Net-Net

Core Description

• Net-net investing values a company by its conservatively adjusted net current asset value per share (NCAVPS), seeking deep discounts for tangible downside protection.
• This contrarian approach, developed by Benjamin Graham, targets small, distressed, or overlooked stocks and requires rigorous screening for asset quality and risks.
• Success depends on diversification, strict sell discipline, continuous due diligence, and patience for catalysts such as buybacks, asset sales, or liquidation.

Definition and Background

Net-net investing is a deep value technique that originated from Benjamin Graham, widely regarded as the father of value investing. It involves valuing stocks based on their net current asset value (NCAV), calculated as adjusted current assets minus all liabilities and preferred shares. The primary idea is to purchase companies whose market prices are significantly below the value of their most liquid balance sheet assets, after deducting all obligations. This approach seeks to provide a substantial margin of safety.

This investment philosophy emerged during the Great Depression, a period when many companies traded at large discounts to their net asset value due to widespread pessimism and economic uncertainty. Graham observed that in such scenarios, investors could assemble a basket of these net-net stocks, trusting that the realizable value of their assets would act as a protective floor for the stock price. Notable practitioners included Warren Buffett, who used this approach effectively during his partnership in the 1950s and 1960s, and Walter Schloss, who diversified across baskets of net-nets to mitigate single-company risk.

Over the decades, academic studies have confirmed that net-net portfolios can outperform broad markets, especially among small-cap stocks during challenging economic conditions. The core rationale remains: purchasing stocks trading at two-thirds or less of their NCAV offers tangible downside protection and, in some cases, considerable gains if a market re-rating or liquidation occurs. However, successful application requires careful due diligence because of high value trap risks, illiquidity, and business decline among eligible companies.

Calculation Methods and Applications

Net-Net Formula and Adjustments

The net-net approach centers investment decisions on balance sheet fundamentals. The basic formulas are:

NCAV = Adjusted Current Assets – Total Liabilities – Preferred Stock
NCAVPS (Net Current Asset Value Per Share) = NCAV ÷ Fully Diluted Shares Outstanding

Adjusted Current Assets generally include:

• Cash and equivalents: Counted at 100 percent of value.
• Short-term investments or marketable securities: Typically marked to market, with occasional minor liquidity discounts.
• Accounts receivable: Discounted by 10–25 percent for doubtful collectability and concentration risks.
• Inventory: Marked down to likely liquidation value (typically a 25–75 percent haircut, with raw materials generally more easily realizable than finished goods).
• Other current assets: Prepaids and non-cash items are heavily discounted or excluded, unless clearly realizable.

Liabilities include:

• All short- and long-term debt
• Lease and pension obligations
• Payables, accruals, and deferred revenue
• Environmental and legal contingencies

Adjustments:

• Exclude restricted or encumbered cash.
• Examine for off-balance sheet risks, such as guarantees and purchase commitments.
• Use conservative estimates, referencing footnotes and management disclosures.

Example Calculation (Hypothetical Case)

NCAV = ($20,000,000 + $24,000,000 + $20,000,000) – $50,000,000 = $14,000,000
NCAVPS = $14,000,000 / 5,000,000 = $2.80 per share
If the stock price is $1.80, it reflects 0.64 times NCAV.

Practical Application

• Investors often acquire net-net stocks at prices below two-thirds (or even half) of NCAV to maintain a solid margin of safety.
• Portfolios are generally diversified across 15–30 companies to manage risk.
• Exit rules may suggest selling when the stock price approaches NCAV or when fundamentals deteriorate.
• It is necessary to recalculate values after each new balance sheet release or material business event.

Comparison, Advantages, and Common Misconceptions

Comparison to Other Value Metrics

• Net-net vs. Price-to-Book (P/B): Net-net focuses exclusively on safe, short-term assets, applying discounts to receivables and inventory. P/B includes all counted assets at historical cost.
• Net-net vs. Enterprise Value to Earnings (EV/EBIT): Net-net disregards ongoing earnings, focusing on potential immediate liquidation value.
• Net-net vs. Discounted Cash Flow (DCF): DCF is forward-looking, relying on forecasts, while net-net emphasizes current, tangible asset values.

Advantages

• High Margin of Safety: Grounded in assets likely to be realized even in difficult conditions, decreasing dependence on earnings forecasts.
• Evidence of Favorable Returns: Research indicates net-net baskets can deliver superior long-term results, especially in neglected microcap segments.
• Simplicity and Transparency: Based on verifiable accounting data, enabling a disciplined, consistent process.

Limitations and Risks

• Value Traps: Many net-net companies are declining businesses and their assets may diminish.
• Limited Liquidity and Universe: Most candidates are microcap stocks with thin trading volumes.
• Uncertain Catalysts: There is no certainty that the market price will rise to NCAV unless there is a clear catalyst such as asset sales, buybacks, or activism.
• Governance Concerns: Ineffective management can reduce NCAV through dilution or suboptimal capital allocation.

Common Misconceptions

• Mistaking Net-net for Double Net Lease: Net-net is an equity assessment method, not a real estate lease term.
• Assuming NCAV Equals Liquidation Value: Actual liquidation proceeds are often less due to various transaction fees, delays, and unforeseen liabilities.
• Neglecting Off-Balance-Sheet Risks: Items such as leases or legal claims may significantly reduce real asset value.
• Excessive Reliance on Screening Tools: Data errors or outdated information may yield incorrect NCAV results.

