Net-Nets Disappearing In The U.S. In Chapter 7 of the value investing classic “The Intelligent Investor,” Benjamin Graham referred to net-nets as “The type of bargain issue that can be most readily identified is a common stock that sells for less than the company’s net working capital alone, after deducting all prior obligations. This would mean that the buyer would pay nothing at all for the fixed assets – buildings, machinery, etc., or any good-will items that might exist.” When Benjamin Graham did a compilation of net-nets in 1957, he found approximately 150 net-nets. But Benjamin Graham also added that “during the general market advance after 1957 the number of such opportunities became extremely limited, and many of those available were showing small operating profits or even losses.” Based on market data as of March 11, 2016, there were 95 net-nets (trading under 1x net current asset value) listed in the U.S., excluding over-the-counter stocks. If I include a market capitalization criteria of the stock being greater than $20 million, the list of net-nets is almost halved to about 54 names. Assuming the market capitalization criteria is further tightened to $50 million, only 27 net-nets remain on the list. Among the 27 net-nets, only nine of them were profitable in the trailing twelve months. There are two key factors that have been commonly attributed to the disappearance of net-nets in the U.S. Firstly, investors armed with sophisticated screening tools have found it easier to screen for net-nets, compared with the limitations of using a pencil and a calculator in the past. As a result, it can be said that the net-net investment opportunity has been arbitraged away. Secondly, as America made the shift from an industrial economy to a knowledge-based one over the past decades, the value of most U.S.-listed companies no longer resides with their tangible assets. Deep value investors have always sought out cheap stocks, but struggled to find a common denominator for undervaluation. Net current asset value, as a proxy for liquidation value, is probably the closest that one can come to identifying a worst-case scenario valuation metric that is easily calculated and applicable across most situations. However, if one digs deeper into the concept of deep value and the underlying rationale of net-net investing, it is possible to widen the deep value investment universe considerably beyond net-nets. Deep value, whose definition may vary widely, is premised on downside protection in the form of asset values, in my opinion. As I will highlight in the sections below, there are still plenty of deep value investment opportunities in the U.S. and in the Asian markets as well. I will apply the $50 million minimum market capitalization for the screens and specific stocks I am discussing below. Net Cash Stocks / Negative Enterprise Value Stocks Net cash stocks refer to companies with net cash (cash and short-term investments net of all interest bearing liabilities) accounting for a significant percentage of their market capitalization. In the extreme case, some of these stocks might have net cash exceeding their market capitalization, and they are also referred to as negative enterprise value stocks. I see net cash stocks as a special case of the classic sum-of-the-parts valuation, where an investor is backing out the easy-to-quantify elements (usually cash and listed investments) of a stock to ultimately get to the stub value of the remaining parts of the company, typically what is difficult to understand and value. For negative enterprise value stocks, the stub value is zero or negative, implying investors are getting certain assets or businesses for free by virtue of the purchase price. I found 126 U.S. stocks trading at 2 times net cash or less (in other words, net cash accounts for over 50% of market capitalization), and 18 negative enterprise value stocks. One example of a net cash stock is RealNetworks (NASDAQ: RNWK ) whose net cash accounts for approximately 61% of market capitalization, implying that the stub (operating businesses excluding Rhapsody) trades at a trailing enterprise value-to-revenues of 0.48 times. RNWK is a digital media services company operating under three business segments: RealPlayer Group, Mobile Entertainment, and Games, which accounted for 23%, 52% and 25% of its 2015 revenue, respectively. RNWK’s operating businesses are not doing well. With the declining popularity (that is an understatement) of RealPlayer and the deteriorating performance of its Mobile Entertainment, and Games businesses, RealNetworks is looking increasingly like a melting ice cube with its top line decreasing in every year from $605 million in 2008 to $125 million in 2015. It was also loss-making in four of the past five years. But there are some recent positive developments in the past year. RNWK sold its social casino games business, including Slingo, for $18 million, which was first announced in July 2015. This implies management is open to the possibility of monetization and divestment, when the right opportunity arises. In November 2015, RNWK announced a partnership with Verizon Communications Inc. (NYSE: VZ ) to allow it to offer its customers the ability to share, transfer and create digital memories with RealNetworks’ newest video app, RealTimes. RNWK also has a hidden asset in the form of its 43% stake in Rhapsody carried on the books at zero value, which