Profitable Net Net Stocks: Produce Greater Returns

This article on profitable net net stocks was written by Net Net Hunter member Bryan Shealy. Bryan worked in the inventory business for 5 years which gives him an edge in net net investing. Article image (creative commons) by Marco Verch, edited by Broken Leg Investing.

What if I told you that there were net net stocks that were just begging for your money? Let me let you in on a little secret. Normally, companies begging for money are losing it by the boatloads; however, there are companies selling for less than their net current asset value (NCAV) alone! That's not even the best part — these companies actually make a profit!

If you’re often wondering if you’re investing in the right types of stocks, use the advice you’ll read here to sift through the millions of stock choices to find the handful of profitable net net stocks that will net you the highest returns.

What Are Profitable Net Nets?

When we talk about profitable net net stocks, we’re specifically referring to stocks that have remained profitable after falling below NCAV or below its net current asset value. These are net nets that are still increasing in both net asset value, or shareholder’s equity.

We’re not talking about stocks that have had a one-time windfall due to the sale of an asset or have been profitable off and on. It seems astounding that such steady-earning stocks even exist! But they do, and what kind of returns can we expect from them?

Profitable Net Net Stock Performance in Context

It should come as no surprise that some net net stocks perform better than others. So, where do profitable net net stocks rank?

The below returns were taken from Tobias Carlisle study in Ben Graham’s Net Nets: Seventy-Five Years Old and Outperforming:

Net Nets, in general, returned 2.55% as a group. Now let's take a look at net nets with positive earnings that may pay a dividend.

These firms returned quite a bit less, at 1.96% as the dividends in the sample brought down the overall return. Let's take a look at a sample of net nets with positive returns and don’t pay dividends.

The returns jump to nearly that of the group as a whole at 2.42%. While owning shares in companies that produce dividends may be a safer bet, that safety results in a much lower return especially when compared to the group.

Immediately you’ll be asking why we should focus our money on profitable net nets when they produce a return just below net nets as a group. Don’t the statistics above imply that it makes sense to focus on money-losing net nets?

Maybe, if you’re a mechanical investor. But there are some serious advantages to profitable net net stocks if you’re prepared to dig beyond the basic stats.

One Reason to Focus on Profitable Net Net Stocks: Increasing Value

As a group, profitable net nets have a performance in the middle of the pack, so why focus on them?

The answer comes down to a difference between mechanical investing and more hands-on net net investing that incorporates qualitative analysis. As Buffett said when he was running his partnership, solid quantitative investing produces solid returns but serious returns are on offer for investors who can spot a good qualitative opportunity. Increasing earnings hints at one such situation.

A simple web search reveals a company's current earnings and performance history. If it has been consistently profitable, the company is increasing in value as its NCAV rises. This compounds your future returns even if the stock price remains stagnant or drops with the market.

Let’s assume you purchased stock in the fictional company Cherry Power at 100, for example, which has a NCAV of 200. If the company earns 20 during the year, and these earnings show up in the company’s current asset accounts, the company would be worth 10% more on a NCAV basis. But, where your stock would have to rise 100%, from 100 to 200 the previous year, it now has to rise 20% more, from 100 to 220, to get back to fair value. Buying profitable net nets, such as Cherry Power, reduces the risk of holding stocks that fail to rise for an extended period of time.

Profitable Net Net Stocks: Growth in Value

A special investment opportunity where a company’s management is busily growing the firm’s earnings year after year can be an exceptional investment. Yes, growth stocks do exist in the world of net net investing. Here, the company is priced below NCAV but also rapidly increasing its earnings per share, providing safety of principle through its discount to NCAV and a good chance of a good profit both through this discount and future growth. This is exactly what made Shelby Davis so rich.

So, the net current asset value (NCAV) is increasing and the company is producing profits; this is where many profitable net net stocks begin to diverge. How do you spot the more promising situations?

There are multiple ways a company can use its profits to increase value — some better than others. Let's identify a few of the positive ways a profitable net net stock can increase its value and compound growth.

The first method is buying back shares. Through purchasing shares management can achieve two goals: avoiding mistakes with capital allocation (spending on the wrong stuff), and increasing shareholder value for remaining shareholders (by increasing earnings per share (EPS) and buying net current assets for much less than they can be liquidated for).

