Net-Net Investing How To, and example of a cheap net-net stock in Japan
Learn how to evaluate a Ben Graham net-net opportunity
In this article, you will learn:
What is a Ben Graham net-net?
How do I calculate if a stock is a net-net?
Why do net-nets (NCAV) stocks often make good investments?
What kind of net-nets should I avoid?
Can I still find good net-nets in the market today?
A real life example of a net-net
What is a Ben Graham net-net?
Ben Graham was a famous investor who worked with Warren Buffet, who defined a NCAV (net current asset value) stock as one where the net current assets - long term liabilities are greater than the market cap of the stock, preferably the market cap is 2/3 or less NCAV.
How do I calculate if a stock is a net-net?
Use this formula:
Current assets - current liabilities - long term liabilities = NCAV (net current asset value).
Market cap / NCAV = 67% or less ideally, and must be <100%.
Why do net-nets (NCAV) stocks often make good investments?
A net-net can be a good investment because it is very cheap: and so the downside risk is minimised. In the NCAV calculation above: if the company was liquidated, i.e. shut down, after paying off all of the liabilities, the shareholders would be left with a profit: so the company is trading in the market for less than the net assets that it owns. The calculation values the fixed assets, e.g. land, buildings etc. at zero: so if those were to be sold in a liquidation, the shareholders would make even more profit.
However, most net-nets are not liquidated - instead, market sentiment changes over time to re-value them more highly - or they can be taken over by another company, or management can launch a share buyback, or they can be taken private by management, etc. To read more about net-nets in general as investments, please see my other article here on the Real Worth Stocks website.
What kind of net-nets should I avoid?
Net-nets making consistent losses:
Net-nets are very cheap relative to their assets, but if they are making losses consistently, then they are like a melting ice-cube: the assets are continually shrinking over time. An example of this type of company are some biotech net-nets, that raise a lot of money from investors, and then spend years spending on R&D making losses, and they may never become profitable. An example of this type of net-net is Midatech Pharma (MTPH) listed in the UK: it has made losses every year from 2012-21, and has negative retained earnings of -£128M. Although it has a NCAV of £9.3M, and a market cap of £2.7M, giving it a market cap:NCAV ratio of just 2.7/9.3 = 29%, I will pass on this company, because it is highly likely to continue to burn cash until it runs out of money, e.g. in 2021 it made a loss of £6.1M. Inverting the concept of the consistent loss making net-nets: the best net-nets are those that are consistently profitable, continually adding to their cash pile. I will share an example of this later on in this article.
Chinese net-nets:
There have been instances of some Chinese net-nets turning out to be frauds, i.e. management has lied about their assets, so I avoid investing in Chinese net-nets.
Net-nets where current assets are mostly inventory
The problem here is that the assets might not be worth what they are stated at on the balance sheet. For example, if a net-net has very little cash, and mostly inventory, and especially if this inventory is a product which either expires or becomes obselete, or demand is driven by trends, this is a problem. An example of this type of net-net is Leeds Group Plc (LDSG), a fabric importer and distributor, which has a NCAV of £11M and a market cap of just £3M. However, it has £10M of current assets in inventories of fabric materials. It is very possible that these materials may not be worth what they are stated at on the balance sheet, so for this reason the company is a pass from me.
Net-nets where current assets are mostly poor quality receivables
If the current assets are mostly receivables, then you as an investor need to gauge the quality of the receivables. For example, a former UK net-net called N Brown (BWNG) is an online fashion retailer, selling clothes to the 16-35 female demographic. £509M of the £666M current assets are receivables: it finances the sale of the clothes to it’s customers via unsecured credit. In the event of a recession, many of it’s customers may default on this credit, so the company may not be able to collect a significant part of those receivables. This particular company is also highly leveraged, carrying £303M of long term debt: so if enough of the receivables are uncollectible, it may face solvency issues.
Can I still find net-nets in the market today?
Yes: they are relatively rare since they are so cheap, however, it is possible to find net-nets in the market today, and previous Real Worth Stocks investments in net-nets have been quite profitable.
Here is a real-life example of a consistently profitable Japanese net-net available in the market today: OM2 Network (7614.T).
