Net-net Stock: One man’s trash, another man’s treasure.

My dad has an old friend called Ah Cheong. Ah Cheong lives most part of his life as a mechanic, by operating a small workshop with two apprentices, until his age caught up with him and he decided to retire. The day he closed his workshop, my dad dramatically said there will never be a better mechanic in this town. After his retirement, Ah Cheong invests in cars to pass time. Unlike some people who buy cars to rent out, or buy second-hand cars with hope to sell them at a higher price, Ah Cheong has a very different car investment strategy. He buys old cars which are virtually junks, with no condition to run anymore, or even if they do, they are going to incur consistent maintenance cost that is higher than buying a new one. Ah Cheong can usually buy these junk cars at very low prices, some of them were even willing give out as free just to get rid of the cars. After that, he would dismantle the car and sell their parts like the rims, battery, audio system, engine cooling system, tyres, scrap metal, almost every parts of the car, and make a profit out of it, by leveraging the connection and experience he acquired over his career.

I always thought of the story of Ah Cheong whenever people ask me how much return can they get from stock investment. Or when they asked me to compare the potential return between stock investment and property investment, or any kind of investment. There’s no answer to it, I believe. There are so many types of investment you can make nowadays. And the potential return, is based on how much you love, how much you know and how much you are willing to learn about the subject of your investment. I doubt if Ah Cheong is going to do good in stock investment. Similarly, despite all the lucrative return my rich uncle brag about his investment in paintings and artwork, I don’t see myself involved in some artwork trading that I have no interest at all.

The last thing we want is Stockify being seen as a tips giving website to the readers. We would like to think Stockify as a website for readers with equal passion in stock investment (just like how passionate Ah Cheong is about the cars).

Benjamin Graham, the father of value investing, would not be a stranger to you if you are serious about value investing. His techniques helped found the school of value investing, the idea of investing in securities trading below their determined intrinsic value. His disciples include Irving Kahn, Walter Schloss, and most notably Warren Buffet. Warren Buffet once said: “To me, Ben Graham was far more than an author or a teacher. More than any other man except my father, he influenced my life.”, at the preface of the Fourth Edition of Benjamin Graham famous book, The Intelligent Investor, which is generally acknowledged as the bible of stock market.

Although some would say that Benjamin Graham is the extremist in value investing, it is undeniable his investment philosophy about the fallibility of future predicting, irrationality of the market, investing with sufficient margin of safety, investing from business perspective, are still widely applicable and serve as the roots of value investing. One of the techniques developed by Graham is called “net-net investing”, which is to invest the stock at a price below net-net-working capital (NNWC) per share.

 NNWC = Cash + (Receivables x 0.75) + (Inventory x 0.5) – Total Liabilities

To translate to English, NNWC theoretically measures the money you would still get back as a shareholder if the company went through liquidation. It conservatively assumes zero value on non-current assets, 75% successful collection on receivables and 50% discount on clearing its inventory, and deduct all the liabilities of the company. In other words, if you are buying a stock at a price below its NNWC, you would still get back more than what you have invested even the company liquidated its business. 

We did find a company listed in Bursa that is trading below its NNWC using 2QFY17 figure, which is FACB Industries Incoporated Berhad FACBIND (2984), and we will use it as the case study in this post.

NNWC of FACBIND

= Cash RM 153,864,000 (excluding RM 1,570,000 pledged to bank) + Receivables RM 17,466,000 x 0.75 + Inventory 12,799,000 x 0.5 – Total Liabilities RM 9,730,000

                           
= RM 153,903,000

divided by total no. of shares outstanding 83,883,000 units

NNWC per share = RM 1.83 

As at 28 April 2017, FACBIND is trading at RM 1.25, more than 30% discount to its NNWC.

One would argue that asset based valuation techniques (NNWC is one of them) no longer works in today’s world as the businesses are turning toward asset-less. Just look at the largest companies by market capitalization today, Apple, Alphabet (Google), Microsoft, Amazon.com and Facebook, these companies hold very little assets in relative to their revenue and earnings.  Even manufacturers, with technology advancement machines are getting more efficient, therefore less machines are being used, resulting in less factory space being occupied. This argument is true to certain extent, but not applicable to Benjamin Graham net-net strategy as it conservatively takes only 3 assets into consideration, that is Cash, 75% of receivables and 50% of invemtory, giving zero value to property, plant and equipment. 

Just before you jump into FACBIND first thing in the morning, there are actually considerations to be made beyond looking at the NNWC number.

