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Thursday, 1 October 2015

Digging deeper with Net Net Value shares

Although local equity markets have had a pretty good run since the financial crisis in 2008, there are still examples of companies trading at low valuations and discounts that can be bought at working capital levels. Majority of them can be found in small cap shares.
My initial aim is to see if I can find any shares that are trading at such levels where the net-net working capital position (the current assets minus all liabilities) divided by the number of shares is worth more than the current share price.
It is actually a very simple calculation to make. If a company’s balance sheet has R100 million in current assets and R40 million in total liabilities (i.e., current and long-term liabilities), then the net-net working capital position is R60 million. If this company has five million shares outstanding, then the net-net working capital position per share is R12. Comparing this with a current share price of, say, R9, we can say that we have found a share that is trading at a discount to its net-net working capital.
When we buying a net-net we are getting the fixed assets, whatever they are, for free.
Net-nets are shares whose net current assets, defined as current assets after subtracting all liabilities (i.e., short and long-term liabilities)—exceed the company’s market capitalization. In other words, a “net-net” exists when working capital divided by the number of shares outstanding has a higher value than the company’s share price in the equity market.
When we find a share at these valuations, we have a situation where the liquid assets alone are worth more than we need to pay to buy the entire company. The company could be bought and put into liquidation and the investor should expect to get back more than what he or she paid for it. The fixed assets come for free, potentially raising the total returns on your investment.
Implementing this Net-net strategy as part of my overall Value investing strategy tends to consistently outperform other investing styles, especially in the long term. So, why if the results are so clearly in the favor of net-net shares, why isn’t every equity investor following this approach?
Well, one argument may be that they are most typically small caps shares. Their share prices (and market capitalization) have shrunk, in many cases by 80% or more. This makes them unattractive for large portfolio managers and unprofitable for brokerage firms to research. 
Some specific value strategies that have worked the best like the following:
  1. Low price in relation to asset value
  2. Low price in relation to earnings
  3. A significant pattern of purchases by one or more insiders (officers and directors)
  4. A significant decline in a stock’s price and Small market capitalization.

Important Characteristics to Look at in Net-Net Shares
  1. Low levels of debt. This is very important when considering investing in deep value situations. As these types of investments usually mean that the company in question is no longer profitable, the balance sheet will be under strain and the margin of safety will be eroded over time. Having little or no debt will put the company in a much stronger and more stable position. It will potentially give the company the possibility to add debt, as there should be headway to do this once the path to return to profitability is re-established. I like current assets to be made of shares, debtors and cash roughly in equal parts. If it is all made up of shares, then any valuation based on that will be much more circumspect.

  2. Positive cash flow. Any new potential investment must have positive cash flow for a number of years in its recent history. Even if all the conditions seem to be in place for a good deep value investment, if cash flow has been negative for a few years I will be very hesitant to invest. At the least, it will be very important to investigate such situations further before investing.

  3. Profitability. The company must have been profitable at some stage. The business model that the company uses must have been profitable in the past. For this reason, I tend not to invest in companies with untried track records. Avoiding companies lacking this requirement and positive cash flow will protect us from an ever-eroding margin of safety where the company may well be forced to raise further capital.

  4. Share Price. The current share price is near or at all-time lows. This indicates the sense of disappointment that the current share price has and that we may be reaching “capitulation level” where further bad news largely leaves the share price at current levels. Looking at this gives me some idea as to what levels the share price should be able to return to once the company hits higher profitability levels again.

  5. Institutional shareholder ownership. I like to see other institutional shareholders on the shareholder list to give me a sense of safety that other shareholders are able to engage with the company when this would be necessary. It is also good to check that the directors and officers of the company own shares, meaning they have “skin in the game and eat their own cooking.”

  6. A stable balance sheet. When checking the accounts of the company, I like to see a balance sheet that stays stable over a period of reporting years, with no frequent changes of accounting treatments or turnover in the accountants/auditors.