I was doing %100 discretionary macro before I found this 4 years ago. I like macro and it comes easy to me, but it was always stressful and I wanted a strategy that brought more peace but still had high returns. I searched every corner of the internet and stumbled upon this. Very few people will listen, and most will mock me, but this post isn't for them. This post is for the old me that was searching for answers and was ready to change and get started on a solid foundation for fundamental analysis by following the example of some of the greatest of all time. Ok here we go!
The go-to strategy for most people is a low cost index fund. The idea behind this is called the Efficient Market Hypothesis. This idea says that all publicly available information is already reflected in the price of all financial assets. Under this idea, the only way to beat the stock market is to have insider information and to be doing insider trading, because insiders have insider information that is not yet available to the public. Once that information goes public, the information becomes useless.
What people don't understand is that in order for markets to be efficient, there has to be liquidity. Take Apple stock for example. Apple has about $10 billion dollars a day in trading volume, meaning that everyday $10 billion dollars worth of Apple stock is traded on the stock market. This liquidity is what makes it possible for new information to reflect itself in the price without friction. The liquidity allows for a large number of people to analyze the stock and buy and sell freely. Large investors need this liquidity and cannot invest in assets with low liquidity. The richer a person becomes, the smaller their universe of stocks becomes, because they need stocks with more and more liquidity. If a large number of people cannot invest in a stock because it is illiquid, then the possibility opens up that the stock could become inefficiently priced.
What makes the strategy possible is the "illiquidity premium". The stock market can be divided into several layers depending on the size of corporations. There are (in descending order), Mega Caps, Large Caps, Mid Caps, Small Caps, Micro Caps, and Nano Caps. The smaller we go, the more illiquid the market becomes which allows for more opportunity to find stocks that are trading at "inefficient" prices. However, our chances don't really go up until we get to the nano caps (companies traded below $30 million dollars in market cap). The people investing in nano caps are individual investors and maybe some boutique investment funds because nano caps are too illiquid for large players. As far as I know, there are no nano cap ETFs or mutual funds because they cannot handle the illiquidity. There are some micro cap ETFs and mutual funds however.
Now we know what pond to be fishing in, but we still don't know how to fish. We need a strategy that:
1: Requires no skill, and is accessible to anyone who can do basic math.
2 Doesn't take a lot of time.
3 It should be conservative because we want to keep our money safe.
4 It should also have a return significantly higher than a broad stock market index because, if it doesn't, then what is the point?
Does this strategy exist? Yes! It is called the Net-Net strategy and it is the highest returning quantitative strategy that I know of. It was invented by Benjamin Graham, who was Warren Buffets mentor. Warren Buffet himself used the strategy for the first 20 years of his career. He stopped using the strategy because he eventually ran into liquidity issues.
The Strategy:
The best way to introduce it is to use an analogy. Imagine someone has a really crappy car. It still runs but the wheels are about to fall off, the paint is chipped and it's making a bunch of noises that are a sure sign of trouble. Could this car be a good investment? Surely not, since it is going to get sent to the scrap yard at any moment. But what if the owner offered to sell it to you at a %50 discount to its scrap value? Now it becomes an attractive investment because we might be able to sell it above its scrap value, since it is still running after all. But if we can't, we can drive it over to the scrap yard, double our money and ride back home on public transportation with a wad of cash in our pocket. Makes sense right?
Take that logic and transfer it over to corporations. The idea is to buy stock in corporations trading below their scrap value. If you were to buy a stock like this, and the next day the management announced the company will be liquidated, you would make money.
The formula for finding the scrap value is to add up all the current (liquid) assets (cash, inventory etc...) and subtract all liabilities. The result is the Net Current Asset Value (NCAV). This is a generic formula for finding the approximate scrap value of a company. The fixed assets (real estate, factories etc...) are ignored and considered as a cherry on top. The most thorough way to find scrap value is to find the liquidation value of the fixed assets as well, but this takes time and the generic formula is good enough. Simple right? It might sound intimidating if you have never heard accounting terms but trust me this is as easy as it gets. If you can operate a can opener, then you can do this basic formula.
If the stock price has a %33 or more discount to NCAV, it is now a candidate for investment. But first it has has to meet 7 more criteria before we invest.
1 It needs to be an operational company. Seems obvious but if you aren't using a screener, or have a crappy screener, you have to check to make sure it's not just a shell corporation. We will talk more about screeners later.
