Looking for deeply undervalued stocks?
Net-net investing is a proven strategy for finding hidden opportunities in companies trading below their net current asset value (NCAV). Pioneered by Benjamin Graham, this approach targets stocks priced so low they’re worth less than the company’s liquidation value.
Though less common now, it’s a niche for those willing to dig deep and spot overlooked gems. By betting on unfairly punished companies, it offers the chance for big returns if the business bounces back.
What you’ll learn
- Explaining Net-Net Investing
- Net-Net Investment Methodology
- Special Considerations in Net-Net Investing
- Real-World Example
- Net-Net vs. Double Net
- Performing a Net-Net Calculation
- Target Audience for Net-Net Investments
- Benefits of Net-Net Investing
- Critiques of Net-Net Investing
- Conclusion
- Net Net: FAQs
Explaining Net-Net Investing
Net-net investing refers to stocks trading well below what’s known as their net current asset value. You can find the NCAV by subtracting a company’s total liabilities from its current assets. This represents the company’s worth if its liquid assets were sold off. This strategy finds companies whose market value is lower than the sum of their liquid assets but doesn’t take into account the value of the long-term assets.
The core principle of net-net investing is that these stocks are deeply undervalued, offering a significant margin of safety. Championing this approach, Benjamin Graham, the father of value investing, emphasized buying stocks far below their intrinsic value. However, companies trading below NCAV often face negative sentiment, poor performance, or uncertainty about profitability, leaving them in pessimistic markets despite their NCAV suggesting higher worth.
The net-net strategy is usually applied to stocks trading for less than two-thirds of their NCAV. What this valuation implies is that value focused investors will find value in businesses that the market has over punished. Over time, the stock price is expected to rise to its intrinsic value, offering significant returns.
This strategy appeals for contrarian investors who look for neglected distressed companies which are ignored by the rest of the market. But it takes patience and good business sense to avoid falling into value traps — stocks that seem cheap but don’t rebound because of other, underlying problems.
Net-Net Investment Methodology
At the core of the net-net investment methodology is calculating a company’s NCAV, which is used to determine how to identify undervalued stocks. NCAV is determined by subtracting total liabilities from total current assets including cash, accounts receivable and inventory, which can be easily converted to cash within a year. Property, equipment and intangibles are excluded so that the evaluation of the liquidation value is conservative.
The formula for NCAV is simple:
Current Assets – Total Liabilities = NCAV
If market capitalization is considerably below NCAV, say less than two-thirds, a stock is a “net-net” candidate. Inspired by the value investing principles of Benjamin Graham, this threshold gives a margin of safety, thereby minimizing downside risk while acting as protection against any further price declines.
The logic is straightforward: Assets that are current might even exceed the stock price even if a company’s operations fail. In a liquidation scenario that means investors could recover more than the market value of the stocks. Just because a stock meets net net criteria, this doesn’t automatically make it safe. Therefore, investors need to look at broader factors like financial stability, management quality, as well as industry conditions in order to avoid value traps.
In particular, this methodology is of interest to contrarian investors that are willing to invest in distressed or overlooked companies. Because these investors are comfortable taking a contrarian bet against the market’s sentiment and feeling comfortable they will get their money back once the stock hits its true value over time.
Special Considerations in Net-Net Investing
Several critical factors you need to consider when investing in net-nets. Net net stocks tend to arise in market conditions; for example, recessions or negative sentiment periods when weaker companies trade below their NCAV. Investors should note that the same low priced stocks are not necessarily attractive buys unless deeper market trends and company specifics are analysed.
Company fundamentals also matter, however. NCAV has its place, along with the other more conventional measures of a firm’s financial health, such as cash flow, price to cash flow, debt levels, and management quality. Companies with large operational challenges and/or poor leadership may bear too much risk for the discount to their NCAV. Our ideal candidates are businesses that have recovery potential or are just temporarily undervalued because of the market inefficiencies.
Another is the size of the discount to NCAV. A stock qualifies as a net-net opportunity when it trades at less than two thirds of NCAV. However, a greater margin of safety comes with larger discounts while indicating deeper problems, such as deteriorating prospects, or the bankruptcy risk. In order for investors to avoid value traps, they must compare the discount against the underlying reasons for the undervaluation.
Net-net investing is not easy and requires discipline, thorough research and a contrarian mindset to find opportunities in distressed or disregarded companies by the market. Taking the time to analyze market conditions, company fundamentals and how deep discounts run, investors can manage the risks and find high returns potential.
Real-World Example
Benjamin Graham was a pioneer of this strategy, and a classic example of a successful net net investment. Graham found companies that were trading way below its NCAV during the Great Depression. When these companies faced financial distress, stock prices were so depressed that the market valued them for less than their liquid assets net of their liabilities.
Graham’s most notable success was in a small steel company. Even with such strong current assets as cash and inventory, the stock price of the company fell due to the negative sentiment and bad market conditions in the industry.
