The zany world of net-nets

Geoff Gannon has been writing a series of very high-quality posts over at GuruFocus. One of his articles on net-nets is particularly interesting. Some sketch notes below.

Buying net-nets from 2002 through to today would give you a return of 27% pa .

Most investors would be better served by ignoring a net-net for two years after they buy it. If a net-net goes bankrupt within two years of you buying it – your mistake was buying it in the first place, not forgetting to sell it.

If you buy 30 stocks exactly like our March pick, you will get good returns over time – as long as you do not sell your winners too fast. You can’t sell a net-net that rises 30% in three months just because you would like to take your profit and get out of the stock. Your result over years and years of net-net investing is going to be much, much worse if you sell your net-nets the moment they start rising.

Remember, your winners have to offset your losers. And you will have losers. The reason a stock becomes a net-net is because just about everyone who looks at the stock hates it, thinks it is a dinosaur, a fraud, an imminent bankruptcy.

Most people who buy net-nets will lose money in net-nets. They aren’t going to hold their winners long enough.

A living, breathing business is worth a lot more than net-nets trade for. So once it becomes obvious to investors that this net-net has life in it – it’s not like buying a blue chip stock at 12 times earnings and selling at 18 times earnings.

Today has only five stocks with a market cap over $10 million. And one of these is a Chine reverse merger stock. And this one – I’m not going to say the name – is clearly a total fraud. (Hint: You can tell it’s a fraud by looking at their inventories and receivables relative to sales and current liabilities).

That’s the key to net-net investing. Over a single year, something will happen to a couple of your net-nets to give you huge gains. Nothing good will happen to the rest. Some will fall lower in price. Some will fail.

Selling your net-net within one year of buying it is often going to result in you watching as that company gets bought out in a year or two or three. When you no longer own it.

For a net-net, to be a true success or a true failure we know one thing – it can’t still be a net-net. It either has something happen to raise its price above NCAV. Or it becomes a total loss.

So, to me, it looks like a net-net portfolio with 100% turnover is simply chucking half of its developing net-nets into the trash each year for no good reason. Even a net-net portfolio with a holding period of two years is probably discarding one out of every four developing net-net stories for no reason other than an urge to be active.

When I look at the numbers, I think they point to a three to five-year timetable.

The oldest and most insider controlled companies have far, far fewer big losers. In fact, the average worst loss in a portfolio of 10 old and insider-controlled net-nets is actually less than a more mainstream strategy like Joel Greenblatt’s magic formula (which actually tends to have big losers).

OK, back to me now.

Regarding backtesting, it could be that 2002 was a particularly auspicious time to start a value-based investing approach, as was 2009.

It’s interesting that a net-net strategy might actually be much more suitable for a private investor than a professional. Net-nets tend to be very small in size, so buying a zoo of them might actually be a good idea.

For giggles, I actually ran a filter through Sharelock Holmes, looking for market caps > £10m, and a GR (Graham Ratio) between 0 and 1. GR is the market cap over the NCAV. And here are the results:

     1	Share_Name                             EPIC Graham_Ratio MarketCap 
     2	RCG HOLDINGS                           RCG  0.21         35.16     
     3	PV CRYSTALOX SOLAR                     PVCS 0.4          18.79     
     4	AMBRIAN CAPITAL                        AMBR 0.45         13.58     
     5	TRADING EMISSIONS                      TRE  0.46         66.24     
     6	NORTHAMBER                             NAR  0.51         10.98     
     7	RUGBY ESTATES                          RES  0.54         11.54     
     8	ARGO GROUP                             ARGO 0.59         10.25     
     9	CAIRN ENERGY                           CNE  0.67         1848.96   
    10	EMBLAZE                                BLZ  0.69         60.29     
    11	VOLVERE                                VLE  0.69         12.85     
    12	SOUTH AFRICAN PROPERTY OPPORTUNITIES   SAPO 0.71         33.03     
    13	POLO RESOURCES                         POL  0.72         77.26     
    14	TELFORD HOMES                          TEF  0.74         48.31     
    15	GLEESON (M J)                          GLE  0.75         64.26     
    16	RENOVO GROUP                           RNVO 0.77         27.03     
    17	FRENCH CONNECTION                      FCCN 0.78         45.09     
    18	DOUGLASBAY CAPITAL                     DBAY 0.8          15.91     
    19	NORCON                                 NCON 0.84         12.93     
    20	PANMURE GORDON AND CO                  PMR  0.86         21.51     
    21	BARRATT DEVELOPMENTS                   BDEV 0.87         1335.72   
    22	ANTISOMA                               ASM  0.89         11.12     
    23	ABBEY                                  ABBY 0.89         102.81    
    24	PLAZA CENTERS NV                       PLAZ 0.91         161.73    
    25	WORLDSPREADS                           WSPR 0.91         14.55     
    26	CHURCHILL MINING                       CHL  0.92         12.22     
    27	BELLWAY                                BWY  0.94         970.66    
    28	HERITAGE OIL                           HOIL 0.94         394.04    
    29	MORSON GROUP                           MRN  0.94         19.26     
    30	MOUNTVIEW ESTATES                      MTVW 0.95         179.98    
    31	RECORD                                 REC  0.96         25        
    32	AURELIAN OIL AND GAS                   AUL  0.96         100.86    
    33	BOVIS HOMES                            BVS  0.97         644.44    

