a stock. There are many other considerations to take note of and a great guideline for investing in Net Net Stocks is written by Jae Jun, founder of Old School Value:
Please do make sure to read through the checklist it is extremely useful and almost necessary to follow every one of his 7 criteria.
I hope you enjoyed today’s article and best of luck with your investment success!
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