Grab These 3 Stocks at Bargain Prices
10/04/2011 7:00 am EST
The Net/Net index is a way of spotting undervalued stocks that are trading below current asset value, says Jonathan Heller. He cautions that these names often have problems, but keen-eyed—and cautious—investors and traders can find some hidden gems.
Kate Stalter: Today I am on the phone with Jonathan Heller. He is the President of KEJ Financial Advisors, and also a columnist at Realmoney.com. And Jon, you also run the Cheap Stocks blog. So tell us about your Net/Net Index and what ideas you are seeing, using that approach.
Jonathan Heller: Just to give you a real brief summary of what those are: Those are companies trading below net current asset value, which is typically a pretty deep valuation. You never see Coca-Cola (KO) or Microsoft (MSFT) trading anywhere near that level.
It is a simple formula. You take company’s current assets, you subtract out all liabilities, and if they have preferred stock and minority interests, you take that out, as well. What you are left with are companies that are trading just very, very cheaply, relative to their assets.
It is an approach developed and actually invented by the greatest value investor of all time, Ben Graham. It fell away through the years, and about ten or 12 years ago I stumbled upon it reading some of Graham’s works and thought, hey this would be interesting to see if we can identify any of these companies.
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I have been at it ever since, writing about them, researching and doing some investing in them. Finally a couple of years ago, I decided it would be interesting to see how they would perform in an index setting. So I have developed a couple of indices.
Kate Stalter: One of the things that caught my attention is some of your columns: You do seem to generate some ideas that you don’t commonly see when running other types of screens. So tell us about some of these.
Jonathan Heller: Yeah, and part of the reason is, when you are generating ideas that are net/nets, they are typically very, very small companies. They are small caps or microcaps. So they could be $100 million market cap and below, and occasionally when you see pullbacks in the market the way we have the past couple of months, every once in awhile you get a decent sized name.
One that is showing up now is a tech company, Ingram Micro (IM), and I do own this company.
But historically, what you end up getting in net/net land are companies that are in trouble…some of them are on their way to bankruptcy.
I liken it to dumpster diving. When you are going through a dumpster, you are looking for anything that might have a few breaths left in it, and sometimes the market has a tendency to really over-punish certain companies. You can find some decent names in here and make some good money.
Kate Stalter: What else is standing out right now?
Jonathan Heller: Right now, there is a lot of technology there. That’s what tends to happen in this kind of market environment, where the global economy, for all intents and purposes, is in bad shape.
So a couple of others on there: Benchmark Electronics (BHE) is on there. That’s also a decent-sized company; the market cap’s around $800 million or so. Also a little bit bigger than you are typically going to see.
The other thing that you see, and there is not a lot right now, but retailers—especially the smaller varieties—tend to start showing up. One that is on there now is a small company called Tuesday Morning (TUES).
It has about 800 stores around the US. I have likened it to a rich man’s dollar store. They get a lot of closeout merchandise and it is sold at higher prices than a dollar store, but some interesting merchandise. It used to be a high-flying company, and now it has found itself in net/net land, which is the place that no company wants to go by choice.
Kate Stalter: How should investors or traders handle these stocks, given that there might be some reasons to be cautious?
Jonathan Heller: Yeah, if you are a trader or investor, you have to be very careful, because first of all, data gets stale really quick.
Secondly, you are apt to find some names that do not have a lot of liquidity, and then you have to be real careful. You could find a company that doesn’t trade a lot of shares, but there are some assets on the books, maybe they have a lot of cash.
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Maybe there is a business there that is good and will turn around, but you have to be real careful about bid-ask spreads, and about your time horizons.
So if you are a trader, I would be looking for those that have suffered greatly over a few-day period, or like the markets that we have seen recently and have a lot of volume. If you have a stomach for long term and can hang on, then you can start to dig a little bit deeper.
There are even interesting names which I won’t mention because they are too small, but below $50 million in market cap you typically see some interesting names. That is an area where institutions aren’t going to touch, so it is really one of the last great areas of the market where you can conceivably generate excess return.|pagebreak|
Kate Stalter: Let me shift gears here a little bit, Jon, and let’s talk about your advisory practice. How are you working with these clients, who presumably have somewhat of a longer time horizon and probably have some different objectives than some of the net/net investors or traders?
Jonathan Heller: Absolutely, that is a great question. In a way, I live a dual life, because my fee-only financial planning practices are very different from the research that I do in the net/net area.
These are clients who, you are absolutely right, they have longer-term goals, and they have children to educate, they want to retire, and they want to get there in a way that is low-cost. They want to get there in a way that is a little bit steadier than taking a great deal of risk. So I build very, very low-cost asset-allocation portfolios.
It is interesting. I am a CFA, and we are the guys that are supposed to very much believe that you can generate excess returns in most areas of the market. But I believe in small-cap- and microcap-land you can do that. Hence, the net/net focus.
But in a lot of areas, my clients, I think, are better off if we index, if we do it in the lowest possible cost way, and just build them good asset-allocation portfolios that are going to see them through to their goals.
Kate Stalter: So what instruments are you putting some of these clients into these days, given all the market volatility?
Jonathan Heller: Well, we are certainly not reactionary. We want to build portfolios that are going to mitigate the downside that we are seeing, and will include everything from TIPS where appropriate, to a little exposure to REITs and exposure to commodities, again in small doses. Certainly international developed and emerging markets, US small cap, and US large cap.
It sounds like that is really too simplistic, but you know, you don’t need to hit home runs to get to your goals. A lot of these clients, they don’t need to hit home runs, nor are they are comfortable with the kind of risks that you would have to take, trading and being in and out.
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I will use high-yield bonds, as well, as a small component. I tell my clients that building a portfolio is a very personal thing, number one. Everyone’s circumstances are different.
It is also like building a cake. You know when you bake a cake you have got many, many different ingredients, very few of which you would consume by themselves. You wouldn’t take a spoonful of Crisco and eat it or a handful of flour and eat it; it would be disgusting. Cocoa powder, unsweetened, would be awful.
When you mix them all together, you get a very nice product, all the flavors mix nicely; that is the way a portfolio is. You never want a complete portfolio of high-yield bonds, but when you throw them in the mix in small doses with REITs, TIPS, and international exposure, you get a pretty decent product. It all has to be designed for the client in particular.
Kate Stalter: So to achieve these objectives, Jon, are there any funds that you find yourself turning to on a regular basis?
Jonathan Heller: I use Vanguard funds a lot, and they could be ETFs too.
I tend to use funds more often than ETFs, but a lot of their index products are about the lowest cost out there that you can get. I found that those are great building blocks to build an asset allocation portfolio.