Assessing A Company’s Liquidation Value

ValueWalk’s Raul Panganiban interviews Evan Bleker, founder of Net-Net Hunter, and author of “Benjamin Graham’s Net-Net Stock Strategy.” In this part, Evan discusses assessing a company’s liquidation value, companies buying back shares, the appropriate amount of diversification, going equal weighted, and if the qualitative aspects impact performance. See the full transcript here.

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What Is A Net-Net? How Do You Calculate It And Is It Just A Balance Sheet Exercise?

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Yeah. So I think the best way to think about a net net stock is just think about a low price to book stock, and then strip out the long term assets from the equation and that’s, that’s basically a net net stock right there.

That’s the easiest way you can possibly explain it. So when we’re looking at net nets, we’re primarily looking at what a conservative assessment of the company’s liquidation value. And in order to do that, we’re relying fundamentally on obviously current assets rather than total assets. And we do that just because the current assets seem to have more reliability and a liquidation scenario.

So it’s not just a balance sheet exercise. But in order to be a net investor in order to use and strategy, stocks need to meet the basic definition of trading below the net current asset value per share. And then I guess after that, I’ve mentioned sweetener. So this is additional criteria that reduce risk and also boost returns.

So just to give your audience a little bit of understanding of the type of things that I look for in my net net, so I like to look for companies that are buying back shares, because that suggests that management thinks the company doesn’t necessarily need the amount of cash it has on hand because the company’s future is brighter than the market thinks. I also like to Look for management who are buying shares themselves.

Because, you know, as Peter Lynch said, management can sell stock for any number of reasons, but they only buy shares on the open market for a single reason. That’s because they think the company’s a good investment, and they want to make money.

And of course, management is also in the best position to, to tell how a company is going to perform going forward. So those are a couple of the things I like to look for. Also catalysts. So Arman considers share buybacks as catalysts. But when I talked about catalysts, I mean, actual business events that are likely to increase or improve the performance of the company going forward or increase the stock price.

I’ll give you for instance, I recently bought a recently bought a bio for biopharma company, I believe it was and they had just failed. Their drugs that they were developing and they had nothing left in the pipeline or they had nothing. Nothing that was further along in the pipeline.

So, you know, investors sold off the company belowliquidation value and management said, Okay, well we’re gonna wind up this company now because, you know, it doesn’t make sense to continue as a going concern. So, but they were sitting on a lot of cash and they had, you know, some patents and they had a team there and management was incentivized to, to really sell the company to another firm so they could get a large payout.

So, you know, if company if the company announces they’re seeking a buyer then and the company is selling for well below liquidation value, then obviously that’s gonna have a large impact on the price during liquidation value, but not necessarily the business. So that’s an example of you know, price catalysts I like to look for.

Is There A Number Of Share Buybacks That You’re Looking For?

I’m not particularly it’s, you know, it’s kind of like how high is up. Obviously, the more the more the companies buying back, the better. And you have to be careful that the company is not just buying back stock to clean up the options that it’s granting its insiders. So oftentimes, what you’ll see is the CEOs and the CFOs, or whatever will have stock options that they exercise on the open market, and that increases the share count. So what the company will do is it’ll turn around and buy back shares on the open market to keep the the shares outstanding, I guess, fairly constant over that period. So, if the company is not cleaning up options, if it’s boring, Back in a meaningful amount of shares, then that’s that’s a great sign. And obviously, the more shares is buying back, the better.

Why Is It Necessary To Apply Those Tweaks And Why Just Can’t Apply The Formula Broadly?