boasts close to 3.5 million paying subscribers. Music subscription service peers like Deezer and Spotify were valued at between $270 and $425 on a per-subscriber basis, based on actual and planned fund raising activities. If I apply the lower end of the valuation range to Rhapsody ($270 per subscriber), the value of RNWK’s interest in Rhapsody should be worth $406 million, more than 2.5 times RNWK’s current market capitalization. Robert Glaser, the founder of RNWK, returned as interim CEO in 2012 and assumed the role as permanent CEO in 2014. His 35% interest in RNWK suggests that his interests are firmly aligned with that of minority shareholders. He is likely to act in the best interests of himself and minority shareholders to eventually halt monetizing the value of RNWK’s assets, if he does not manage to turn around RNWK’s operating businesses. The key risk factors for RNWK include the continued cash burn at its operating businesses being unsuccessful and the decline in the value of Rhapsody due to competition. Net cash stocks with the following characteristics should be heavily discounted: the company is a melting ice cube and burning through cash rapidly (RNWK is an exception considering its stake in Rhapsody and the alignment of interests between the CEO/founder and minority shareholders); the nature of the company’s business requires it to hold cash for either working capital or expansion opportunities; there is a timing issue e.g. a huge special cash dividend has been factored into the price, but not the company’s financials yet, or the company may have an element of seasonality which causes it to accumulate cash at a certain point of the year and draw down the cash to meet liabilities later; the company has significant off-balance debt; the bulk of the stock’s cash is held at partially owned subsidiaries where the possibility of repatriating the cash to the parent company is low; the stock may have certain operating subsidiaries which are mandated by laws and regulations to maintain a certain cash balance. Low P/B Stocks One has to go back to Eugene Fama and Kenneth French’s 1992 research paper titled “The Cross-Section of Expected Stock Returns” to find the first (as far as I know and have read) academic study showcasing the outperformance of low P/B stock relative to their high P/B counterparts. Moving from theory to practice, Donald Smith is one of a handful of fund managers who devotes himself exclusively to the low P/B deep value approach. On his firm’s website, it is emphasized in the Investment Philosophy and Process section that “Donald Smith & Co., Inc. is a deep-value manager employing a strict bottom-up approach. We generally invest in stocks of out-of-favor companies that are valued in the bottom decile of price-to-tangible book value ratios. Studies have shown, and our superior record has confirmed, that this universe of stocks substantially outperforms the broader market over extended cycles.” Fishing in the bottom decile of price-to-tangible book value ratios as opposed to net-nets has its advantages, considering that there will always be stocks (10% of the universe) trading in the bottom decile of price-to-tangible book value ratios even as an increasing number of stocks are valued above net current asset value. One such deep value low P/B stock is Orion Marine Group (NYSE: ORN ). Orion Marine trades at 0.54 times P/B & around tangible book, and it is trading towards the lower end of its historical valuation range. Click to enlarge Started in 1994 and listed in 2007, Orion Marine is a leading marine specialty contractor serving the heavy civil marine infrastructure market in the Gulf Coast, Atlantic Seaboard & Caribbean Basin, the West Coast, as well as Alaska and Canada. Its heavy civil marine construction segment services include marine transportation facility construction, marine pipeline construction, marine environmental structures, dredging of waterways, channels and ports, environmental dredging, design, and specialty services. In 2015, the Company started its new commercial concrete business segment with the acquisition of TAS Commercial Concrete. Founded in 1980 and headquartered in Houston, Texas, TAS Commercial Concrete is the second-largest Texas-based concrete contractor and provides turnkey services covering all phases of commercial concrete construction. While Orion Marine is no wide moat stock, it does benefit from moderate entry barriers. Dredging and marine construction are immune to foreign competition, thanks to the Jones Act. Orion Marine also benefits from its longstanding working relationships with the government which grants the necessary security clearances. This gives the Company an edge over new entrants in the bidding for public projects. The decent future growth prospects for Orion Marine in the mid-to-long term should increase its capacity utilization and enhance profit margins. Firstly, funding for public projects remains healthy. For example, the U.S. Army Corp of Engineers funds the country’s waterways and is focused on expanding the usability of the Gulf Intracoastal Waterways. Its annual budgets for Operations and Maintenance and Construction are $2.9 billion and $1.7 billion, respectively. Another example is The RESTORE Act (the Resources and Ecosystems Sustainability, Tourist Opportunities, and Revived Economies of the Gulf Coast States Act), signed into law in July 2012, is focused on coastal