Net-Net Investing: Method, Examples, and Insights
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Summary:
Dive into the World of Net-Net Investing: A Comprehensive Guide Unlock the secrets of Net-Net investing, a strategy introduced by renowned economist Benjamin Graham. Net-Net investing assesses a company’s stock based on its net current assets, with a keen focus on cash and short-term assets. Ideal for short-term gains, this guide delves into the methodology, formula, and key takeaways, while addressing its criticisms. Comprehensive examples illustrate its application. Whether you’re a seasoned investor or a novice, explore how Net-Net investing can be a valuable addition to your investment portfolio.
Unveiling the secrets of Net-Net investing: A comprehensive guide
In the realm of value investing, one methodology stands out for its simplicity and focus on short-term gains: Net-Net investing. This technique, initially developed by the celebrated economist Benjamin Graham, revolves around evaluating a company’s stock based on its net current assets per share (NCAVPS). In this comprehensive guide, we will explore the nuances of Net-Net investing, dissect the key takeaways, dive into the formula behind it, address criticisms, and highlight its special considerations.
What is Net-Net?
Net-Net represents a unique approach to value investing. It appraises a company’s stock by concentrating solely on its net current assets per share (NCAVPS). This method holds current assets in high regard, treating cash and cash equivalents at full value. It also adjusts accounts receivable for doubtful accounts and reduces inventory to liquidation values. The crux of Net-Net value lies in deducting total liabilities from these adjusted current assets.
The formula
The formula for net current asset value per share (NCAVPS) is:
NCAVPS = Current assets – (Total liabilities + Preferred stock) ÷ # Shares outstanding
According to Graham, investors will benefit greatly if they invest in companies whose stock prices are no more than 67% of their NCAV per share. And, in fact, a study done by the State University of New York showed that from the period of 1970 to 1983 an investor could have earned an average return of 29.4% by purchasing stocks that fulfilled Graham’s requirement and holding them for one year.
However, Graham made it clear that not all stocks chosen using the NCAVPS formula would have strong returns, and that investors should also diversify their holdings when using this strategy. Graham recommended holding at least 30 stocks.
Special considerations
Net-Net investing defines current assets as assets that are either cash or can be converted into cash within 12 months. This includes assets like accounts receivable and inventory. These current assets are then reduced by current liabilities, such as accounts payable, to calculate the net current assets. The beauty of this approach is its laser focus on the cash a company can generate within the next 12 months, with no consideration for long-term assets or liabilities.
Criticisms
The reason net-net stocks may not be a great long-term investment is simply because management teams rarely opt to liquidate a company at the first sign of trouble. In the short term, a net-net stock may make up the gap between current assets and market cap. However, over the long term, an incompetent management team or a flawed business model can quickly erode their balance sheets.
For instance, the rise of e-commerce giants like Amazon.com has forced many retailers into Net-Net positions over time. In the short term, some investors may profit from these stocks, but the long-term outcome is less promising. Many of these businesses have gone bankrupt or been acquired at discounted prices, emphasizing the perils of relying on this strategy without considering the broader market landscape.
Understanding Net-Net investing
Benjamin Graham introduced the Net-Net strategy at a time when financial information was not as readily available, and net-nets were more accepted as a company valuation model. When a viable company is identified as a net-net, the analysis focused only on the firm’s current assets and liabilities, without taking other tangible assets or long-term liabilities into account.
Essentially, investing in a net-net was a safe play in the short term because its current assets were worth more than its market price. In a sense, the long-term growth potential and any value from long-term assets are free to an investor in a net-net. Net-net stocks will usually be reassessed by the market and priced closer to their true value in the short term. Long term, however, net-net stocks can be problematic.
Special considerations
Net-Net investing defines current assets as assets that are either cash or can be converted into cash within 12 months. This includes assets like accounts receivable and inventory. These current assets are then reduced by current liabilities, such as accounts payable, to calculate the net current assets. The beauty of this approach is its laser focus on the cash a company can generate within the next 12 months, with no consideration for long-term assets or liabilities.
Comprehensive examples
Let’s explore some comprehensive examples to better understand Net-Net investing:
Example 1: XYZ Corporation
XYZ Corporation is a small manufacturing company with a market capitalization of $5 million. Its current assets, including cash, accounts receivable, and inventory, total $2 million. The company’s total liabilities are $1 million, and it has no preferred stock outstanding. The number of shares outstanding is 500,000.
To calculate the NCAVPS:
NCAVPS = $2,000,000 – ($1,000,000 + 0) ÷ 500,000 = $2
Based on Graham’s recommendation, an investor could consider purchasing XYZ Corporation’s stock if it’s trading at no more than 67% of its NCAVPS, which would be $1.34 ($2 * 0.67).
Conclusion
In conclusion, Net-Net investing is a unique and time-tested approach in the world of value investing. It primarily appeals to investors seeking short-term gains, as it bypasses the complexities of long-term asset and liability assessments. However, it’s crucial to recognize that the Net-Net strategy comes with its set of limitations, and its efficacy can vary based on market conditions and individual stock performance.
Before embracing the Net-Net approach, consider your investment goals and risk tolerance. If you are looking for short-term opportunities with a focus on current assets, Net-Net investing might be an attractive strategy. However, if your investment horizon extends beyond the short term, you should explore other investment strategies that consider long-term factors.
Frequently asked questions
How is Net-Net value calculated?
Net-Net value is calculated by deducting a company’s total liabilities from its adjusted current assets, which include cash, adjusted accounts receivable, and inventory reduced to liquidation values.
Why is Net-Net investing considered a short-term strategy?
Net-Net investing is considered a short-term strategy because it primarily focuses on a company’s current assets and does not consider long-term assets or liabilities. This approach aims for quick gains based on current asset valuations.
What are the criticisms of Net-Net investing?
Net-Net investing faces criticism due to its reliance on the assumption that a company will liquidate at the first sign of trouble, ignoring long-term potential. Additionally, it may lead to investing in troubled companies that do not recover.
Is Net-Net investing suitable for all investors?
Net-Net investing may be suitable for investors seeking short-term opportunities and willing to accept the associated risks. It is not ideal for all investors, especially those with a long-term investment horizon or risk-averse individuals.
Key takeaways
- Net-Net is a value investing strategy developed by Benjamin Graham.
- It evaluates a company’s stock based on its net current assets per share (NCAVPS).
- Current assets, including cash, accounts receivable, and inventory, are the focal point.
- This strategy is geared toward short-term investments and does not consider long-term assets or liabilities.
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