Is the market expensive or cheap? What the small cap net-nets are telling us...

Imagine you're on a trip driving through a distant city.  You take a wrong turn and find yourself in a seedy and industrial part of town.  It isn't bad per se, but gritty, grimy and full of buildings that look like they were last taken care of before the computer age.  You find yourself thinking "I couldn't be paid enough to own a building like that in a place like this..."

That's most people's thoughts.  But what if you found out one of those buildings was for sale.  And inside the building was nice and clean, a bit outdated, but orderly.  On top of that there was a file cabinet with a drawer full of stock certificates.  The lower drawer of the cabinet was loaded with cash.  There were also some piles of coins that had questionable value along with some machinery that could be worth a lot to the right buyer.  All told the value of the cash and stock certificates alone were far in excess of the list price for the building.  Would you purchase it then?

That's the situation some small cap investors find themselves in when digging through the forgotten names of the OTC market.  Names that are a little dusty, in the wrong parts of town, but full of cash and valuables that exceed their listed price.  The technical term for companies like this is a net-net.  That is, a company whose cash, receivables, securities and inventory minus all liabilities is greater than its market cap.

Net-net's were popularized by the father of value investing, Benjamin Graham.  Value investing is a historic type of investing that was popular when stocks traded on fundamental metrics such as revenue or profits.  These days if a modem can't dial into your company's website on the information super highway then why even invest?  Or maybe the phrase is "if your company hasn't figured out how to turn capex into opex though software subscriptions while burning cash then don't invest."  I sometimes get my bubbles mixed up..  

The market has shifted from valuing companies based on fundamentals to valuing them based on their story.  If a company can tell a great story they trade with a nice valuation.  If a company is run by stalwarts who care about things called margins and cash then they might as well be worthless, or even less than worthless!  The market will pay you to buy shares in some of these companies.  

Historically purchasing a basket of net-net stocks has outperformed the market.  The reason for this is simple.  These companies are left for dead and trade for less than being dead.  When they inevitably show signs of life investors become excited and bid up their price from less than dead to dead, or maybe they appreciate all the way to "we might be a viable concern."

A second reason that these stocks work is because in theory their downside is limited.  If you are trading for less than dead it is really hard to fall much further.  Someone will always argue that at any level your stock can fall even more.  But as you fall the valuation gap increases, and at some point that gap becomes so crazy that the valuation itself can become a catalyst.

The problem around net-nets is the narrative.  They're already viewed as less than dead.  Most are probably still advertising on MySpace or in the YellowPages.  There are a lot that enter the net-net stage as they are falling towards a terminal value of zero.  The ones heading to zero are affectionately called "melting ice cubes."

You can sometimes invest in a melting ice cube and get out before it totally melts, but it's rare.  Don't waste your time.

There are other times, like now, when you can invest in a handful of companies that are net-nets, that have been around for decades, are profitable, and some are even growing.

While the overall market appears to be wildly expensive given the state of the economy there are a handful of net-nets that are crazy cheap.  Crazy cheap as in trades for less than net current assets and for 3x EV/EBIT.

In the most recent issue (our Thirtieth, published yesterday!) of the Oddball Stocks Newsletter we covered half a dozen of these. Some were covered on the blog in the past but are back to trading at discounts, thanks to the Oddball bear market inside of the bull market. (Or biggest bubble of all time?) This happens with the net-nets: they round trip it and back again. If you subscribe to the Newsletter you can see the latest batch.

The point of this post isn't to pitch my product, it's more about what the resurgence of these names says for the market.

When markets are high there are usually no net-nets to be found.  Everything is elevated including companies that probably should be trading for less than net current assets.  And when markets crash there are dozens to hundreds of net-nets as investors give up and sell everything they can.

In Japan post 1992 crash there have been periods where hundreds of profitable, well capitalized and growing companies trade for less than net current assets.  Investors who purchased baskets of these (myself included) and sold when valuations went from horrible to not-so-bad did especially well.  Investors who kept holding didn't do as well.

In the US there were hundreds of net-nets in the wake of the 1929 market crash.  Since then we've had periods where there might be a dozen or a few dozen.  In these periods investors who dipped their toe into the net-net pool, or into slightly higher quality small stocks trading at low book values did especially well against the market as whole.

What's different this time is there are green shoots in the net-net space at a time when the market as a whole appears overvalued.  One possibility is that an investor buying a basket of net-nets and shorting the indexes could crush the market if history repeats.  Of course this time seems different than most times and it's possible the growing group of net-nets will simply expand as more small companies fall in price as investors move to larger tech names.

It's impossible to know the future.  But what I do know is that personally I've been rewarded for buying profitable net-nets in bulk when they start to appear in the market.  I don't know if the future will be anything like the past, but I know where I'll be placing my bets..

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