Buying Net-Nets: What is the Right Margin of Safety?

A guy emailed me the following question after reading my report on Japanese net nets:

Hey Gurpreet,

When investing in net-nets, where do you set your Margin of Safety? Graham bought at 2/3 NCAV. Do you subscribe to that? Obviously the line gets blurred when a company is selling at NCAV but the majority of those assets are cash. Do you have a hard and fast rule before you start or stop buying a net-net? And if you were buying at 2/3 NCAV do you use a discounted NCAV, such as inventories only worth 50%, receivables 75%, etc, or just buying at a 2/3 discount to non-discounted NCAV?

I don't have a one-size- fits -all approach towards investing in net- nets. And I do not think value investing in general could be boiled down to any neat equation or an arcane formula. But then yes for value investors it’s vital to set up a margin of safety.  A decent margin of safety. How much? That depends upon quality. Quality of assets and quality of earnings. And the starting point of setting up my margin of safety depends upon these two factors. 

Before I delve further let me tell you that if we are doing value investing especially in the Graham tradition we want to make sure that  we don't just want to read Graham's rules superficially  and miss the spirit of his writing . The subtext of 2/3 this rule is that we cannot determine exact asset values from the balance sheet. As he says in his seminal work Security Analysis that the first rule in calculating liquidating value is that all liabilities are real but the value of the assets must be questioned. The values of most assets are arbitrary except cash.Moreover, the assets especially the liquid assets could be squandered by the management or burned by a bad operating business causing asset values to shrink. So to get margin of safety we have to look for sufficient gap between the net current asset values and the price what Mr. Market is assigning to the company.

Like investment beta which aims to quantify risk but utterly fails to measure it, relying solely on 2/3 rule to measure margin of safety in today's market is flawed.

Also keep one thing in mind about Mr Market and that not only he is manic depressive but evolving everyday too. Especially the American Mr Market. Every day he is getting more efficient and smarter. And he has become lot more efficient today than he was at Graham’s time.

He has become more efficient now because there are more people than before who are looking for value. So there is a high competition. We have the internet where it takes seconds to dig into stuff, access reports and transfer funds to buy stocks anywhere in the world . It has become extremely difficult if not impossible to buy stocks trading at 2/3 of their net- net values.

That is why Walter Schloss said in an interview that after net-nets stocks disappeared they had to lower their standards and look for stocks trading below book values. The idea is to buy stocks trading cheap relative to all asset values. And he said he does it because to buy earnings at discount he has to know more about the business. So he went for an extremely diversified portfolio.

Actually most net-nets deserve to be net-nets because of a terrible underlying business with a long history of operating losses. And that gradually erodes cash and current assets so it could cease to be a net-net after some time. What you want to look for in a net- nets is a business that's not a cash guzzler because if it is one then that can easily change the other side of the equation. And that could shrink the net current asset value over time .Time could be a brutal enemy indeed of this kind of a crumbling business.

So you may look for other positive factors that corroborate this margin of safety. It could be excess cash relative to assets. It could be high return on invested capital. It could be ten straight years of positive operating income. Good management, ample free cash flows and /or combination of all the factors above. In a nutshell, look at business quality that comes from its ability to generate high returns on capital and ability to generate good free cash flow consistently. Some kind of competitive advantage. Again that’s extremely rare to find all this in net-nets stocks. 

Or you may choose not to probe deeper into the business but invest using the statistical approach. So you go for extreme diversification.  That is fine although this is something I can't do because I can’t help delving into 10-K’s,10-Q’s and proxies. And as I said before Mr Market is far smarter now than it was before I also need to answer this key question in my mind: what makes this stock mispriced? 
But more often you will find a business that doesn’t generate acceptable returns on equity or invested capital and could still be a bargain. Japanese net-nets are a good example of these kinds of businesses. Not able to deploy cash to earn high returns they allow cash to build up on their balance sheets. The result: they end up earning paltry returns on equity. 

As I said in first paragraph I look for quality of assets and quality of earnings in a net-nets. And depending upon that I am willing to sacrifice the gap between value and stock price.