rehabilitation along the Gulf Coast and is expected to be a long-term driver (estimated $10-$15 billion over the next 15 years) of coastal restoration work. Secondly, the expansion of the Panama Canal (Gulf and East Coast Ports deepening channels and expanding facilities to handle larger ships), expected to be completed in 2016, requires ports along the Gulf Coast and Atlantic Seaboard to expand port infrastructure and perform additional dredging services, to cater to increases in cargo volume and future demands from larger ships transiting the Panama Canal. Thirdly, the Company currently serves several popular cruise line destinations, making it a beneficiary of port expansion and development to meet increasing demands as a result of the growing number and size of cruise ships. Orion Marine is less vulnerable to oil price declines as its energy & energy-related opportunities are largely concentrated with the midstream or downstream energy segments. The key risk factor for Orion Marine is that it runs a capital-intensive business with high fixed costs (operating leverage implies that the bottom line will decrease to a significantly larger extent compared with the top line), so revenue and capacity utilization are key to profitability. Furthermore, the Company has a history of M&A, which can be potentially value-destroying. Click to enlarge Interestingly, Orion Marine is a holding of Charles Brandes of Brandes Investment. Charles Brandes met Benjamin Graham when he was managing the front desk of a small brokerage firm in La Jolla, California, which inspired him to start his investment firm operated along Graham principles. On the investment firm’s website, Brandes Investment Partners writes that it “believes the value-investing philosophy of Benjamin Graham – centered on buying companies selling at discounts to estimates of their true worth – remains crucial to delivering long-term returns. This singular focus has allowed Brandes to help clients worldwide with their investment needs since the firm’s founding in 1974.” Brandes Investment has been aggressively adding to its position in Orion Marine in the past three quarters, purchasing 58,150 shares, 26,245 shares and 40,464 shares in Q2 2015, Q3 2015 and Q4 2015, respectively, effectively tripling its stake over this period. It is noteworthy that Brandes Investment claims to be “among the first investment firms to bring a global perspective to value investing” in its corporate brochure , and this links well to the next section on replicating the net-net investment strategy outside of the U.S. Asian Net-Nets Going back to net-nets that I first touched upon at the beginning of the article, the opportunity set for net-nets still exists, if one is willing to look beyond the U.S. market, particularly Asia. There are approximately 256 Asian-listed (including Japan, Hong Kong, Australia and South East Asia, but excluding Korea and Taiwan) net-nets with market capitalizations above $50 million, of which 206 were making money in the last twelve months. Japan (including the Tokyo and Nagoya Stock Exchanges) accounts for more than half of the 206 names with 111 net-nets, while Hong Kong is a close second with 74 profitable net-nets. I have written extensively about Asian net-nets in articles published here , here and here . Graham’s Final 1976 Interview In Benjamin Graham’s last published interview in 1976 with the Financial Analysts Journal, he still expressed his strong conviction in net-nets, when asked “how an individual investor should create and maintain his common stock portfolio.” My first, more limited, technique confines itself to the purchase of common stocks at less than their working-capital value, or net-current-asset value, giving no weight to the plant and other fixed assets, and deducting all liabilities in full from the current assets. We used this approach extensively in managing investment funds, and over a 30-odd year period we must have earned an average of some 20 per cent per year from this source. For a while, however, after the mid-1950’s, this brand of buying opportunity became very scarce because of the pervasive bull market. But it has returned in quantity since the 1973-74 decline. In January 1976 we counted over 300 such issues in the Standard & Poor’s Stock Guide – about 10 per cent of the total. I consider it a foolproof method of systematic investment – once again, not on the basis of individual results but in terms of the expectable group outcome. Graham acknowledged that net-net investing in the U.S. “appears severely limited in its application, but we found it almost unfailingly dependable and satisfactory in 30-odd years of managing moderate-sized investment funds.” He proposed an alternative investment approach involving “buying groups of stocks at less than their current or intrinsic value as indicated by one or more simple criteria.” Graham’s preferred metric was trailing P/E under 7, but he suggested other metrics as well, including dividend yields exceeding 7% and book value more than 120 percent of price (which is equivalent to a P/B ratio of under 0.83). Note: Subscribers to my Asia/U.S. Deep-Value Wide-Moat Stocks get full access to the watchlists, profiles and idea write-ups of deep-value investment candidates and value traps, which include net-nets, net cash stocks, low P/B stocks and sum-of-the-parts discounts. 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.