So, you can apply the formula broadly. And if you do it on a large enough number of companies, you diversify widely enough you will be roughly right. So on average, the assessment you will make on your companies will be roughly equal to the liquidation value. But if you understand the formula and the principles behind it, you can really apply the those principles and those concepts in a more nuanced way. So different industries. We’ll have different sorts of inventory, for example. So if you think about, you know, a pipe or steel construction industry, they might have a lot of steel pipe, and that the price of that pipe will be fairly constant. It’ll fluctuate somewhat, but it won’t fluctuate as much as the company that has a bunch of iPhone 5s. So, you know, if if you’re holding your steel pipe for, you know, two, three years, it will fluctuate, but if you’re, if you’re holding your iPhone 5s for two, three years that the price of or the value of that inventory is going to drop considerably. So being able to understand the concepts and the formula and what we’re really doing will help you better assess what sort of discounts you might want to put on current asset accounts. Also, in some cases, a company might have have restricted cash as a long term asset. And in those situations, if you don’t think that the company is necessarily gonna liquidate tomorrow, you might want to include that in the net current asset value. And if you really understand the formula and what we’re doing with the principles, you can make those judgement calls in your, your liquidation assessment will be more accurate.

How Much Is The Appropriate Diversification?

Yeah, I don’t like giving exact numbers here. Because it’s kind of like the how high up is up question, but I think that you, Joel Greenblatt wrote a really good book called, You Can Be a Stock Market Genius. It’s it’s a great book with a terrible name. Within the first couple chapters, he talks about diversification and and the diminishing returns involved in that and He shows that, you know, you can cut your risk in half if you if you invest into companies and, and then there’s some sort of, I guess you could call it some sort of efficient point where if you have more stocks than this, you’re really not doing anything for reducing your risk. So I think that he lists that point at around 10. So that’s what I took away from, from the, the table that he had in his book. So I like, you know, 1012, somewhere in there. For me, that’s about the best diversification. It also helps that I know what I’m doing when I’m assessing companies. I know the qualitative factors to look for. I think that I still make lots of mistakes, but I’ve maybe make fewer mistakes than somebody who’s new to net nets. Whereas if you’re a just starting out as an investor or just starting out with net nets, obviously, it pays to go with more diversification because the impact of any decision you make or any mistake that you make on your portfolio is going to be a lot less because, you know, each company is has less impact on your portfolio generally. So I would say, the upper limit if you if you really want to pick an upper limit, don’t go more than 30. I, I like, you know, with close friends that have started the strategy just on their own, I say, you know, maybe think about doing 24 because if you’re doing 24, that’s two picks a month and you can easily do that. So that’s enough diversification is fairly manageable.

Do You Place Those Bets Evenly?

I do. And, you know, there’s a lot to be said about, you know, the The Kelley formula and you know, Buffett, he, he likes to bet heavily when the odds are in his favour. I think that in order to, in order to overweight, some companies more than others, you really have to be gifted in terms of business and investing. And I’m kind of a blue collar investor. So I could find my way around the balance sheets and I understand qualitative aspects, but I wouldn’t, I wouldn’t call myself gifted investor. So unless you have a buffet like skill, I would probably be going equal weighted, especially with magnets. I mean, you look at your portfolio, and the ones that you think will work out beautifully. The, you know, they often don’t, but then the ones that, you know, you bought because they just seemed like good value and you had no special confidence and I’m suddenly the rock, you know, 300% you’re like, well, that’s a left field. So I think If you have a little bit of modesty in your own skills, and as investors as value investors, we definitely should, then you should probably be going equally weighted.

Is That Necessary To Add More Percentage To Your Performance Or Is It Better To Just Apply That Formula And Take The Proper Diversification?

Yeah, I mean, that’s a really good question. Somewhat, the question is, you know, does qualitative aspects do they really have an impact on your performance, or should you just go fully quantitative, and there’s definitely solid solid arguments that you can make. Either way. I mean, there there is a really good A book that I think a lot of your listeners will probably have read called Thinking Fast and Slow. And and in that book they discuss the failure of experts, and how it’s beneficial just to stick to a checklist. So if you apply the net net strategy, you know, an argument can be made that you know, just sticking with the mechanical formula, just buying a diverse basket of them is the best way to go. On the other hand, you have people like Buffett saying, back in his partnership days that you know, while the sure money is made on the quantitative side, that if you’re right, on the qualitative side, that’s when you really make a lot of money. So yeah, for me, personally, I tend to go with I make sure that my quantitative side is covered, so I don’t ignore that but I always So look for those sweeteners. So you know, anything that can’t really be quantified nicely would be, I guess, one of those sweeteners. So the catalysts and all that.

Liquidation value and beyond in full transcript.

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