Graham saw that the company was selling far below its NCAV and provided a large margin of safety. Buoyed by his analysis, he bought shares, assuming either the market would come to see the value of the company over time or that a liquidation could net him more than the stock’s price per share based on asset sales.
Later, when the economy recovered, the steel company’s stock recovered sharply and delivered such great returns. Graham came to believe that buying stocks deeply discounted from NCAV would provide a tremendous upside with a minimal downside.
This example highlights the core principle of net-net investing: Buying stocks selling for substantially below NCAV offers a cushion against losses and the opportunity for good returns. It also emphasizes that being patient and taking time to value as everything doesn’t come back, it is necessary to identify the ones which can return or can turn around in value.
Net-Net vs. Double Net
The net-net and double net strategies are value investing approaches that both identify stocks trading at deep discount to intrinsic value but they are slightly different in terms of their focus and even their methods of valuation.
The stock gives a strong margin of safety if a company is trading for less than its liquid assets. Investors looking for undervalued opportunities in distressed or overlooked companies suffering from negative sentiment or economic downturns where the price of the shares becomes below the value of liquid assets this approach suits them well.
The double net strategy stems from net-net strategy with additional fixed assets considered in valuation. This method also considers long term assets like property, plant and equipment and subtract all liabilities other than current assets.
Stocks that qualify under the double net strategy trade below the combined value of those assets, and provide further opportunity to investors in companies with hard assets that are undervalued. This larger context does, of course, mandate full consideration of what the long term assets actually contribute, lest their contribution is overestimated.
The net-net approach, in short, is more conservative since it uses current assets only and strives to provide enough margin of safety. Including fixed assets in the double net strategy gives us a wider range of opportunities, but requires that we pay more attention to analyzing their real worth. Each of these strategies can identify deeply undervalued stocks in their own way, but they do so in manners that appeal to specific levels of risk tolerance and investment focus.
Performing a Net-Net Calculation
Performing a net-net calculation is simple with the right financial data from a company’s balance sheet. The goal is to see if a stock is trading below its NCAV, the value of liquid assets minus liabilities. Here’s a step-by-step guide:
1. Gather the Financial Data
Begin by collecting the financial data from the company’s most recent balance sheet. You will need the figures for current assets, total liabilities, and any preferred stock (if applicable). These numbers can usually be found in a company’s quarterly or annual financial filings.
2. Calculate Current Assets
Current assets include cash and cash equivalents, marketable securities, accounts receivable, and inventory. This step is straightforward—simply add up these items to get the total current assets.
For example, if a company’s balance sheet lists:
- Cash: $2 million
- Marketable securities: $1 million
- Accounts receivable: $3 million
- Inventory: $4 million
Then, total current assets = $2M + $1M + $3M + $4M = $10 million.
3. Subtract Total Liabilities
Next, subtract the company’s total liabilities from the current assets. Liabilities include accounts payable, short-term debt, and long-term debt, among others. You will find the total liabilities listed on the balance sheet.
Assume the total liabilities for this company amount to $6 million. Subtracting this from the total current assets of $10 million gives:
- NCAV = $10M – $6M = $4 million.
4. Adjust for Preferred Stock
If the company has preferred stock, subtract its value from the NCAV. If there is no preferred stock, you can skip this step.
5. Compare NCAV to Market Capitalization
Now that you have the NCAV, compare it to the company’s market capitalization (the total value of the company’s outstanding shares). If the company’s market cap is lower than the NCAV, it qualifies as a net-net stock. For instance, if the company’s market cap is $3 million, but its NCAV is $4 million, the stock is trading below its net current asset value, making it a potential net-net investment opportunity.
By following this method, investors can identify undervalued stocks that may provide significant upside potential when the market corrects its mispricing.
Target Audience for Net-Net Investments
The characteristics of the trade have a tendency to attract a certain type of investor. Usually, the value investors that get the most out of net-net investing are those with higher risk appetites and a longer view. This approach centers on picking lowly priced companies that are going through some temporary issue or in temporarily unloved industries. Thus its appeal to contrarian investors — those who trade against market trends on the assumption that eventually the market will realize the stock’s real value.
Net net investors also tend to have good financial analysis skills and lots of patience. However, because net net stocks are usually low-priced companies, they can be more volatile and illiquid than larger, more established firms. This approach suits investors willing to venture into these risks and are willing to hold their positions longer in order to reap the rewards.
Net-net investing is not right for conservative investors who require immediate returns. This strategy is successful because it demands a good understanding of balance sheet analysis and a readiness to purchase shares in businesses that are often misunderstood or operating through difficult times. The potential for big returns is there, but the route is uncertain — precisely why it appeals to value seeking investors with a long enough time horizon to wait for the market to correct its mispricing of value.
Benefits of Net-Net Investing
There are a number of advantages to net-net investing which make it a highly compelling strategy for investors who are prepared to accept its risks. The one advantage is the possibility of generating big returns. Deeply undervalued net net stocks may collectively trade at a discount to their NCAV. Investors can make a bundle, as stock prices bounce back, when these companies conquer their difficulties or the market reconsiders their value.