1) Something must be wrong…

Of course something must be wrong! There’s no business owner with a sound mind would sell his company at a price below NNWC! The first task for investors is to identify the reason for the stock  to trade below its NNWC. It could be drastic changes like losing the main client, the biggest trade receivable went default, the main product of the company is no longer needed by the market, being accused of accounting fraud and so on. After identifying the reasons, ask yourself if you are still interested in the company even if it is trading at a dirt cheap price below its NNWC.

In the case of FACBIND, we believe it is the serious lack of transparency of the company making it unwanted. We understand that the company is operating in three divisions, i.e. the bedding operation, the stainless steel operation and association in power plant operation. From the latest financial report, we know that its bedding operation is profit making, while the stainless steel operation and association in power plant operation are loss-making at the moment. And that’s all we know! The management don’t even bother to disclose the breakdown of the revenue, profit (loss) in each division, making it impossible for investors to conduct further research, thus shy away from the company.

FACBIND is also a loss making company in disguise. The company looks profitable on the book, but when we took out the other income from the Income Statement, the business is hardly profit generating, as indicated in Illustration 1 & 2. Details of the other income is not again not being disclosed, but we believe it is mainly derived from interest on Fixed Deposit.

 Illustration 1: Profitability of FACBIND over the years

 Illustration 2: Normalised profit margin of FACBIND over the years

2) How long can the business sustain?

Now you know the problem with the company, so the next question you should ask is: “How long the company is going to last given current situation?”

We mentioned that NNWC is the money you would still get back as a shareholder when the company went through liquidation. However, liquidation is not likely to happen right after you bought the stock. In fact, liquidations are rare in the market. Therefore, most of the time you actually are waiting for the market to give a fair valuation to the stock. The point is, you have got to wait anyway. Net-net investing selects it picks based on the value of the cash, trade receivables and inventories of the company, so investors should make sure that these assets are not shrinking away while they are waiting.

The most effective way to this is to look into the Free Cash Flow (FCF) generating capoability of the company. FCF is being used because it measures the company’s capability to generate cash from its operation and deduct any necessary expenditure to maintain the business. If the company is still generating FCF, there’s nothing much to worry about. If the FCF of the company is negative, calculate how long does it take for all the cash to be burned away. In the case of FACBIND, it is still generating positive FCF in recent two financial years, and only there is only 1 negative FCF out of 5 financial years under coverage.

Besides that, it is ideal to find a net-net stock without any borrowings. External factors like the sudden spike of interest rate or strengthening in foreign loan currency could crush the company assets. FACBIND fulfill this criteria as well.

3) Accounting Fraud

What if everything you knew was a lie?

Net-net investing is highly dependent on figures on the balance sheet. What if the company falsified their financial statements in the first place? Then it would have defeated the very reason you look into this stock. There are many ways to assess the authenticity of a financial statement. FACBIND’s lack of transparency in its financial statements made us have some reservations about its authenticity.

4) The right mentality

Even if the net-net stock you found have fulfilled the all the criteria above, do you have what it takes to invest in the company? As the cliche goes: “It is always simple, but not easy.” If there is an award for most unromantic stock picking technique, then net-net investing is definitely a strong contender. You are basically buying garbage, there is no pride in it, and there is no interesting story to tell about. Your stock will not appear on the news as the brokers latest buy call. Worse, they could hit the headlines for the wrong reasons, making you to question your decisions. The technique itself is very straightforward, but not as easy as it seems.

Conclusion:

One man’s trash is another man’s treasure. Junk car is trash to most people, but it is treasure to Ah Cheong. Isn’t it the same with net-net investing?

Ah Cheong likes the idea of junk car investing because he doesn’t have to put much time to look into every specification of the car. Just like net-net investing, we don’t have to spend too much time to look into the business prospect, it is relatively straightforward.

Ah Cheong never expects the junk car he bought going to be in running condition, but he is sure that the car is trading at scrap value so there’s no much room for depreciation. Neither should you expect the operations of a company is doing fine if it is trading below its NNWC, but you know that there is sufficient margin of safety at that price.

The most difficult part perhaps, it is not a romantic idea to invest in junk cars. Nobody is going to be impressed when they see Ah Cheong’s backyard that is full of junk cars, especially at the same time my rich uncle is constantly bragging about his art gallery. Similarly, net-net investing strategy takes time, whether waiting for the company to actually go through liquidation, or waiting for the market to give the value it deserves. While you are waiting, your friends’ bragging about the kind of performance their growth stocks are making, that is definitely going to make your wait felt longer, and more suffering. 

Will you buy a net-net stock?

Note: we are not suggesting FACBIND as a stock pick, it is merely used as the case study in this post.

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