Author Archives: Scalper1

How To Destroy Your Net Net Stock Portfolio

Are you tired of building wealth? Would you rather watch your money burn? One of Canada’s leading newspapers came out in 2013 with a list of net net stocks that it expected would produce amazing returns. Author Robert Tattersall, co-founder of the Saxon family of mutual funds, looked back in time and put together a basket of net nets trading on the Canadian markets at the start of 2012. His strategy was simple: a basket of Canadian net nets, 21 to be exact, trading at no more than a 20% premium to NCAV, with no additional filtering. Over 2012 the stocks would have performed very well, recording an 18% gain versus the TSX’s 4% return. That result is on par with the returns of net net stocks generally. Over 2013, however, returns began to sour. Rather than the market crushing performance of the previous year, Tattersall’s basket of net nets actually underperformed the market, returning just 2% compared to the market’s 7.2% return. What Went Wrong? Part of the problem was the holding period. Net nets show their best yearly performance as a group over a 1 year holding period but then perform worse the longer you hold onto the stocks. Over a two year period, a net net stock’s CAGR drops in a meaningful way. Over a 3 year holding period, results are even lower. Returns decrease step by step until in year 5 a lot of the advantage of owning a basket of net net stocks is destroyed. If you want to run a net net stock portfolio, annual rebalancing is a must. But holding period length is not the only thing potential net net stock investors should keep in mind, and it wouldn’t have been responsible for the large drop in performance his portfolio saw. There is a fair amount of variance in portfolio returns, after all. But, astute readers will notice two other fatal flaws. It’s no secret that net nets perform spectacularly when you stick to the strategy over a long period of time. Not all net nets perform the same. I crafted my Core7 Scorecard to help identify the net nets that have a better chance of outperforming net nets in general and help avoid firms that will disappoint. While it’s impossible to avoid every firm that will produce a loss or ensure that all the highest returning net nets are in your portfolio, it does a good job of stacking the odds in your favor. One of the key requirements in my scorecard is avoiding Chinese net nets and resource exploration companies. China has become famous in the West for its spectacular growth, but it’s also developed a bit of a reputation for offering up western market listed firms that are nothing more than frauds. These companies over-inflate their Balance Sheet figures, record assets they don’t actually have, and even tally up growth in revenue or earnings that just didn’t happen. Understandably, these companies don’t make for the best net nets. After all, if you’re going to be basing your investment decisions on Balance Sheet figures, it’s usually best to stick to firms you have reasonable grounds to assume are producing accurate financial statements. Resource exploration firms are a whole other can of worms. While they may have more accurate financial statements (i.e. they’re less likely to be outright frauds), these companies have a long history of destroying shareholder wealth. They start with a public offering of stock and then spend the money trying to find resources to harvest. This process can take years, if they find anything at all, and the entire time the company keeps draining its bank account. Most companies never actually find a deposit, but do a very good job of eroding shareholder value. 9 Net Nets for 2014? Maybe? These facts aren’t exactly a secret on the Street, so it’s interesting that David Sandel of Simcoe Partners would choose to include Chinese reverse merger and resource exploration firms in his followup portfolio for 2014. Just like Tattersall’s 2012/2013 portfolio, Sandel picked a basket of net nets that he suggested investors purchase for 2014: Automodular Corp. ( OTCPK:AMZKF ) -10.16% Monument Mining Ltd. (MMTF) -41.17% Energold Drilling Corp. ( OTCPK:EGDFF ) -50% Indigo Books & Music Inc. ( OTC:IDGBF ) +46.25% Greenstar Agricultural Corp. (GRCGF) -51.17% Goodfellow Inc. ( OTC:GFELF ) +5.73% Mirasol Resources Ltd. ( OTCPK:MRZLF ) +20.44% ACE Aviation Holdings Inc. ( OTC:ACAVF ) 0% Coopers Park Corp. ( OTC:CJPKF ) +43.93% All 9 net nets were still listed on Google Finance 12 months. If equally weighted, the portfolio would have produced a loss of -4.02%. A quick look at the firms is instructive. Of the firms selected, 3 were resource exploration firms (Monument, Energold, Mirasol) and one was actually a Chinese firm (Greenstar). The return to this group of 4 stocks was an average loss of -24.38%. If investors had skipped over the resource exploration and Chinese firms, they would have enjoyed a much more rewarding +17.15% return versus the TSX’s +6.23% gain. Not exactly statistically significant, but illustrative. Wise Stock Selection for the Best Returns At this point, astute readers will point out that these exploration firms were purchased right before a big drop in commodity prices generally. That’s a fair point, and one more reason to avoid resource firms altogether unless purchased in the depths of a serious bear market. While retail and industrial firms can turn themselves around with effort, planning, and decent judgement, the fate of resource firms are more or less wedded to commodity prices. Net nets don’t work out every year, and not every company will see positive returns. Seeing losses from time to time comes with the territory when buying net nets. Still, despite the occasional loss, net nets produce better returns over the long run than any other value strategy. Returns are consistently above a 25% CAGR in academic studies and my own portfolio has done very well. You shouldn’t just buy any net net, however. Some net nets have a much greater chance of suffering large losses; while other net nets have characteristics associated with outsized returns. Most of my net nets are debt free, have been growing NCAV, are increasing earnings, were bought with a PE below 10x (less than half the market PE!) and at an average discount to NCAV of 55%. If you want to make the most of your net net stock investing, you really have to group the best possible stocks into your portfolio. Why would you do anything else? Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

