Tuesday, December 2, 2008

All Net-Nets Not Created Equal

Ben Graham, oft considered the father of value investing, found that buying companies trading at a 33% discount to their Current Assets minus Total Liabilities offered investors great returns. The idea is that even at liquidation the investor will get more than his investment, but chances are things will turn around before that's required. For many years, stocks trading at such discounts were near impossible to find in North American markets. Today is a different story, however, as fear has driven the market to such levels that once again stocks such as these exist in droves.

But not all such companies are worth investing in. If the company is burning its assets due to floundering operations, well its liquidation value won't be worth much at all! Consider Shermag (SMG), a furniture manufacturer and distributor. Last year, it had current assets of $48 million and total liabilities of $36 million, yet it was trading at a market cap of just $6 million.

Great value? Hardly not. The company has lost about $15 million per year for the last three years. As it burns through its assets in this manner, it quickly erodes any balance sheet value it appears to have.

When looking through net-nets, be sure to keep in mind that not all of them offer great value. It takes patience and an understanding of the underlying business to ascertain whether you've found a diamond in the rough.

6 comments:

VISHNU said...

Hi,

You are writing nice articles in this blog. I am regularly reading your articles. I want to add below comments on Net Nets

Net Net is just a screening method. Graham gave fantastic example in terms of American Laundry Machine. As per the example Liabilities should be taken 100 % basis. (Since it can be understated I feel it should be taken 120% basis).Inventory should be taken as 60% basis. Accounts receivable should be taken as 85 % Basis.
This again depends on Industry. Cigarette Manufacturer’s Inventory can be taken as 100% Basis.

I also feel that most of the stocks you will see in Net Net is a Capital Heavy Companies. If you Screen the stocks by Net Net then filter the stocks based on their corresponding discounts (Inventory etc) and then remove all capital heavy companies ,You will end up with bargains.

Regards
Vishnu

kashah9 said...

BK,

Hi. I have a basic question on NET-NETS. How do you define Total Liabilities??

Kaushal.

Saj Karsan said...

Hi kashah9,

Basically the line item on the most recent balance sheet called "Total Liabilities". This is mostly comprised of what the company owes other parties.

kashah9 said...

Hi,

Got that. Here in India, the line Total Liabilities means Shareholders Funds + Total Debt. Usually Current Liabilities are not shown with Total Liabilities but are deducted from Current Assets. So, according to you (and as per Ben Graham) Total Liabilities means Shareholders Funds + Total Debt but excluding Current Liabilities. Sorry...but I'm trying to understand this properly...

Kaushal.

Saj Karsan said...

Hi,

It sounds like there is quite a difference between Total Liabilities in the US and in India. The Total Liabilities I refer to includes current liabilities, and does not include shareholder equity (but would include any shareholder loans that might be owed to specific shareholders).

kashah9 said...

Many many thanks...

Kaushal.

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