Notes – How To Pick Net-Nets: Two Philosophies From Geoff Gannon And Gurpreet Narang (@geoffgannon, #net-nets)

Buying Net-Nets: What Is The Right Margin Of Safety? by Gurpreet Narang

  • Margin of safety demanded depends on the quality of assets and quality of earnings
  • The subtext of Graham’s 2/3 Rule is that asset values on the balance sheet are inexact
  • In liquidation, liabilities are real but asset values are questionable
  • Liquid assets are easily squandered by bad management or bad operating businesses
  • In addition to discounting assets, look for other positive factors to enhance margin of safety:
    • excess cash relative to assets
    • high return on invested capital
    • ten straight years of operating income
    • ample free cash flows
  • The more liquid the assets, the better the margin of safety
  • One way to improve upon NCAV is P/NQAV, or Price-to-Net Quick Asset value (cash, securities and receivables)
  • Discount demanded moves in inverse proportion to:
    • quality of assets
    • quality of management
    • quality of return on assets
  • Earnings should be backed up by cash flows, preferably with free cash flows
  • Net-nets should be chosen for inherent cheapness, not a hope for liquidation
  • Walter Schloss: “A stock well-bought is half-sold.”
  • Michael Burry: buy at prices “so low that a potential acquirer proposing them would be laughed out of the boardroom”

How To Pick Net-Nets by Geoff Gannon

  • Best Net-Nets:
    • Are around $25M market cap or les
    • High insider ownership
    • High F-score
  • Biggest risks for Net-Nets:
    • Fraud
    • Bankruptcy
    • Share dilution
  • Look for Net-Nets:
    • In the US
    • With positive retained earnings
    • Z-score >3
    • Highest F-scores amongst current crop of NCAVs
    • Highest insider ownership %
  • Similarly, avoid:
    • Foreign
    • Negative retained earnings
    • Z-score <3
    • Lower/lowest F-score
    • Lower/lowest insider ownershi
  • Magic Formula for NCAVs:
    • Rank by F-score
    • Rank by insider ownership
  • Add up the two ranks and choose the highest combined scores
  • You don’t need upside potential, you need downside protection
  • Hold them for longer than a year
  • Take the 10-Q and read it like a credit analyst, asking yourself, “Would you be willing to lend money to this company?”
  • More by Geoff Gannon at How To Pick Solid Net-Nets