Benjamin Graham's Net-Net Stock Strategy: A Review

A Review of Evan Bleker's Book About Net-Net Investing

Two years ago, when I decided to stop indexing and begin studying and investing in stocks, I read Benjamin Graham's The Intelligent Investor. I'd owned the book since I was twenty years old. When I was twenty, I did not have the background knowledge to make sense of much of the book, nor did I have any money to try to follow Graham's advice. But two years ago, when I reread the book, it made a lot of sense.

One exciting idea was net-net stocks. These are stocks that are selling for less than their net working capital minus total liabilities. These are very cheap stocks. I can remember reading a few articles on net-net investing and browsing some forums. What I read discouraged me. Net-net investing was risky: apparently, many people had accidentally purchased fraudulent Chinese stocks that appeared to be net-nets. And, even more discouraging, the consensus was that one could not build a strategy around net-nets because there were so few available. The market had gotten too expensive for such stocks to exist.

So, over the last two years, I have tried buying stocks with low EV-EBIT ratios. And, more recently, I have tried using valuation techniques to estimate the intrinsic value of a stock, buying it if it is selling below my estimated intrinsic value.

But I haven't tried net-net investing.

Recently, though, I heard Evan Bleker, the founder of http://www.netnethunter.com, on a podcast and heard about his terrific success with a net-net strategy. So I bought his book – Benjamin Graham's Net-Net Stock Strategy: A Practical Guide to Successful Deep Value Investing in Today's Markets – and read it.

If you are new to investing, especially if you are new to deep value investing, I would highly recommend this book. Evan Bleker explains what net-net investing is, overviews the academic studies on it, explains how some investors have implemented this approach, and advises the reader on how to implement it in her own portfolio.

Bleker explains why net-net investing works. When you purchase a net-net stock, you are purchasing it at a big discount to its liquidation value. Most business property, plant, and equipment (PPE) and an operating business (even if the operating business is failing). But a net-net valuation ignores that. A net-net stock can cover its current liabilities and other liabilities (including pension, leases, and priority shares) with its current assets alone. That means that, in a sense, you get for free the PPE and the operating business.

Yes, these businesses are often struggling businesses. So the stock still might not do well. But you are at least placing the odds in your favor. Maybe the business rebounds. Maybe the business liquidates and the shareholders get more money than they paid for the business. Several scenarios could work out in the investor's favor. And if you consistently buy a diverse basket of net-net stocks, then over time your returns will be good. For most decades, you'll beat the S&P 500, even if some years you don't.

As an analogy (and this is my own analogy, not Bleker's), imagine if you were buying rental houses as an investment strategy. Imagine that I offered you a rental house that was worth $100,000. It was, however, losing money each month and you weren't sure if and when it would become profitable. Now, that sounds somewhat risky. But what I told you that there was $50,000 of cash in the house you could have, only a $25,000 loan that you'd have to assume if you bought the house, and that I'd sell it the entire property – cash, debt, and all – for $15,000.

So, you'd get a $100,000 asset, a monthly stream of rents, $25,000 cash after you'd paid off the loan, and it would only cost you $15,000. Even though the rental property is risky – you don't know how long it'll lose money – you can see that this is a risk worth taking. If you had enough of these properties, then over time you would likely make money. You could eventually just sell the house. Or maybe the rents go up and you start making money each month rather than losing it. Either way, you have a decent chance of making money.

Net-net investing works through a similar logic. You are buying at such a discounted value that the odds are tilted in your favor to make money. And the academic studies bear it out. Bleker takes the reader through several academic studies on net-net investing. Bleker points out that net-net investing is one of the few investment approaches that is backed by academic studies and easy enough for amateur investors to follow. And the academic backing is impressive. He writes:

I have spent a few years collecting academic and industry studies assessing net-net stocks. Incredibly, while I have specifically sought disconfirming studies, I've only found one that fails to find significant outperformance. Every other study, 14 in total, has shown that Graham's strategy significantly outperforms major market indices. (Kindle Location 1119-1138)

Of course, many people shy away from this strategy for several reasons.

1. Bad businesses: The reason these stocks sell so at such a cheap price is that the businesses are not doing well. If you want a stock that is backed by an exciting, growing business, then net-net investing will not be attractive. Bleker says that it isn't uncommon for net-net stocks to be businesses that have seen a steep decline in revenues and an even steeper decline in share price (Kindle Location 898).

2. Small and unknown businesses: Often, net-net stocks are small and unknown businesses. They aren't the types of businesses that people talk about at dinner parties.

3. Often hard to find: Net-net investments can be hard to find. Bleker estimates that it takes 20 to 30 hours a month of digging to find enough quality net-net stocks to make this your complete investment strategy.