There are 32 companies – which is actually a good selection. I actually know nothing about nearly all of them, although there’s a couple I’m aware of. Let me take a quick shufty at what’s in there.

Top of the list is RCG. Ah yes, RCG. Bless. I’ve talked about that many times. And not in the good way.

Interesting to see PVCS, the alternative energy company. It’s down because the bottom fell out on that particular fad. Who knows, it might actually do something. It’s been around for awhile, so management might pull a rabit out of the hat. I think that one of the points about net-net investing is that you have to do some nose-holding. They’re junk, everyone knows that, and so some extent the lesson seems to be that if you second-guess these things, you could end up doing worse.

There’s some real businesses in the list: I’m talking about housebuilders (GLE, BDEV, BVS, BWY, TEF). Housebuilders have actually had a good run over the last year, and you can see that some of them are close to losing their net-net status. Just goes to show. If you had worried about what the housing market was or wasn’t going to do, you would have missed out on Bellway +9.9% against the Footsie fall of 4.2%, Bovis Homes up 6.5%, and so on. That’s at least a 10% outperformance against the index. Is that good enough for you?

Polo Resources – I actually think that’s a good company. I invested in that (don’t hold it now), and did rather well out of it. The directors have been very good at spotting undervalued resources. You’ll probably do OK on that one, actually. Think of it as an investment trust, though. It’s not really a "trading" company.

Panmure Gordon – provides corporate and institutional investment banking and stockbroking services. No doubt many many investors would have heard of them on account of their analyst reports.

What else we got in there?

Trading Emissions – a company I highlighted some time ago (at a higher price – sorry guys). That trades carbon credits. It’s a kind of trust that was set up to cash in on the bizarre idea of selling quotas on how much you can pollute the planet. We can now recognise this as a complete non-business – the trade of a mere mental construct – probably the most idiotic idea ever. It’s like someone suddenly decided to set up a corn exchange for Facebook’s Farmville, or something. Yet, despite the sheer inevitability of the collapse of the business model, it has net cash of £56m, slightly below its market cap of £66m. An activist investor is involved (can’t remember the name offhand, but it’s a bunch of activist pros), and as far as I know, the company is actually going through an orderly liquidation process. So you never know, something might actually come out of all this.

Record. It provides currency management services for institional clients. If memory serves, it didn’t do their job very well, so their clients left. Again, it’s a company where you never know. It’s sitting on nearly £20m of cash, against a market cap of £25m.

Wordspreads. That one’s an anomoly, I think. Their shares were suspended on 16-Mar-2012 owing to accounting irregularities. The short version is that they’re a spreadbetting company who mixed client money in with their own, made bets that went wrong, and now everybody’s goose is cooked. I’d like to think that there’d be jailtime involved for the guilty parties, but I wont get my hopes up. The situation is completely hopeless – a KPMG was appointed as administrators on 23-Mar-2012. On 29-Mar-2012, a receiver resigned. This one’s got no chance. Not that it matters anyway, because thankfully the shares are suspended and you can’t buy them anyway.

French Connection. This is a troubled clothes manufacturer and retailer. The directors have a significant stake of £18m, and I seem to recall that their sales in Asia were actually doing reasonably well. It’s also held by some top-class posters at Motley Fool. Richard Beddard also has it in his portfolio. So, you never know on this one. It aint dead yet, not by a longshot.

Cairn Energy. I don’t know why it’s so lowly-rated. It’s actually quite a big company. I haven’t been following the story; but presumably things can’t be that bad. Dunno.

Emblaze. I never heard of this one until I did a net-net scan, but thought I’d take a look at it out of curiousity. It’s been trading for at least a decade, and only appears to have made an operating profit in two of them. Its median ROE over the last decade is -8.1%. Yes, that’s right, over the last decade, it ROE has been negative. I think it’s safe to say that it’s not a hidden champion that has managed to secure the services of top-tier management. Interestingly, their NCAV is made up predominantly of cash. You might want to check this bucket of spit out to see if there’s a liquidation possibility here.