From assets perspective I mean the liquid assets in total assets. The more liquid the assets the better margin of safety you get.  Excess cash relative to low liabilities stares at you from the balance sheet and could indicate cheapness. This is obvious. Although keep in mind that it is not completely fool proof. After all it’s liquid -which a bad management can easily piss especially when it has got it in plenty. TV Today which is an Indian stock is a good example. If you take a peek at its 2008 balance sheet you will find it held $22 million in liquid funds. And the stock was trading at enterprise value to operating cash flow of just 3. A clear bargain. But over the next 3 years the management continually squandered the funds into its radio business which resulted in cash of less than $ 5 million in 2011 balance sheet. The terrible radio business that churned out delicious jingles chewed up all the cash.

The problem complicates further when we consider inventories. In researching the Japanese net-net stocks for my report. I used the Price /NQAV ratio instead of usual Price /NCAV. NQAV means Net Quick Asset Value.  Net quick assets are assets which can be turned quickly into cash. Basically, they are cash, securities and receivables.  They do not include inventories. By deducting inventories from current assets we arrive at a better, more liquid asset values and hence greater margin of safety. The problem with inventories is manifold.  It could become obsolete fast like microprocessors or it could be overvalued .You cannot take these at their face value. You will have to know more about the business.

The following excerpt from the famous Tweedy Browne fund's annual report of 1995 perfectly illustrates my point.

In the early 1980s, we had an investor in one of our investment pools who thought he could make just such a selection. Rather than paying us as managers, he redeemed his investment of $100,000 and bought what he believed was the cheapest stock among more than 80 in the portfolio. The company, Lazare Kaplan International, was a diamond wholesaler. At the peak of the diamond market, the market value of its inventory of stones less all liabilities on a per share basis far exceeded the market price of the stock. However, when the bottom fell out of the diamond market, an event few had predicted including us. The value of Lazare Kaplan's inventory plunged and the company was forced into bankruptcy. This was one of the few investments we have owned which suffered this corporate fate.

So you have to look at the quality of assets to arrive at margin of safety. The better quality of assets a net-net boasts the less discount you may be willing to take.  The better the management that controls these assets the less discount you may be willing to take. The better return on these assets the business cranks out year after year the less discount you may be willing to take.

And most important thing: earning power and and its quality. Earnings that are backed up by cash flows. Especially free cash flows. I want to emphasize this because I look at so many net- nets that have bloated inventory and accounts receivables that soak up all the operating cash flows –the life blood of the business. How long do you think will the business be able to continue that?
I also made this point in my Japanese net-nets report.  I gave a bath tub analogy.

Allow me again to quote from the report:

Sometimes what appears as a value stock becomes a value trap because the terrible underlying business that burns cash. So some businesses do deserve to be net -nets. Forever. Which is a better Bath tub? One which perpetually drains its water. Or the one that sports a fancy faucet which keeps on flushing the liquid into the tub. I prefer the latter. Therefore I also looked for ample free cash flow that ensures plenty of ‘supply’ of cash into the company from its operations

So I would rather go for a business that trades tad lower to its net current asset value but has an above average business quality than a poor business that sports a larger discount to its net current asset value. 

People look for net-nets and the first thing they want to know is whether it is going to liquidate or would make an activist target. That’s a wrong approach. The net nets should be chosen for their inherent cheapness and not in a hope for liquidations.

Agreed Graham talked about liquidation value but that was because he used to - it seems to me - assume the worst case scenario: Liquidation .And whether it possible to get his capital back or not. For example , he told Walter Schloss about GEICO that “If this purchase doesn’t work out we can always liquidate and get our money back.” That's why he preferred liquid assets.

Basically Graham liked these stocks because they were clearly selling for less than what  they were worth conservatively.

Warren Buffet during his early partnership days –when he was buying these kind of stocks -once said he doesn’t count on making a good sale. He just buys at a price so attractive that even a mediocre sale gives good results. Walter Schloss also aptly observed: “A stock well-bought is half-sold.”
And here's one of my favourite investors Dr. Michael Burry, who eloquently spills in his fund’s letter:

In fact, at all times I strive to buy stock at prices per share that no acquirer could ever pay for the whole company – not because the prices are too high, but because the prices are so low that a potential acquirer proposing them would be laughed out of the boardroom. Such is the opportunity afforded by the very human market for common stocks. 

So weigh all the factors and then think objectively whether you get an adequate margin of safety or not. Don’t scratch your head about when to buy or setting a precise bar. Just look for obvious bargains where the stock price trades less than what you think it’s conservatively worth.

Way less.