Net-Net Investment Strategy

[ghchua]

Personally I think for Net-Net and Deep Value to work you must be able to control management either by representation in the board or distressed. That's not the game for OPMI

Hi specuvestor,

I beg to differ here. As a minority shareholder, the investment case for net net stocks (or deep value ones) is not to unlock the entire NAV of the company that one have invested. It is almost impossible without a controlling stake in the company. The aim is to unlock as much as possible and if you buy cheap enough, there is some upside for one to capture. 

Let's say you bought a stock at 0.2x book value. If you manage to unlock at 0.5x book value, it can be considered a successful investment case.

[opmi]

Personally I think for Net-Net and Deep Value to work you must be able to control management either by representation in the board or distressed. That's not the game for OPMI

Hi specuvestor,

I beg to differ here. As a minority shareholder, the investment case for net net stocks (or deep value ones) is not to unlock the entire NAV of the company that one have invested. It is almost impossible without a controlling stake in the company. The aim is to unlock as much as possible and if you buy cheap enough, there is some upside for one to capture. 

Let's say you bought a stock at 0.2x book value. If you manage to unlock at 0.5x book value, it can be considered a successful investment case.

Yes. the margin of safety can grow with the valuation (book value etc) of the assets grows with it. Even if stay at 0.2x BV. also make $ already.

One different way of thinking about net-net assets is it does not have to be cash or receivables or short term investments.
The problem with net-net S-chips is people tends to focus on the cash, rather than the assets.  

Can be property under development or investment prop or factory land in PRC/VN/Msia/SG . Though percevied to be illiquid,
investment properties can be sold quickly at <20% discount eg the Shanghai service apt (sold) owned by HLGE.

Can also be property projects. These projects are 'self-liquidating' in nature. 

In fact, any business that is consistently cashflow generating can be sold, water plants with offtake agreements, power plants with PPA, ships etc

The problem with property developers is that they want to build an empire and continue to roll. So small chance of getting special div.
The best is that the assets is non-core, that has grown in value over the years.

The above thinking is learned from Marty Whitman/Third Avenue one.
 
The underlying idea is that OPMI and controlling shareholders must have alignment of interests, for the near term. That is the best OPMI can realistically hope for.

[specuvestor]

Hi ghchua

For a company that goes 0.2X Book there is already a trail of bodies along the path. And as usual we think we won't be one of them

So in order for OPMI to benefit one has to buy at almost near bottom with near perfect timing (not forgeting that a stock that's down 90% is one that's down 80% and then halved again), have patience to hold on and then like you say get a LOW BALL offer. Even if undervalued assets are sold, it is still stuck in the structure which in the first place, the market don't trust management to be kind to OPMI. You have to somehow take care of yourselves. There are many ways to drain off cash without going through OPMI.

I don't think this is a 1 foot bar to cross. It's sexy for cocktail talk to charm people about stock picking skills and a great ego booster but I don't think it's a consistent strategy for OPMI.

And yes as per VB opmi mention, relistically you can only hope to read management's mind to have alignment of interest. Corollary is that in the first place if they don't care about shareholders then this alignment is going to get very difficult, except to guess where they going to place their next chess piece. It's not an investment game anymore. It's a chess game. Otherwise you have to be management yourself.

Buffett had to negotiate directly with management to get his cigar puff as well, which is why to some he was considered an activist investor in his early days
https://superiornorthllc.com/2019/09/08/...investing/

Personally I think for Net-Net and Deep Value to work you must be able to control management either by representation in the board or distressed. That's not the game for OPMI

Hi specuvestor,

I beg to differ here. As a minority shareholder, the investment case for net net stocks (or deep value ones) is not to unlock the entire NAV of the company that one have invested. It is almost impossible without a controlling stake in the company. The aim is to unlock as much as possible and if you buy cheap enough, there is some upside for one to capture. 

Let's say you bought a stock at 0.2x book value. If you manage to unlock at 0.5x book value, it can be considered a successful investment case.

[ghchua]

Hi specuvestor,

There are few thoughts on this in my mind. But I think maybe I take a few successful generic case examples for net-net or deep value cases, without giving specific names. Note that I am using your same structure example, that is, without any unlocking of value via big special dividend payout from cash holdings and/or asset sales or change in controlling shareholder or a hostile bid etc.