It is important to note that simply increasing EPS by buying back shares will not necessarily create value for a company. The shares need to be repurchased for less than the company’s intrinsic value in order to benefit long term shareholders.

According to The Value of Share Buybacks: by Magnus Erik Hvass Pedersen. Shareholders should assess:

If the company has sustainable debt and it has made all investments and acquisitions that are available with satisfactory expected returns, and the company still has cash in excess of what it will likely need in the future, then the choice is between dividend payout or share buyback. Share buybacks should only be made when the share price is sufficiently low compared to the value to eternal shareholders.

Only after debt and other possible investments have been made should a company engage in share repurchases. With profitable net net stocks, since they have so much cash on hand, it will likely be value-enhancing.

As Magnus Pedersen has said in the above paragraph if you are buying back shares in your own company, debt, and other possible investment opportunities must have been evaluated and considered. Simply buying shares in an undervalued company cannot produce long-term beneficial results if the company is not increasing its earnings. Eventually, cash-heavy net net stocks will become cash neutral and begin to stagnate.  

Profitable net net stocks can instead look for undervalued assets among competitors or suppliers. This could lead to a two-fold benefit — it would create a change in future prospects, and it could create vertical integration and economies of scale.

Vertical integration is essentially purchasing parts of your supply chain in order to gain the benefit of controlling the flow of product from raw materials into finished goods. This helps reduce transaction costs and increases communication while aligning company goals.

Through management’s careful analysis of investments, acquisitions, and share buybacks. Profitable net nets can increase the value of their stock even while the stock price is falling.

Problems with Profitable Net Nets

Why are profitable net net stocks so cheap? What went wrong?

Not all investments in profitable net net stocks end so cheerily. A profitable net net stock may soon become unprofitable due to rising competition and falling sales. Net nets become net nets due to major business problems, after all.

As an example of this, the current quarter results may be rosy, but due to something extraneous such as depressed commodity values that don’t take effect until the next quarter, the future has a much less rosy outlook. There may even be a pending lawsuit that is depressing share value but not yet impacting the bottom line.

Technology creates another issue with profitable net nets. If profitable net nets do not invest in new technology — or worse, a new technology completely erases the need for the firm’s product or service — a profitable net net will soon become unprofitable. This is why it is important to perform a qualitative analysis to determine if the company can remain profitable in the future.

These issues will drag down the share price — especially in the near term. Often investors buy net nets only to see the price drop further for these very reasons. However, as long as management invests in the company’s future and takes the correct steps profitable net net stocks can remain profitable and increase in value at a steady pace.

Profitable Net Net Stocks with a Dividend

Today, a lot of investors seek out dividend paying net nets, such as Broken Leg Investing’s Pay Daddy net nets. These firms are great selections for income investors. But, their lower returns as a group also suggest a common downside to the investment situation.

One explanation is that in many cases, a profitable, dividend-paying, firms trading below net current asset value may retain their dividend out of fear of displeasing longtime shareholders rather than spend the cash on a smart acquisition or business investment. For example, a profitable net net may be stuck in a cycle of stagnation due to a longtime dividend it has issued its shareholders, where the money would be better spent on developing software or a new line of shoes to boost earnings. Dropping this dividend would mean upsetting income investors and could send the share price into freefall.

Tobias Carlisle explains what Benjamin Graham favored in deep value stocks in his paper, Ben Graham’s Net Nets: Seventy-Five Years Old and Outperforming:

“Graham frequently recommended that it was best to select NCAV securities that had positive earnings and paid a dividend.”

If the great Benjamin Graham recommended that you buy shares in companies producing profits and issuing dividends, then that surely must be the best way to go, right?

Many net net studies have shown that companies that have no dividend and produce positive earnings result in higher returns than companies with dividends. The difference here is the risk. Graham was obsessed with reducing risk, not losing money. Graham also stated, and researchers have since found, that dividend paying net nets have the lowest systemic risk of the group. More tend to work out. In Graham’s case, he simply determined that the additional systemic risk of net nets that failed to produce a dividend was not worth the extra group returns.

Conclusion

Deciding which profitable net net stocks to invest in can be a complicated matter. At the end of the day, net net investing really comes down to risk vs reward. While profitable net net stocks are often increasing in value, not all are created equal and there are a number of ways to boost your returns or manage your risk.

Net Net Hunter can help identify these return-boosting traits and push you to become a better investor.

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