Ah. Net-nets. So much more interesting than investing in proper companies. You’ll laugh, you’ll cry, but you’ll certainly never be bored.

Of course, I save the piece de resistance until last. You gotta love this. That company is MUBL (MBL Group). It’s been much talked about by Motley Fool, and even I’ve mentioned it. In fact, a post on TMF was addressed to me yesterday, pointing out its connection with JD.L (JD Sports Fashion). The common connection is Peter Cowgill, who serves on both boards. Questions have been raised about the integrity and competency of management at MUBL.MUBL presses DVDs or something, which it supplies to supermarket MRW (Morrisons). MRW is a huge customer. Or I should say, was. MRW decided not to renew its contract, leaving MUBL in a place of extreme hurt, and basically bringing its whole viability into questioning. There’s also suspicion in some quarters that some director deals were, let us say, "extemely well timed". Amongst other things, the whole stink has carried over to JD. due to the Cowgill connection. Companies associated with Cowgill have also been accused of being over-remunerated. I think that leads to some questions as to whether JD can be considered investible. Anyhoo, that’s a different story. Sticking to MUBL, though … on 30-Mar-2012, the company announced an acquisition:

MBL Group plc, the UK distributor of home entertainment products, is pleased to announce that it has conditionally agreed to purchase the trade and certain assets of Listen2 ("L2"), Garden Bird Supplies ("GBS") and Garden Centre Online ("GCO") from Flying Brands Limited for a total cash consideration of £0.72m on completion. 

Apparently, it quite now likes the bird seed market. For real! Of course, there have lots of cheap jokes on Motley Fool, although I haven’t read any jibes about them on Twitter.

Yes, I’m making a funny. I swear I’m not making this up, though.

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About mcturra2000

Computer programmer living in Scotland.
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8 Responses to The zany world of net-nets

  1. d says:

    careful. Some firms have market caps in GBP, but report in foreign currencies (eg Cairn), which distorts your price/NCAV calc.

  2. thomas says:

    hi,
    nice list, what is your screener ?
    Why market cap > 10M ?
    Bye

  3. mcturra2000 says:

    @d: I had a quick check on a company, and the numbers do appear to have been converted to GBP before the calcs had been performed. So I think they’re OK.

    @thomas: I used Sharelock Holmes. I used £10M because it’s small enough to throw up lots of candidates, but not so small that you’ll get eaten alive by illiquidity – although they’ll be plenty enough to dislike even at the £10M level.

  4. thomas says:

    Thanks,
    You thinks mubl is a value trap ?

    They are some net net In France and Italia
    In my portfolio: Vianini Industria SpA, Titon Holdings PLC TechniLine SA
    but illiquidity…

    Bye

    • mcturra2000 says:

      I see MUBL is up 32% in early morning trading, on account of it announcing that its losses had narrowed. I don’t really like net-nets. They’re usually mediocre as businesses (that’s why they’re net-nets), so it’s difficult to have any confidence that they’ll get anywhere. Unless one has special insight, I think the best that most people can do is buy a basket of them, and let statistics do the rest. In effect, I think all net-nets are value traps – it’s the long tails (i.e. an unforeseeable lucky break by a few of them) that bail you out.

      I think the managment of MUBL has shown distinct lack of competency. Having a major customer that is critical to your survival is just asking for trouble. I scoffed when I heard about their bird seed business. Bird seed?? For real? I look at it this way: they’re unlikely to know more about the bird seed business than the CD business – and they didn’t seem to know that much about the CD business.

      I think, ultimately, at best, MUBL is a company that is just going to kind of bounce along the bottom, like a turkey that will never reach takeoff velocity no matter hard it flaps its wings. At worst, it’ll go bankrupt.

      Just my opinion, of course, and I could easily be wrong.

  5. Karl says:

    Hi Mark,
    I enjoyed this post.
    Now 3.25 years have passed since that screen of net nets showing a healthy basket of 33 companies, how have things panned out in summer 2015?
    After all, the advice is to roughly hold for up to 3 yrs, since most net nets work out by then.

    Following a quick and superficial look:
    – Cannot find share prices for c.15 of them. That’s a worrying survivorship bias if we assume they failed or delisted or bought out at a higher price? Assume as a group they made 0% over these 3 years.