1. A company trading at 0.2x book. Few years later, it is still trading at 0.2x book. But because book value has increased for the past few years (mainly due to revaluation of investment properties and/or development profits), share price tracked the increase in book value. Minorities can choose to exit after a few years, even if assets are locked in the structure you have mentioned.

2. A company trading at 0.2x book. There is a low ball offer as I have mentioned. Minorities can choose to exit via the exit offer. Again, the structure is still the same.

3. A company trading at 0.2x book. But market suddenly realized their investment properties are valued at cost less depreciation in their balance sheet, and their revalued NAV is actually much higher than the reported one due to accounting treatment of investment properties. Market re-rated the same stock at 0.2x book, but at 0.2x revalued book value. Minorities can choose to exit. Again, the structure is still the same.

4. A company trading at 0.2x book. But market suddenly realized that there might be redevelopment potential in some of the assets in their balance sheet. Seems like some hotels or offices are sitting on valuable freehold land at good locations. Market re-rated the stock. Book value is not revalued as those freehold land are being sat on by operating assets. Minorities can choose to exit. Again, the structure is still the same.

I just gave 4 cases here for net-net or deep value which are exit opportunities for minorities which are stuck with the same structure as you have mentioned. I am sure there are many more which I missed out, but I think I will just end here.

[specuvestor]

Hi ghchua

Firstly we are using an extreme case of 0.2X book. I’m sure many thinks 0.5X is cheap enough as well. That’s why I said there had been bodies on the trail to 0.2X

But I’m also sure that there are those who made good money on picking net net just as there are traders good at catching a falling knife or professional gamblers. Point is I don’t think this is a consistent strategy for your average OPMI

If you have a long enough track record you can calculate your CAGR over this period vs a stock index benchmark for opportunity costing. You could be very successful but the probability is that the tenor would severely crimp the returns unless like I said previously, your timing is superior

In case 1 it’s definitely unusual for a growth company that trades at such valuation. However the probability that these are s-chip or Suharto era high inflation Indonesia type of stock is much higher. My experience is that it is more likely such stock starts at 1X book and trades down to 0.5X book as time goes by. If you able to get 0.2X book and trust the management (yes again management) that’s really a gem

2-4 are generally the catalysts needed for deep value stocks. So again there’s usually a reval initiated by management either by valuation, JV, sale, spinoff etc. Again it depends on management. Very unlikely a company holds say a valuable land in their balance sheet and book goes 1X to 0.2X over extended period of time, and suddenly mr market wakes up WITHOUT human intervention

So does deep value works for OPMI? Yes it does sometimes but on the timing of catalysts, whether internally from management or external activists or institutional bargain hunters, that determines your CAGR. But timing and tenor is uncertain and can be excruciating if you have been to AGMs of such companies. I do not talk from a theoretical point of view: I too have held deep value stocks for years before giving up and the stock rerate years later.

“First, the original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.”

[ghchua]

Hi specuvestor,

As I have said before earlier in this topic, you need to hold a portfolio of deep value and net net stocks for the strategy to work. If you don't like s-chips, you can filter them out. If you are unsure of the timeline, you set say a 3 year target for each stock. If it doesn't happen, you sell the stock after 3 years and replace it with a new net net or deep value stock. Repeat for the other stocks in your portfolio. But still, you need a portfolio of stocks.

Having a portfolio of stocks will spread out your exit time risk of only few stocks that exhibits these characteristics. So, this will address the timing issue that you have cited.

As for the few case examples that I have cited, the problem is that the market is not as efficient in some of these deep value stocks. Re-rating can come without the management having to initiate anything. Like government having a future master plan in some areas that the company holds land in, noises from the market that the company is selling their investment properties etc. These are exit opportunities which minorities can take note of.

[Wildreamz]

Hi specuvestor,

As I have said before earlier in this topic, you need to hold a portfolio of deep value and net net stocks for the strategy to work. If you don't like s-chips, you can filter them out. If you are unsure of the timeline, you set say a 3 year target for each stock. If it doesn't happen, you sell the stock after 3 years and replace it with a new net net or deep value stock. Repeat for the other stocks in your portfolio. But still, you need a portfolio of stocks.

Having a portfolio of stocks will spread out your exit time risk of only few stocks that exhibits these characteristics. So, this will address the timing issue that you have cited.

As for the few case examples that I have cited, the problem is that the market is not as efficient in some of these deep value stocks. Re-rating can come without the management having to initiate anything. Like government having a future master plan in some areas that the company holds land in, noises from the market that the company is selling their investment properties etc. These are exit opportunities which minorities can take note of.