One other advantage of the strategy is that it has a strong margin of safety. Net-net investors take the additional step of targeting the stocks with the lowest market capitalization to market value for the same reason; because they reduce the risk of paying too much. The prices of these stocks are such that their current assets, including cash, accounts receivable, and inventory, exceed the market value of the stock, and hence act as a cushion even in case of liquidation.
Contrarian investors also find net-net investing appealing because it opens up market inefficiency opportunities to exploit. Because of their temporary issues these stocks are often dismissed or avoided but they have a strong potential to bounce back when conditions improve and the market agrees they can add the much desired value.
This strategy finally improves portfolio diversification. Small, less-followed companies, also known as net-nets, are a nice counterbalance to larger or more growth-oriented holdings. These overlooked opportunities can play a role in portfolio rebalancing and add to a portfolio’s risk-return profile, with substantial upside and limited downside risk.
Net-net investing offers strong return potential, built-in margin of safety, contrarian opportunities and diversification benefits — all of which can make it an extremely powerful tool for disciplined investors.
Critiques of Net-Net Investing
However, more criticisms and limitations exist about net-net investing for value investors. It is considered less effective in a strong bull market by most. At those times, however, the vast majority of stocks trade at a significant premium to their NCAV, which makes the net-net opportunities scarce. The scarcity of these forms of investment may compel investors to hold excess cash, or to settle for less ideal investments.
Another major limitation is the risk of “value traps.” These occur when a stock appears undervalued but underperforms due to structural issues such as poor management, deteriorating fundamentals, or bankruptcy risks. Many net-net stocks trade significantly below their NCAV for valid reasons, and investing in these companies may result in little to no price recovery. In such cases, the perceived discount is an illusion rather than an opportunity.
Net-nets also face a liquidity challenge. These stocks are often with smaller, lesser-known companies and typically have very low trading volume, making it difficult and expensive to enter or exit a position without penetrating prices.
Real-time trade alerts can serve as a valuable supplementary tool, helping investors monitor market movements and execute trades more efficiently in such low-liquidity environments. Additionally, there is minimal analyst coverage and little known about many of these companies, making the due diligence process riskier, as these types of investments can be easily misjudged.
Lastly, it can be a bad thing that net-net investments take so long to be successful. Of course, these opportunities pay off only over long periods of time, since the market takes a long time to recognize and correct the undervaluation. Investors seeking quick returns or unwilling to hold stocks for longer durations will not favor this strategy.
Conclusion
Deeply undervalued stocks are what net net investing brings to the table. Using the net current asset value approach, investors can identify companies that are trading with a significant discount, and capitalize on the recovery in mispricing when the market adjusts its pricing. Instead, this is a strategy that promotes conservative valuation and downside protection by concentrating on those stocks that are already cheap.
But investing net net has risks. There is worry of value traps, where companies are undervalued because of declining fundamentals or poor management. Opportunities are also determined by market conditions as undervalued stocks are rare in bull markets. But for patient, long term investors, net net investing is still a powerful way of uncovering value that is hidden.
Net-net investing is successful only if stock selection is done well, fundamental analysis is done thoroughly, and an investor is aware of market dynamics. It is not for all investors or all market conditions, but should be considered for those that seek to capture significant returns during volatile markets, all while having a margin of safety.
Decoding Net Net: FAQs
What Distinguishes Net-Net Investing from Other Value Investing Strategies?
Buying stocks trading below their NCAV is a more conservative way than traditional value investing. Unlike other strategies that use metrics like price to earnings ratios or discounted cash flows, net net investing focuses on current assets, and targets stocks that are already below liquidation value as a strong margin of safety.
How Frequently Do Net-Net Opportunities Occur in the Market?
The only time net-net opportunities come around is when stock prices are low and in bull markets, net-net opportunities are rare. Bear markets or an economic downturn with low investor sentiment and plenty of undervalued stocks are where they are more common. Often these opportunities arise in smaller cap stocks or distressed sectors and patience is needed and a willingness to look at lesser followed companies.
What Are the Risks Associated with Investing in Net-Net Stocks?
Value traps are key risks: Stocks don’t catch up with their fundamentals because of deteriorating fundamentals, bad management, or industry problems. They are usually low liquidity, meaning that the trades can get very volatile and the exits can be very tricky. Moreover, a long term outlook is required due to the fact that the market may not recognize a stock’s true value quickly enough, taking longer than it should.
Can Net-Net Investing Be Applied to International Markets?
Yes, there are far more net net opportunities in international markets, particularly in countries where the markets are inefficient. But such a move comes at a cost of political instability, currency fluctuations and divergence of accounting standards.
How Does Market Volatility Impact Net-Net Investing Strategies?
Market volatility can create both opportunities and risks for net-net investing. This drive up can make fundamentally strong stocks drop below NCAV and thus become attractive, but it also increases price fluctuations, especially in small or distressed companies. Volatility plays to the advantage of patient net-net investors who can buy into stocks that have been unfairly depressed by fear.