Practical Guide

Screening and Selection

Begin with a universe of microcap stocks, ideally those with market capitalizations below USD 200,000,000. Basic screening criteria include:

• Price-to-NCAV under 0.67 times
• High current ratio (above 1.5)
• Limited, stable cash burn with no persistent losses
• Simple, straightforward businesses with clean audit opinions
• Minimal off-balance-sheet liabilities

Verification steps:

• Assess the salability of assets, such as the quality and concentration of inventory and receivables.
• Evaluate insider alignment through management shareholdings.
• Review recent significant corporate actions such as asset sales or rights offerings.

Portfolio Construction and Risk Management

• Maintain diversification, ideally with 15–30 positions.
• Consider equal or liquidity-adjusted weights; avoid concentrated positions.
• Source all key data directly from regulatory filings, not solely from aggregators.
• Set clear exit triggers, such as the price nearing NCAV or deteriorating asset quality.
• Monitor key items, including inventory turnover, receivables aging, legal risks, and potential dilution.
• Avoid increasing allocation if the original investment thesis deteriorates.

Case Study: U.S. Microcap Net-Net (Hypothetical Example, Not Investment Advice)

In early 2009, a hypothetical U.S. electronics distributor with diversified receivables and well-appraised inventory traded at just 0.5 times NCAV. Management addressed the crisis by selling a non-core asset and reducing debt, then carried out a tender offer. Within 18 months, as inventories were liquidated and asset values realized, the stock’s market price moved above NCAV, generating a gross total return exceeding 100 percent despite unchanged revenues. This scenario required patience, a diversified portfolio, and disciplined risk management to navigate periods of volatility and business uncertainty.

Resources for Learning and Improvement

Classic Books and Primary Sources:

• Security Analysis and The Intelligent Investor by Benjamin Graham (original discussions of NCAV and net-net techniques)
• Tweedy, Browne’s “What Has Worked in Investing” and Walter Schloss’s investor letters

Academic Research:

• Henry Oppenheimer, “Ben Graham’s Net Current Asset Values: A Performance Update” (Financial Analysts Journal, 1986)
• Academic journals including JSTOR, SSRN, and FAJ for research on net-net portfolio performance and factor analysis

Investor Letters and Case Studies:

• Warren Buffett’s Partnership Letters (1957–1969) for hands-on application of the net-net approach
• Communications from value managers such as Tweedy, Browne for process analysis

Online Forums and Communities:

• ValueInvestorsClub (VIC) and MicroCapClub for discussion and analysis of net-net situations
• The Corner of Berkshire & Fairfax forum for detailed net-net case studies

Data Providers and Screeners:

• Bloomberg, FactSet, and Capital IQ for detailed financial statements (hands-on balance sheet adjustments are recommended)
• Custom screeners available from some online brokerages and financial news portals

Regulatory Filings:

• EDGAR (U.S.), SEDAR+ (Canada), Companies House (UK), and EDINET (Japan) for sourcing the latest public filings and reading footnotes

Courses and Lectures:

• Value investing programs at Columbia Business School and the Ben Graham Centre for Value Investing
• SEC’s investor education portal for learning about general accounting standards and balance sheet interpretation

FAQs

What is a net-net stock?

A net-net stock is a company whose market price is below its net current asset value per share (NCAVPS). NCAVPS is calculated as current assets (cash, receivables, inventory, discounted for risk) minus all liabilities and preferred stock, divided by the total number of shares outstanding.

Why do net-net opportunities exist in markets?

Net-net opportunities commonly arise during market distress, forced selling, or neglect—often among small-cap companies with limited analyst coverage. Behavioral biases and market inefficiencies can result in stocks trading below their net current asset value.

What are the main risks of net-net investing?

Key risks include value traps where business decline erodes asset value, governance issues causing dilution, inaccurate liquidation value estimates, and significant illiquidity making it challenging to exit.

How long is a typical holding period for a net-net stock?

Net-net stocks are often held for one to three years. The investment thesis is realized when a catalyst (e.g., asset sales, buybacks, liquidation) closes the price gap with NCAV. Otherwise, prices can remain depressed for extended periods.

How many holdings should be in a net-net portfolio?

Diversification is important. Many experienced practitioners hold between 15 and 30 positions to reduce single-company risk and the potential impact of business setbacks.

Is NCAV a guaranteed liquidation value?

NCAV is a conservative proxy, not a guaranteed outcome. Actual liquidation proceeds can be reduced by legal fees, asset markdowns, taxes, and unforeseen liabilities.

Should investors rely solely on screens for net-net selection?

No. Automated screens can have stale or inaccurate data. Always verify numbers using primary filings and review footnotes and off-balance-sheet items for a complete risk assessment.

Conclusion

Net-net investing, founded on disciplined analysis of a company’s net current asset value, represents a tangible and structured approach to deep value investing. From Benjamin Graham’s seminal research to subsequent academic studies and investment practice, the evidence supports that buying below NCAV can provide a degree of downside protection and, at times, significant upside.

However, the successful application of this strategy requires more than mechanical screening. Investors need to adjust for asset quality, account for off-balance-sheet risks, and continuously assess governance practices. Diversification, strict sell discipline, and patience are essential in managing the volatility, illiquidity, and company-specific risks involved. Although the net-net universe is limited and cyclical, typically more abundant during market downturns, this approach remains a methodical, evidence-based strategy for those looking to exploit market inefficiencies at the fundamental balance sheet level. By focusing on quantifiable, discounted assets, the net-net approach continues to serve as a robust, though demanding, tool within the value investor’s toolkit.