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STRATEGY LAB

‘Net-net’ stocks: A timeless value strategy – but pickings are slim Add to ...

Norman Rothery is the value investor for Globe Investor’s Strategy Lab. Follow his contributions here and view his model portfolio here.

The summer was cool and rainy in cottage country this year. The weather had me huddling by the fire at a cottage on Georgian Bay near Lion’s Head, Ont. But the conditions were perfect for sipping hot chocolate and reading.

In the evenings, I enjoyed perusing Victor J. Wendl’s book The Net Current Asset Value Approach to Stock Investing. Mr. Wendl works as a fee-only adviser in St. Louis, Mo., and the book focuses on a strategy first suggested by famous money manager Benjamin Graham in the 1930s.

Near the depths of the Great Depression, Mr. Graham wrote a series of articles that highlighted businesses that could be snapped up for less than their liquidation value. The outlook was so bleak for these firms that the market believed they were better off dead than alive. Anyone who was brave enough to buy a basket of them, and hold on, did very well indeed.

To find such stocks, Mr. Graham calculated each firm’s net-net value, which is equal to its current assets less all of its liabilities. Firms trading at a significant discount to this value attracted his attention.

Mr. Graham’s well-known protege, Warren Buffett, bought similarly depressed stocks when he started his hedge fund decades ago. But it was only after taking control of Berkshire Hathaway, an ailing textile concern, that he proved to be a great CEO.

But Mr. Buffett now buys quality firms at fair prices. Problem is, only a few stocks trade below their net-net values in normal times and they’re generally too small for large investors to bother with.

That leaves the field open to small investors who might benefit from Mr. Wendl’s book, which is devoted to a series of back-tests of the net-net method.

In one study, he looked at the returns generated by investors who bought U.S. stocks for less than 75 per cent of their net-net value from 1951 through 2009. He took care to avoid truly tiny stocks and stuck to firms with market capitalizations in excess of $25-million (adjusted for inflation based on 2002 dollars).

Even after including many small firms in his study, there were long periods when fewer than 10 stocks passed the test. But, for safety reasons, he was unwilling to put more than 10 per cent of his hypothetical portfolio into any single stock. When 10 candidates couldn’t be found, the remainder of the portfolio was parked in Treasury bills. (I hasten to add that all but the most experienced investors should hold significantly more than 10 stocks.)

Despite occasionally being heavily invested in Treasuries, the net-net portfolio generated compound average annual returns of 19.9 per cent from 1951 through 2009. They handily beat the S&P 500, which climbed 10.7 per cent annually over the same period.

That’s just one of Mr. Wendl’s findings. He also determined that dividend-paying net-net stocks generally fared better than non-dividend payers. In addition, net-net stocks with earnings yields exceeding 10 per cent also outperformed.

Given the market’s recent run, it should come as no surprise that net-net stocks are scarce in Canada these days. I could find only one trading just below its net-net value that paid a dividend using S&P Capital IQ.

The candidate is Hammond Manufacturing Co. Ltd., which makes electrical and electronic components. The Guelph, Ont.-based firm pays a (special) dividend yield of 1.3 per cent and sports a 17-per-cent earnings yield.

But it is a tiny stock with a market capitalization of $18-million, which should only be considered by patient and knowledgeable investors. Even then, they’d be wise to think carefully before diving in.

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