4. Periods of Underperformance: The strategy doesn't work consistently every year. Some years the strategy trails the market; other years it soundly beats the market. Investors have to apply this strategy for the long-term. (Kindle Location 1328)

Finding Net-Nets

How do you go about finding net-net investments? You can start with a screen for low price-to-book stocks. If your screener allows, place a requirement that the current ratio is 1.5 or greater. And then you can start digging through the results. It is time-intensive, but the initial look is just adding up the current assets, subtracting total liabilities, and subtracting any other liabilities (pension funds, priority stock, lawsuit-related payments, operating leases, etc.) that you can obviously see. Then, divide that by the shares outstanding and compare it to the stock price. If it is lower, then mark it for deeper study. The screening and the initial pass can be done while watching TV. The deeper study will need more sustained focus.

So, even if you are busy, there is a way to find net-net stocks.

(Bleker's website, Net-Net Hunter, has a subscription service that provides one with an already-curated-and-vetted list of net-nets to invest in. I am not a subscriber, though.)

Once you find a company you want to investigate more closely, you can examine its balance sheet to see if it is a net-net stock. Bleker says that the formula that modern investors use is as follows:

Net Current Asset Value (NCAV) = Current Assets - Total Liabilities - Preferred Shares - Off Balance Sheet Liabilities. (Kindle Location 265)

There are a few details that can affect this calculation. For example, you need to worry about stock options, how you'll handle operating leases, whether there are pension or lawsuit liabilities, and so on. (Kindle Locations 289, 420, 429 & 457) If you want to see how Bleker handles these, then buy and read his book.

Checklist

One of the most valuable parts of the book is when Bleker provides a checklist of characteristics to look for in a net-net stock. By following his checklist, you can improve your chances, he thinks, of getting market-beating returns. In part, the checklist helps the investor avoid businesses drowning in debt or potential frauds. The checklist also helps the investor zero in on areas of the markets where successful net-net stocks can be found.

For the full checklist, check out Bleker's website or his book. But here are a few of the important components of the checklist:

• Small-Cap Stock or Smaller: Most net-net stocks are tiny stocks, with market caps of "less than $100 million" (Kindle Location 924) He prefers net-net stocks with a market cap of less than $50 million. (Kindle Location 2752)

• Avoid Certain Industries: Avoid stocks in the industries/sectors: "financial, regulated, real estate, resource exploration, early stage bio, and early stage pharmaceutical firms, as well as closed funds and ADRs." (Kindle Location 2652)

• A Current Ratio of 1.5 or More: Bleker requires a current ratio (current assets divided by current liabilities) of at least 1.5 (Kindle Location 2698).

• Debt-to-Equity Ratio: He requires a debt-to-equity ratio of 50% or less. (Kindle Location 2708) He prefers a debt-to-equity ratio of 20% of less. (Kindle Location 2758)

• Buying Back Shares: He prefers net-net stocks that are buying back their shares. (Kindle Location 2726)

• Burn Rate: Burn rate is the decline in net current asset value. Bleker won't buy a stock with a burn rate over the last 12 months of 25% or greater. (Kindle Location 2707)

Implementing the Strategy

How, then, should an investor implement this strategy?

First, find quality net-net stocks. You can do this by manually searching through a list of stocks or by joining Bleker's web service that provides you with quality net-net stocks.

Second, buy a basket of them. Bleker recommends buying at least 20, but "ideally 30" net-nets. (Kindle Location 3103)

Third, sell a holding after one year. Holding it longer doesn't improve your annual returns over time. (Kindle Location 1337, 1362) You might decide to sell once it reaches NCAV, or just hold for the whole year. Graham's rule was to sell after two years or a 50% increase, whichever arrived first. Selling when a stock reaches NCAV might keep you from realizing the stock gains as it rises above NCAV.

Fourth, give it a decade. Bleker points out that net-net investing doesn't outperform every year. So it might take a decade to realize the market-beating performance. (Kindle Location 3103)

How Is the Unschooled Investor Implementing It?

As I said at the beginning, I've been aware of net-net investing for a couple of years. But I haven't invested in it yet. But that has changed since I read Bleker's book.

Unfortunately, my self-directed IRA doesn't allow me to invest in international stocks, and all my stock investments are within my IRA. I might eventually switch to a broker that allows me to invest internationally. But, for now, my investing universe is more limited than Bleker's.

So, I won't be able to form my entire investment strategy from net-net stocks.

But I have decided to prioritize net-net stocks. That is, when I find a net-net stock that meets the baseline criteria that Bleker sets out, I'll buy it. My decision right now is to invest 3% of my portfolio in each net-net stock I find. If I have to sell other, none net-net stocks to do so, then I will. I'm convinced that net-net investing will generate better returns for me than other approaches, so I'm willing to prioritize this approach.

I wanted to keep my sell decision simple: unless I'm convinced that the stock is a good business that is undervalued even at NCAV (most net-nets aren't…), then I will sell it at NCAV.

In sum, Bleker's book makes an impact on my investment approach. I hope this review is helpful to you. Subscribe to his service or buy his book if you are interested in net-net investing.