In the original Ben Graham Security analysis, he even had explicit formulas to determine what's a Net Net and the expected returns, and a holding period of 3 years etc.. But those are just heuristics based on experience and trial and error in the 1930s - 1950s era etc (https://www.netnethunter.com/net-net-sto...n-formula/).

Nothing ensures such a strategy will definitely work out and beat the market every time today. But I agree, proper diversification (20-30), and the option to gain majority stake (or outright acquire) to influence management to unlock value of the company (e.g by liquidating assets, and distributing them to shareholders) would probably maximize the probability of success of such a strategy.

[Corgitator]

Just want to share my two cents. I used to do a lot of deep value (net-net, cigar butts, NCAV, whatever you call it) investing many years ago. It's very profitable in terms of % returns, but I have been doing less and less of it largely because of scalability/liquidity issues (curse of having a bigger capital pool).

1. Catalyst is overrated - most investment thesis with a catalyst never quite have the catalyst play out the way they imagined, or an entirely different catalyst comes to play. To me, time is the best catalyst. In an ideal world, we want to take control of these net-nets, and commence liquidation (similar to what Buffett was doing to Sanborn Maps etc in his early years). But even without control, the returns are good so long as the assets are legitimate (emphasis added). The reason being that humans are greedy and there are millions of investors looking for a good deal everyday. If you see a legitmate asset selling for dirt cheap prices, you wouldn't expect the price to stay low for long. For the net-nets that worked out for me, they usually undergo a valuation re-rating, gets taken over, or there's some huge capital reduction that resulted in substantial investment gains.

2. You need to be patient with net-nets. As mentioned above, time is your best catalyst. Two important caveats: the assets need to be judged legitimate (and this requires a certain skill set to do well, or you will end up with many S-Chips as pointed out), and the degradation of asset value needs to be slow (no point buying 50-cent dollars if the dollar is declining by 25 cents every year). This is arguably the hardest part to do, and people who can't do this well tend to dismiss deep value investing because it didn't work for them.

3. It's all about asymmetry in returns at the end of the day. From my experience, I lose some money in 45% of my net-nets, make some money in 50% of my net-nets, and hit a huge winner 5% of the time. If you've done the analysis correctly (as per part 2), the losses will not be significant because of MOS, the small gains will not be significant either because at the end of the day the business is mediocre, but it's that 5% of huge winners that generate all the alpha. While it's arrogant to say so, but I actually disagree with Graham's rule to sell after a 50% gain. Given the extreme pessimism in such businesses, the ones that did end up turning around give you huge returns (people might forget that AEM used to be a net-net).

4. Finally, the approach goes through periods of booms/busts (like all approaches). If you look at SG now, there's barely any net-nets with sufficient liquidity (just a handful). These stuff are available in abundance after a crash. But of course, there's always Japan, a weird country where there's always many net-nets (high quality ones as well).

[opmi]

To add to this discussion: If an OPMI acquire a sizable stake of a net-net, usually it is like Roach Hotel....can check in but cannot check out...because of little liquidity.
So to self-create a catalyst or influence the mgt, it takes deep pockets, longer inv horizon, high conviction, sado-maschoistic tendency or/and craziness.
If looking for 50% or 1x, probably not worth the risk. Maybe 3-5x.

In my opinion, many OPMI are lazy bunch of NATO free-riders (myself included sometimes) who dont support the collective effort - in context of defending low-ball offers/screwing by IPTs. Hahaha.

[money]

To add to this discussion: If an OPMI acquire a sizable stake of a net-net, usually it is like Roach Hotel....can check in but cannot check out...because of little liquidity.
So to self-create a catalyst or influence the mgt, it takes deep pockets, longer inv horizon, high conviction, sado-maschoistic tendency or/and craziness.
If looking for 50% or 1x, probably not worth the risk. Maybe 3-5x.

In my opinion, many OPMI are lazy bunch of NATO free-riders (myself included sometimes) who dont support the collective effort -  in context of defending low-ball offers/screwing by IPTs. Hahaha.

To add on, it is probably not difficult to pick up the methodology of analysing net-nets. Takes effort of course

But to eventually make better than average returns, you will need the right character and mindset to stay the course, and possibly also know when to sell

Alternatively, stick with big cap stocks with decent ROE to get average returns, that's probably what most of us deserve