    Of the remaining 16 companies:
    – buying an equal basket in April 2012 would generate 78% growth in summer 2015 = 24% annual average return, which matches others findings in this decent market.
    – 6 of the 16 are significantly down by >50%
    – 6 of the 16 are significantly up by c.>230%
    – remaining 4 are roughly the same (i.e. a loss relative to the market).
    -4 of the 6 big gainers were builders. If you weren’t invested in them, your returns would be closer to 5% p.a.
    – But factoring in the 15 companies with no details remaining that on aggregate were worth 0% over these 3 years, then the overall basket generated 12% annual average growth (half at 24%, half at 0%). Still beats the market.

    This little snapshot sample would support what Gannon and others advise. With net nets, you either:
    – wait ’til the market offers a basket of at least 20, and then buy all of them and hold for 3 years and replace sellers (or buy 10 at 5% of capital into each to mimic allocation into 20 companies), or
    – be selective and go stockpicking the better net nets from the bad. Gannon likes those with a good % director ownership and a decent Piotroski score above say 6.
    Personally, I think that assessing each companies’ negative news and its probability of producing a negative payoff is important to sifting the diamond nets from the garbage. Also avoid those with the ncav value in gradual decline over the past 5 years. And finally select those that you know, with general business sense, are a business model that is usually cash generative.

    My net nets personally owned as of Aug 2015 that fit the above criteria:
    – Norcon; consultancies are generally cash generative,
    – Skil Ports; creating a port and ports generally have attractive economics (a moat, pardon the pun).
    – Univision; Chinese, but has a key asset off the balance sheet and been trading for many years.
    – MTI Wireless; Operating for years, good % ownership and 7 Piotroski score.

    And watching two more to fall a little. Rejected 11 after examining them for 30 mins each and rejected another 20 after a 1 min glance. This rejection rate is for a concentrated portfolio of 7% of capital into each net net (14 stock portfolio), so the threshold standard is set high.
    But it gives an idea of the work put in to invest nearly a third of capital when investing smaller amounts.
    Cheers.

    • mcturra2000 says:

      Thanks for the feedback. It would be a good idea for me to check on the progress, but I’m a little lazy, unfortunately. Some of the true returns may be a little tricky to calculate. Trading Emissions, for example, was a trust in liquidation, IIRC, so it would be necessary to look at total return to obtain a more accurate picture of the true patters of returns.

      Looking at the list, I see that many of the companies are reasonable. They contain quite a few builders, which would have had a fantastic run since the portfolio was created. Most of the candidates are what you might call “viable”. A noticeable exception is RCG Holdings, which was pretty much a fraud. Polo Resources, which actually had promise, seems to have collapsed. I also have vague recollections of Worldspreads being an effective fraud.

      I suspect that the US markets has many more candidates to chose from than the UK. When I checked for net-nets earlier this year, there seemed to be slim pickings for the UK. The spreads are likely to be horrendous, too.

      Stockopedia has, for example, a Ben Graham NCAV screen. All companies, except one, have a market cap below £40m. The median company has a market cap of around £5m. That it incredibly small. The annualised return since inception, at the end of 2011 was 15.4%. So it was a very good return.

      Their Net-Net screen returned an annualised 14.3%. Again, the companies involved were miniscule, so it’s difficult to know how this would affect the real returns in terms of spreads, slippage, and soforth.

      The returns are quite volatile. Over a 1-year period, the Net-Net screen was down 17.5%, compared to the FT 100, which was down only 1.1%. That is, potentially, quite confidence-shaking, and investors would need to ensure that they can tolerate this risk. Easier said than done!

    • mcturra2000 says:

      I would just like to add a quick caveat about quality measures. Tobias Carlisle, who runs the Greenback’d website, found that it was loss-making net-nets that actually performed the best. By sticking with the better quality businesses, you might actually be harming your performance.

      It could be that all of the real performance happens in “the long tail”, suggesting that you may need to stick to a statistical process, rather than introduce human judgement. The big returns may be in the ones you least expect.

      It probably still pays to avoid fraud, though. I have had a quick look at Stockopedia’s Net Nets screen. They contain names like China Chaintek, Camkids, Jiasen International Holdings, Geong International, and China CDM Exchange Centre; all of which I suspect are frauds. There’s also Asian Citrus, which, while I am not convinced is a fraud, does look iffy, in my view.

      That’s a lot of potential frauds in there (!), and I think the quality of net-nets seems to have deteriorated since my list was originally compiled. I suspect, but haven’t attempted to confirm, that it is the existence of such frauds that have kind-of “floated to the surface” that have lead to the poor performance of the Net-Net screen over the last year.

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