Can You Successfully Invest In Illiquid Net Net Stocks? Yes.
A lot of investors assume that net net stocks are fundamentally flawed because they're so illiquid and have huge bid-ask spreads. Why then have I been able to rack-up returns well over 30% per year using this strategy?
Usually if I get an objection to one of my articles it's that since net net stocks are so illiquid it's impossible to buy or sell them. Take this comment on Seeking Alpha, for example:
Great article - but with a volume of 19,819 shares / day at price of 0.20 CAD / share thats extremely low liquidity levels and if you want to invest any significant amount of money it will take forever to get in and out of the position.
It's definitely true that these companies have less liquidity than other stocks. If you're used to looking at medium or large cap companies than the liquidity of net net stocks can seem breathtakingly small. A skimpy amount of trading day to day will have different consequences for different investors, however.
Benjamin Graham's Net Net Stocks Are Perfect For Investors Managing Less Than $10 000 000 USD
Obviously, if you have large amounts of money then you'll find it difficult to buy net net stocks -- at least in the quantities that you would have to for a net net stock to make a significant impact on your portfolio. A value investor trying to invest in Sangoma Technologies, as the commenter mentioned above, would face a 19 000 shares a day trading volume, or daily volume of $4 000 USD. At that amount of volume, someone managing $1 000 000 would need to acquire all the trading volume over 25 days to build a 10% position.
Clearly, after a certain amount of assets under management -- typically more than $10 million -- this strategy faces big barriers. If you're managing even more than $10 000 000 USD then you're likely to be priced out of North American net net stocks most of the time -- if not permanently.
Larger investors really have to explore international markets if they're intent on taking full advantage of Benjamin Graham's favourite value investing strategy. At any one time some international market is facing significant headwinds, some sort of crisis that sends the stock averages plummeting. These markets usually offer international NCAV investors spectacular opportunities, much like the opportunities found during serious recessions in America.
What about small and medium sized value investors?
Medium sized retail investors, investors managing around $1 000 000, have much more opportunity to exploit Benjamin Graham's strategy than larger investors have but obviously aren't as flexible as investors with small portfolios. While it may take them a fair amount of time for medium sized value investors to build positions in smaller companies like Sangoma Technologies, it's still possible and it only gets easier as volume nudges upwards.
The smallest investors, however, those managing much less than $1 000 000 USD, have the most opportunity. With small portfolios, it's possible to buy companies with absolutely tiny market caps -- in the $1-2 000 000 USD range -- without much problem. Acquiring a 10% position in a firm like Sangoma when managing a $500 000 portfolio would take a much more manageable 12 days, and only 6 days with a $250 000 portfolio.
For smaller portfolios, volume almost becomes a non-issue. In fact, I'm managing less than $250 000 USD of my own money and have only had issues buying and selling 2 or 3 of the 18 positions I've held in the last 3 years. The results of my net net stocks have been extraordinary.
In truth, Sangoma is one of the smaller net net stocks that come available. Since 2011, I've found a number of firms with market caps of $50 million or more trading below NCAV. Those net net stocks are far easier to buy and the number of larger firms trading below their net current asset value rises as you step into international markets. Just this month, after a quick look through some of the net net stocks available in Japan, there are a number of firms on offer with market caps above $100 ooo ooo USD.
Tip-Toeing Into Net Net Stocks
Don't make the mistake of thinking that you have to buy your entire holding with one trade on a single trading day. Professional money managers -- even the best -- don't buy stocks that way most of the time. Positions are built up over a number of days or weeks to avoid chasing the stock.
As more money is invested into an illiquid stock, the price of that stock tends to rise. If an professional money manager wanted to invest $10 000 000 into a single stock, for example, and uses a regular market order then he might push the price of the stock up and end up buying it well above the initial quoted market value.
Instead of trying to purchase his entire position on a single day using a market order he uses limit orders and spaces his purchases out over a number of days. Warren Buffett, for example, purchased half of the trading volume of Coke over the course of a few weeks.
Yes, making multiple purchases to buy net net stocks increases your trading costs but if you're using a decent discount broker then the amount that you're spending is really not that much -- especially compared to the returns that this strategy offers. Capital gains more than make up for any additional costs.
What about massive bid-ask spreads?
Another common concern raised when investing in stocks of small illiquid companies is the huge bid-ask spread that investors have to face.
The quoted market value of a stock is not necessarily the price that you can buy or sell it for. Haggling occures when buying or selling most stocks. When buying a stock, the buyer makes an offer for the stock at a certain price. This is known as the bid price. Sellers who want to sell their holdings suggest a price that they would be willing to sell for. This is known as the ask price.
The concern that some investors have is that they'll ultimately have to pay a price closer to the ask price when trying to buy an illiquid stock just to entice a seller into selling. For illiquid stocks, this can mean a price far more expensive than the publicly displayed stock price (for example, on Google Finance). Conversely, when selling they would need to sell for far less than the publicly quoted price. This spread makes some investors feel as if this would drastically decrease their profit.
My own experience suggests that this is almost a non-issue. I regularly buy and sell stocks of tiny companies at the publicly quoted price. How? Simple: limit orders. If I were to place a market order with my broker then I would be buying at whatever price the sellers wanted to sell to me for. By placing a limit buy order with my broker for the publicly quoted price I lock in the price that I'm willing to pay. This is akin to playing hardball bargaining at a flea market -- and I've typically never had a problem buying or selling a security for my limit order price.
In fact, since I've started buying and selling stocks of tiny illiquid companies, I have only faced 2 or 3 situations where I have had to increase my bid price to buy a stock -- and often these firms had market caps of less than $2 million USD! In the last situation, I purchased a stock of a company with a market cap of $6.9 million, a publicly quoted price of $1.38 and only around $1500 USD worth of daily volume. In that situation, I only had to increase my bid price 2 cents, from $1.38 to $1.40/share, to purchase my holding -- a cost I feel was well worth it.
Selling is far easier -- I've only encountered one stock which I found it tough to sell: my boneheaded purchase of TotalTelcom. TotalTelcom was my own fault -- it was already a sub-$1 000 000 USD company with unusually thin volume. Since I did a poor job in selecting it, it turned out to be my largest loser, retreating further in price, and seeing the volume evaporate to an even larger degree.
In the majority of cases, stocks are easier to sell than buy. As the company starts to rebound, the stock takes off and buyers flood in to purchase shares. In the 1951 edition of Security Analysis, Benjamin Graham explains that when the price rises and excitement grows so does trading volume. This is partly why Benjamin Graham recommends going with value over volume if you have to chose between the two -- and this sentiment has helped shape my selling policy. As deep value investor Seth Klarman says, you have to feed the birds when the birds are chirping.
Where does this leave your own investment strategy?
I hope I've cleared up one of the most commonly asked questions about investing in small illiquid net net stocks. Whether this strategy is open to you really depends on the amount of money you're trying to invest. With a portfolio of under $1 000 000 USD you have a good chance of selecting some of the best net net stocks on offer today, but with a portfolio of far less than that you can nearly invest in anything on offer. Average daily volume and the mythological bid-ask spread are not concerns you typically have to worry about if you have patients and buy using limit orders.
A far bigger problem is being able to find suitable net net stocks to buy. You can solve this by requesting a Net Net Hunter membership. Find out how to get the best net net stock opportunities right now -- Click Here.
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