Arista Investors Work Around Cisco ITC Patent Win, Drive Stock Up

Analysts and investors Wednesday shrugged off Arista Networks’ initial loss to Cisco Systems in patent-infringement litigation, expecting Arista to engineer “workarounds” by the time the decisions are finalized. By afternoon in the stock market today , the stock of loser Arista ( ANET ) was up almost 6% to near 61 after touching 61.79 earlier in the day, while winner Cisco ( CSCO ) stock was up marginally to near 23. Both had closed down about 2.7% after the “initial final determination” was issued Tuesday . International Trade Commission Administrative Law Judge David Shaw said Arista violated Section 337 of the Tariff Act 17 times, but declined to cite 15 other claims of violations that Cisco brought against Arista. The upheld claims involve one patent for externally managing router-configuration data with a centralized database and two patents for private virtual local area networks (VLANs). Shaw’s decision was foreshadowed by ITC attorneys in September. A parallel ITC case and two federal court lawsuits also are pending against Arista, which has filed a countersuit in one of the U.S. District Court cases and claimed an antitrust violation by Cisco in a lawsuit filed last week. “Arista expects to have workarounds ready for all of the infringing elements in a second-quarter software release,” wrote William Blair analyst Jason Ader in a research note issued Wednesday. “These workarounds will have to be approved by the ITC, but Arista management appears confident in this outcome and in minimal disruption to its business.” Likewise, Nomura analyst Jeffrey Kvaal noted that investors already had learned of Arista’s intended workarounds for Q2. “We retain our positive view on Arista shares and neutral view on Cisco shares,” he advised clients in a research note. Nomura maintains a buy rating on Arista with a 95 price target. William Blair reaffirmed a market-perform rating for Arista, akin to a hold rating. “Given the complexity of the legal arguments, the myriad suits and countersuits, and the wide range of potential outcomes, we prefer to stay on the sidelines for the time being, but we maintain a positive bias on Arista’s fundamentals, business momentum, and market position,” Ader said.  