2 Is the company owner operated? Why should I have a stake in the company if the management doesn't have a stake in the company? This is actually considered optional by most people doing this strategy but I consider it mandatory, except in special situations. I like to see that the CEO owns at least 5 years salary worth of stock. I also like to see the CEO buying stock on the open market but that doesn't always happen.
3 The company needs to have a current ratio above 1.5. A current ratio is a fancy way of calculating if the company has an emergency fund for a rainy day. They need to have enough liquid assets to cover short term liabilities. It is calculated by dividing the current assets by the current liabilities.
4 The company needs to have a low debt to equity ratio (D/E). This is a simple way to check if there is too much debt. Too much debt could bankrupt a company. First we calculate the equity by adding up all assets and subtracting all liabilities. This is the Net Asset Value (NAV). I like to strip out intangibles and goodwill to calculate Net Tangible Asset Value (NTAV or NTA), but this is optional. Once we have the equity (NAV), we divide the total liabilities by the equity. Some people only divide the long term debt by the equity. We want the D/E ratio to be %50 or lower. Statistically, companies with %20 or lower have had the best returns.
5 The company needs to have a low burn rate. Generally when companies are trading below scrap value, they are experiencing problems that are hopefully short term. They are generally going through a period of unprofitability. Since they are not able to meet all their expenses from selling product, they may rely on their emergency fund to get them through the tough times. However, we need to see that they have control of their expenses and that they are not burning through their emergency fund too fast. We check this by tracking their NCAV through time.
6 The company shouldn't be diluting shares. Another way companies can get cash to make it through the tough times, is to sell shares in the open market. Most people running this strategy do not tolerate any share dilution.
7 The company should have been profitable in the past 10 years. If the company has already been in trouble for over 10 years and they haven't fixed the problem, then the company might be dying. We want companies facing short term problems, not long term problems.
That's basically it. How has the strategy performed? It returns ~25% per year. Don't believe me? Here is a link to a few independent studies: https://www.quant-investing.com/blog/why-and-how-to-implement-a-net-net-investment-strategy-world-wide
Since the strategy is quantitative in nature and doesn't require investment skill, it can be backtested and many backtests have been performed by different people.
Since this is a statistical strategy, we want to hold 20 stocks at a time to protect ourselves from single stock risk. The stocks are held for a year and then whatever no longer fits the criteria is sold and replaced. The losers are sold before the year end and the winners are sold after a year end to maximize tax efficiency.
Okay so now that the strategy is explained, we have to actually find these stocks. Benjamin Graham and Warren Buffett had to comb through thousands of stocks by hand, but we live in modern times and we no longer have to do this. The way to find the stocks is to use a screening tool. The screen searches through a financial data base of stocks and pulls out all the stocks trading below NCAV. A high quality screener will also screen for the 7 things I outlined, except for insider ownership, that you have to do yourself. With a high quality screener, I can just pluck 20 stocks from the screen and buy them. I don't have to do any calculations or further research. If I have a crummy screener, I will have to check everything myself.
If you have a good screen, the only work is actually buying and selling the stocks. Since the stocks are illiquid, there is usually a large spread between the bid and ask price. You will have to learn how to place your own limit orders and it could take weeks to get your orders filled. So there will be work in managing the portfolio. Getting locked into investments from illiquidity is not a problem. I am in contact with several people running the strategy and getting locked into an investment has never come up in conversation but it is technically possible, especially if you have a lot of money. But in general, if you are able to buy the stock, then you will be able to sell the stock. The strategy becomes difficult to implement once the investor has $5-$10 million dollars. Once you get over $5 million, you may have issues buying and selling and you will get locked out of the strategy eventually. This is what happened to Warren Buffett. Once he got locked out, he had to adjust his strategy and became the investor he is today.
The reason why you have never heard of Net-Nets is because nobody has a financial incentive to tell you about it. Wall Street is not going to tell you about it because they cannot package it into an ETF or mutual fund to sell it to you. Rich people are not going to tell you about it because they can't focus on it (because of liquidity). Maybe your financial advisor would tell you IF they were competent. But as we all know, they are not competent, which is why we fired them and bought an index fun instead. This strategy has fallen into obscurity because markets have become so efficient, but it is still used among a small group of people in the most inefficient stratum of the market, the nano caps.
That about wraps it up. I want this information to get out there because I want to see you succeed in your financial goals. I just happened to stumble on this, but if you don't tumble down the right rabbit hole, you will never find out about this. But now you have! Knowledge is power.
Cheers, Charlie
Submitted April 30, 2024 at 11:51PM by Excellent_Border_302 https://ift.tt/mQORhNn
