How to Leverage +EV to Earn More on Your Net Net Stocks

The following is a guest post by Danny Harper and may or may not reflect the views of anyone else at Net Net Hunter.

Investing is about numbers. That much is certain. This quantitative focus makes the concepts of probability and risk management that much more important, and investors must stay vigilant when it comes to seeking out and analyzing opportunities.

Simply picking stocks can sometimes lead to big wins, but many of the most successful investors are individuals and firms who take a logical, mathematical approach to choosing companies.

One such method for targeting investment candidates is gauging positive expected value -- a concept I recently wrote about. This method is essential when it comes to identifying undervalued stocks.

When legends like Warren Buffett see value and growth as joined at the hip, and make use of expected value as an important metric for money management, others should take note.

So let’s dive right in and learn a bit more about the concept of expected value. Along the way, we will discuss the historical performance of this type of value investing, and some of the most important indicators to look out for when creating a portfolio.

Expected Value Rundown

Expected value is a term used in probability mathematics to describe the long-term average outcomes of a given scenario. In dice, the expected value is 3.5, because, in the long run, due to the law of large numbers, the arithmetic mean of the values will almost surely converge to the expected value as the number of repetitions increase.

In the world of investing, expected value can be used to determine the likelihood of your return on investment by finding the probability-weighted average of all possible values.

This is particularly effective when it comes to undervalued stocks. A strong company that is trading below its book value can be seen as an expected value candidate, and these stocks are bought on the assumption that, in time, their market price will reflect at least their fair value.

By analyzing the balances sheet and identifying simple deep value metrics, it is possible to conclude whether the investment has positive expected value, or in simpler terms, a greater chance for profit.

+EV and Net Net Stocks

The financial concept of positive EV and the stock designation of a Net Net commonly coincide together. Net Net investing is a value investing technique in which a company is valued solely on its net current assets.

In general, net net stocks come with big potential for positive expected value by the way they are priced and structured. The metric used to denote a net net stock is a share price that trades below its net current asset value (NCAV).

To calculate NCAV, just use the following formula:

(Company's current assets - [total liabilities + unfunded pension + face value of preferred]) = NCAV

According to the creator of the NCAV designation, Benjamin Graham, investors can benefit greatly from a portfolio of stocks that are priced at 67% of their NCAV per share, their net net value. By purchasing good companies that are undervalued as compared to their total assets, the power of positive expected value will become apparent.

When legendary investors such as Warren Buffett and Walter Schloss use this approach, one should take notice. Buffett is well known for buying great companies at good prices, but it's important to remember that he earned his highest average annual percentage returns when he ran his partnership and was picking net net stocks. In one of his partnership letters, the Oracle of Omaha stated that NCAV stocks tend to work out well within 3 years, at a success rate of 70%-80%. 

The numbers and statistics relating to net net stock returns is hard to argue against, with academic studies and historical precedent proving their long-term value. Analysts have been gauging net net stocks since the 20’s, and history shows a 15-20% excess return over the market, or in other words, a 25-30% annual return.

In James Montier’s 2008 study, “Net-Nets Outdated or Outstanding,” the author went international and looked at the surprisingly fertile NCAV market of Japan. What he found was returns from 1985 to 2007 that handily beat the lagging general indexes of Japan. In fact, while Japanese stocks as a whole provided investors with a 5% annual growth rate, net nets brought in an excess return of over 15% a year (a total CAGR of 20% per year).

Joel Greenblatt, manager of Gotham Capital and paragon of deep value investing, earned a return of 48.5% compounded over 20 years (1985-2005), besting even Warren Buffett's partnership returns.

In an early paper he co-authored with Richard Pzena, “How the Small Investor Can Beat The Market: By Buying Stocks That are Selling Below Their Liquidation Value” (The Journal of Portfolio Management 1981:7.4:45-52), the pair used Grahams NCAV metric and value investing's classic PE ratio to create four portfolios which they compared against the OTC and Value Line’s own value index. The end result was that their four NCAV portfolios beat the larger indexes by a wide margin.

When the researchers combined liquidation value with smaller PE ratios (Price below 85% of NCAV, a PE of less than 5x, and no dividends required), the results were even better, with a 42% gain from 1973-1978 vs 1.3% for OTC and a slight loss for Value Line. The portfolio beat the market by 40.7%!

For a more detailed summary of the study, read here.