OM2 Network (7614.T)
Business description
OM2 Network processes and sells meat in Japan, retailing prepared foods, and also operates a network of restaurants - yakinuku (grilled meat) and shabu-shabu (Japanese hotpot). They have large format stores, where they retail meat and also process it, and have started also selling salads, and Western foods. Recently, they have been opening concessions within larger stores. There is a trend towards prepared foods, so they are aiming to take advantage of this by opening more restaurants. Most stores are leased, rather than owned outright. About 20% of revenue comes from catering (this made a loss of $1.9M in 2021, but was affected by Covid restrictions), and about 80% from meat retail (profit of $12.7M in 2021). All figures have been converted to US dollars from Japanese yen, at a rate of $1 = ¥131.
Durability, Quality and Risks
Durability:
Meat processing and retail is a fairly durable business, e.g. during the pandemic, their meat retail stores were open as normal as they were considered an essential business so were allowed to operate through the pandemic, and they remained profitable during this period. However, their restaurants business which is 20% of their total revenue, was affected and was loss making in 2020-21: though the company was still profitable overall.
There is no issue with customer concentration: with no customer accounting for more than 10% of revenues.
Quality: In order to evaluate the quality of earnings, I will calculate the three year average owner earnings (a measure favoured by Warren Buffet) as follows:
Owner earnings = Net earnings +depreciation and amortisation - change in working capital - capex
Risks:
OM2 Network has stated that they wish to push more into restaurants - this was loss making in 2020-21. It is unclear what level of profitability will be achieved in this segment in 2022 and 2023: however it represents a small proportion of their overall revenues. The risk is that they make a more major acquisition in this area: and therefore allocate more of their capital to a business with potentially poor returns.
Capital Allocation
OM2 Network used $3.7M in 2021 to purchase a restaurant group, Marucho Kobeyo Co, Ltd. Management state that their policy on allocating capital is to ‘further enhance management structure, open new stores, and expand into new business fields.’ Therefore, management plan to spend most of their capital by reinvesting in the business. However, it is fair to say that the business is extremely overcapitalised, with cash and equivalents of $70M in Jan-22, vs the market cap. of $56M. Therefore, management are likely to continue to hoard most cash on the balance sheet.
Dividend policy:
OM2 Network has paid out a ¥24 or $0.18 dividend for the past four years, and management state that they intend to maintain a stable dividend. The coverage ratio vs the average last four years’ earnings is ~5x, and the payout ratio is therefore 21%. Yield is currently 2.2%.
Share buybacks:
In FY20, OM Network bought back 0.2% of shares outstanding, and bought back no shares in FY21.
Growth
Over the last four years, revenue has very slightly shrunk, starting at $237M in 2018, to $227M in 2021, for a negative CAGR of -1%.
Environmental, Social and Governance
OM2 Network does not comment in it’s annual securities report on its environmental performance. It does report that there are no trade unions amongst its workforce - which is not surprising since only 16% of Japan’s workers are part of a trade union. It also reports that labour-management relations are, ‘harmonious.’
Management
The current CEO and President is Tsutomu Ohkoshi, who is 73 years old and has been in this position since the year 2000. He holds almost no shares in the business. Directors are paid only a basic salary, and executive director compensation was $0.3M in 2021, vs profits of $7M.
Appraisal
Since OM2 network is consistently profitable, and also a net-net, it can be valued based on P/E, free cash flow plus growth, and price to NCAV (net current asset value).
P/E: In order to calculate a P/E ratio, owner earnings are calculated. The average owner earnings in the last three years was $5.7M, vs the current market cap of $56M, so the P/E ratio is 9.9x.
Free cash flow plus growth. Owner earnings is a good measure of free cash flow: so the free cash flow yield is $5.7M/$56M = 10%. Growth was calculated above at -1% CAGR: so the free cash flow plus growth yield on the stock is 9%.
NCAV (net current asset value).
From above NCAV = Current assets - current liabilities - long term liabilities = NCAV (net current asset value).
NCAV = current assets ($95M) - current liabilities ($23M) - long term liabilities ($5M) = $67M
Market cap is $56M, so market cap: NCAV is $56M/$67M = 84%.
Therefore, the company is a net-net, since the NCAV is above the market cap: and also the current assets consist mostly of cash and equivalents (there is $73M cash and equivalents and only a small amount of inventory., so the current assets figures are very reliable.
However, the price:NCAV ratio is more than the 67% ratio that Ben Graham suggested was optimal.
OM2 Markets is a profitable net-net that doesn’t quite meet Ben Graham’s criteria. However, I found a much better Japanese net-net stock that exceeds his criteria, which is the Feb-23 Real Worth Stocks pick. To read our in depth research report and valuation on this stock, subscribe now below to our paid membership, with a free 7 day trial.