Wednesday, June 24, 2009

Don't Just Buy Any Net-Net

During recessions, with this one being no exception, value investors usually rejoice at the opportunity to purchase stocks at discounts to their net current asset values. That is, stocks that trade for less than their current assets minus their entire liabilities. While purchasing an "index" of net-nets should result in above average profits (if history is any guide), further careful analysis can lead to even higher returns.

Not all net-nets are worth investing in. If the company is burning its assets due to floundering operations, its value (liquidation or otherwise) 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. 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. Today, it trades for $300,000, but the drop in value should have caught no one by surprise.

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.


Anonymous said...

If a public company is burning through its assets in order to continue operating (as opposed to in order to satisfy its liabilities), wouldn't the better decision be to liquidate it? At some point, new directors should be elected by some angry shareholders, with a mandate to either turn the fortunes of the company around or to liquidate. Do you agree? If so, might opportunities be present around the time when new directors are appointed?

Saj Karsan said...

I agree that the better decision would be to liquidate it. Unfortunately, that doesn't always happen, and new directors/management may think they can turn the company around, burning assets in the process.

Anonymous said...

When a company is "burning" through it's assets, wouldn't that mean the company is producing positive cash flow?

Saj Karsan said...

I guess it depends on your definition of burning, and what is being done with any cash that is produced.