How to Boost EV When Buying Net Net Stocks

While the potential for +EV can be enough of an incentive to invest in deep value companies, the best investors are the ones who combine the strategy's raw statistical advantage with additional criteria that will boost returns. Not all net net stocks are created equal, after all, so selection has a huge impact on your overall portfolio returns.

Here are some of the key metrics to look at when assessing the +EV candidates:

Low Price to NCAV - As mentioned above, stocks trading below book value are bought by investors on the assumption that, in time, their market price will reflect at least their fair value. Net net stocks work under the exact same principle, but exclude long term assets to stay even more conservative in appraising fair value.

What net net investors should seek out are companies with an Price to NCAV of less than 50%. Simple arithmetic demonstrates that the smaller this ratio is, the higher the returns will be on average. In practice, stocks trading for the cheapest prices relative to NCAV tend to work out much better than NCAV stocks trading at less of a discount -- all else being equal. 

For an example, let’s use two fictional stocks, Biotica and Hyperion. Biotica trades at 40% of NCAV, whereas Hyperion trades at 60%. If Hyperion was to rebound up to its full net current asset value, they would only have to rise 66%, while Biotica would need a 125% bump to hit fair value. Further, the simple fact is that the higher priced net net stock has greater potential to fall further, while the cheaper option could still provide solid returns even without officially reaching full NCAV status.

Low Debt to Equity - The long-time American investment firm, Tweedy, Browne Company LLC, which manages around $13b,operates in accordance with the principle’s of Benjamin Graham, and are one of the largest institutional investors who has used Graham's net net stocks strategy.

In a paper titled, "What Has Worked in Investing," Tweedy Browne summarizes a large body of academic studies and highlights the fact that firms that take on less debt perform significantly better than their debt-heavy peers. When looking at net net stocks specifically, net net stocks in general which were trading for a 67% discount or less from 1970 to 1981 returned 28.8%, while net net stocks that had a Debt to Equity figure of 20% or less returned 34.9%. Over the same period, the S&P 500 returned 9%.

Insider Buys - If there is anyone who knows about the health of the business, it is the insiders. Executives and owners are privy to information that many are not. Insiders have what is commonly called insight information (knowledge about new marketing programs, product price increases, cost cuts, increased order rates, etc…).

If insiders are buying you can expect good things to happen. The choice to add to their position is usually a strong indicator of future stock behaviour. While insiders can sell shares for a multitude of reasons, they BUY because they see the potential for future capital gains.

Officers, directors, and large shareholders will (rationally) make insider buys when the stock is depressed in relation to the current value which would be ascribable to the company's assets.

Since it is not uncommon to see significant insider buying at low price/earning or at low prices in relation to book value, this action should be a prime early indicator for identifying an exceptional positive expected value stock.

Increasing Dividends - The directional trend of dividend payouts is also an important metric when analyzing net net stocks.

Tweedy, Browne looks for a yield considerably higher than the rest of the market/sector since that may signal a depressed price. What we're looking at with net net stocks, though, is the direction of dividends. An increase in dividends is a strong indicator of business strength and confidence, because bumping up payouts generally means that more money is coming in then management thinks it's going to need.

What management in its right mind would dish out cash to shareholders when it suspects that the company may not be able to survive its current crisis? Not many, which is why this is such a positive indicator.

Share Buybacks - Similar to insider buys, share buybacks are a sign of confidence and an indicator of an undervalued company. Otherwise known as share repurchasing, buybacks are simply shares of company buys back from the marketplace, reducing the number of outstanding shares. The firm can either purchase shares directly from the market, or offer its shareholders the option to tender their shares directly to the company at a fixed price.

Keep in mind that when a shareholder does a buyback, and the supply of outstanding shares is decreased, it will bump up earnings per share, NCAV per share, and the eventual market price of the remaining shares.

While this could possibly be a last-ditch effort to make a stock more fundamentally attractive, for companies going through a crisis, it is commonly a vote of confidence that shows that the company offer significant value at current levels.

Stack the Odds in Your Favour by Looking for Great Investment Characteristics

These are just 5 factors that you can put to work when selecting the most promising net net stocks. For a complete list, download my Net Net Hunter Investment Scorecard right here.

Net Net investing is all about vetting and identifying value. This makes the investment-discovery process the most important aspect of investing, by far. By conducting due diligence and staying the course in terms of investing discipline, net net stock offer large (and satisfying) returns.

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