Beat the Market with Net Net Stocks
A proven strategy for Retail Investors to beat the markets
Retail Investors’ Competitive Advantage
In this previous article about beating the funds as a retail investor, we explored the unique characteristics of funds and retail investors/traders. Here is a summary of the unique competitive advantages a retail investor has:
You are a small fish in a large ocean of sharks and whales managing billions of dollars. Smaller, more confined waters such as underwater caves are ripe with opportunities that only you, the retail investor can exploit. Because the bigger funds are too big to fit into such fertile hunting grounds. It is here that you, the retail investor has a natural competitive edge.
As you manage much smaller amounts of money, you have an innate agility advantage; you are able to buy and sell with much greater precision.
Underwater Sea Cave; Grotta Azzurra, Anacapri, Italy
What are Net Net Stocks?
Net nets are deep value stocks that trade below something called Net Current Asset Value (NCAV). NCAV is an extremely conservative estimate of a company’s liquidation value (what the shareholders would be very likely to get if the company was voluntarily shut down). This is how NCAV is defined:
NCAV = Current Assets - Total Liabilities*
*Total Liabilities includes things such as preferred stock claims, off-balance sheet leases, commitments, and pension obligations
Notice how zero value is given to non-current assets such as plants, office real estate, etc. This is done to be conservative and have a margin of safety in the investment.
Net net stocks are also called Cigar Butt stocks as they are similar to getting a free, final puff off a cigar butt on the ground.
Net net stock investing was successfully implemented by Warren Buffett in his early career. In fact, Buffett has often said that if he were a small retail investor today, he would go back and invest in net net type of stocks:
In the movie, Other People's Money, there’s a scene where Danny deVito gives a great, simple explanation of how Net Current Asset Value is calculated:
A lot of research has been done on Net Net investing over the years and it has consistently shown annual returns of above 20% or even above 30% in the long run.
Does Net Net Investing Still Work?
A common critique is that good NCAV investing opportunities don’t exist nowadays as markets have become a lot more efficient.
This is true… But only in some parts of the world:
In the US, net net investing strategies have not been a consistent means of outperformance relative to the SPX500 total return index. The mean annual outperformance was 5.64%, but at a low Information Ratio (IR) of 0.18. IR measures consistency of outperformance. An IR of below 0.4 generally suggests inconsistent outperformance.
Indian Net Nets: Consistent Outperformers
However, in some other markets with more inefficiencies, net net investing is still very much alive and well. For example, here is how my strategy on equally-weighted, monthly-rebalanced portfolio of Indian net nets have performed relative to the Indian stock market index (BSE500 Total Return Index):
An average annualized return of 47% and average annualized outperformance of 25.89% over the BSE500 Total Return Index, at a high IR of 0.74 shows consistent outperformance of the strategy.
How does the Indian Net Net Strategy Work?
The results of the Indian Net Nets strategy shown above come from a Net Nets selection process I’ve developed from years of research. Broadly, it is based on 5 key selection considerations:
Undervaluation of the net net stock based on Price/NCAV (similar to the P/E or P/B ratio; the lower this number is, the more undervalued or inexpensive the stock is)
Exclusion of certain sectors that do not work well with a net net investing strategy
Market capitalization considerations; smaller net net stocks tend to perform better
Assessments of debt levels to avoid stocks at risk of bankruptcy or financial distress
Assessments of current liquidity to ensure companies are able to conduct everyday operations
The Indian Net Net strategy spits out a collection of net net stocks every month to invest in, with equal allocation. One should remain invested in those stocks so long as those stocks are in the monthly lists. If a stock is removed from the monthly list, then it is the signal to sell that stock. On average, 80% of the net net stocks that were present in the list for one month, will also be in the list the next month.
What kind of Stocks are in the Indian Net Nets Portfolio?
The following shows a list of 61 net net stocks that were members of the Indian Net Nets Portfolio for at least 1 month during the period 1st Jan 2012 till 31st December 2021.
You can see the total return generated by these stocks when they were in the portfolio, along with the total number of months they spent in the Net Net portfolio, and their average monthly return:
The median net net stock:
Was present in the portfolio for 5.0 months (not necessarily consecutive months)
Generated an average monthly return of 4.1%
The median is a better, consistent measure of the “average” in this case, since the arithmetic mean average would be skewed to show higher, better returns (9.7% per month).
Nuances of Indian Net Net Investing
Net net investing is more of a portfolio strategy, rather than a strategy where you select individual stock winners. It is harder to confidently say that a single net net stock will generate good returns. But it is easier to have confidence that a diversified collection of such net net stocks will do well.
The problem is that in this strategy applied to the Indian market, you only have 6 net net stocks on average that make it into the monthly list. This leads to quite a concentrated portfolio! Hence, I suggest having an upper limit to how much money you are comfortable allocating to Indian Net Nets. It would not be wise for example, to have your entire retirement savings allocated to such a concentrated group of 6 stocks!
Look at this time-series of the Indian Net Net Portfolio’s monthly returns:
This shows that whilst overall, there will be periods of big returns, to really succeed, patience is required to sometimes tolerate consecutive months of negative returns, without deviating from the strategy.
Also, when buying or selling these net net stocks, it is critically important to use limit-orders, rather than buy at market prices with market orders! This is because the liquidity on these stocks are usually lower, so buying with market orders will usually increase your purchase cost significantly!
Follow for Monthly Portfolio Picks of Indian Net Nets
Every month, I publish the Indian Net Nets that make it into the Monthly Indian Net Net Portfolio. This will give you a list of stocks that, based on research and history, hold great odds of outperforming the market. And it is free! Here are the latest month’s Indian Net Net picks.
Subscribe and follow for updates!
Best,
Raj Arishtocrat from SEE ACT WIN