True Value Investing Still Works

Value investing is on the ropes. At least, that’s what you’d think reading articles like this one that highlight how “value” has underperformed “growth” in recent years. I put those words in quotes, partly because the distinction between value and growth is somewhat arbitrary , and also because the critics of value investing tend to attack metrics that have no real connection to shareholder value creation. Patrick O’Shaughnessy did a great job of attacking this myth on his blog, The Investor’s Field Guide . He points out that, over the last ten years, investors that have bought the cheapest stocks based on price to accounting book value have significantly underperformed. As we recently pointed out , book value relies upon flawed accounting metrics, diminishing its usefulness for investors. Unfortunately, most of the “value” indexes that people reference, such as the Russell 3000 Value Index, are based primarily off of price to book. As O’Shaughnessy points out, the performance of value strategies varies greatly depending on which metric you use. If you picked the cheapest stocks based on earnings, you did poorly in 2015 but slightly overperformed over the last decade. Stocks with the cheapest price to sale ratios have done very well recently. Despite their superior recent performance, these metrics have their own problems. We’ve pointed out many times how price to earnings ratios are inherently flawed and have almost no relationship with actual value. The sales number is at least less easy for executives to manipulate, but it also ignores structural margin differences and the impact of the balance sheet. What’s The Solution? Investors looking for value need to take a holistic approach that measures a company’s ability to deliver economic earnings to investors and quantifies the expectations for future cash flows embedded in its current stock price. This is what New Constructs aims to do, and while that process is not easy, it can be rewarding, as shown by the long-term outperformance of our strategies . As you can see from Figure 1, over the past decade our Most Attractive Large and Small Cap stocks have outperformed a combination of the S&P 500 and Russell 2000 by 80%. Figure 1: Most Attractive Stocks Outperform Click to enlarge Sources: New Constructs, LLC and company filings. The diligence we do helps us to uncover hidden gems that might not show up in simplistic, traditional value screens, such as computer chip manufacturer NVIDIA (NASDAQ: NVDA ). When we highlighted NVDA as a long idea in September, it had a P/E of 24 and a P/B of 3. Hardly numbers that are going to make your “average” value investor salivate. However, a closer look showed that these numbers were misleading. For one, NVDA’s reported income was artificially depressed by a $60 million write-down hidden in the footnotes . Plus, the company earns a fantastic return on invested capital ( ROIC ) of 34%, demonstrating its competitive advantage and its ability to efficiently allocate capital. After making adjustments to determine the true earnings quality and quantifying the market’s expectations for future cash flows, we saw that NVDA had a price to economic book value ( PEBV ) of just 1.1, implying that the market believed the company would only grow after tax operating profit ( NOPAT ) by 10% for the remainder of its corporate life. For a company that had just doubled its NOPAT the year before, those expectations seemed awfully low. Sure enough, the market has adjusted its expectations for NVDA in the past few months, driving the stock up 25% even as the S&P 500 has fallen by 2%. When the markets get volatile, it’s the real value stocks, the ones with economic profits and low market expectations, that thrive. Meanwhile, the imposters get exposed. Avoiding Value Traps and Imposters Succeeding in a struggling market is as much about avoiding the bad stocks as it is about picking the good ones. Our research helps clients avoid “value traps” that seem like they might be cheap on the surface but are actually significantly overvalued when you look a little closer. One such value trap we warned investors about was Olin Corporation (NYSE: OLN ) back in June of 2014. The stock had a P/E of 13 and a P/B of 2 at the time, but those numbers were highly misleading. Hidden non-operating items boosted its reported earnings by $25 million. Plus, the company was facing obvious headwinds in the form of falling commodity prices for its chemicals division and an unsustainably high level of demand for its Winchester ammunition segment. Despite this fact, the market was expecting that OLN grow NOPAT by 5.5% for 35 years, an unrealistically long timeframe for such a weak and highly commoditized business. OLN was able to coast by on its inflated accounting earnings when the market was strong, but that all changed after the S&P 500 hit its peak in the spring of 2015. Since then, the stock’s been in free fall, and it’s now down 42% from when we made our Danger Zone call. Investors that pick stocks like OLN and ignore ones like NVDA due to simplistic metrics are not truly value investors. In a buyer-beware system like our market, you need to understand how to separate real value-investing research from the imposters. True value investing means performing your due diligence to understand the real economics of the underlying business and the profits it will have to achieve in the future to justify its stock price. Only by doing this hard work can investors uncover value and protect their portfolio. Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.