What’s the most important thing to look for in a net-net? Retained earnings.
Retained earnings are one of those odd little items nobody pays attention to. Folks new to accounting often get confused by retained earnings – thinking it’s some kind of asset account. Like it holds cash or something. It doesn’t.
This is one of the places where it helps to have a background in accounting. In the first couple weeks of any financial accounting course, they teach you about retained earnings. They show you how the accounting cycle works. And they have you complete closing entries.
As you know, a balance sheet shows a business’s position at a point in time. And an income statement shows a business’s performance over a period of time. There is no such thing as a balance sheet for the year 2010. But there is such a thing as a balance sheet for December 31, 2010.
Income statements reset. Balance sheets don’t. On January 1, 2011, you can just keep piling up new assets and liabilities on the same old balance sheet you had back on December 31. But that’s not how income statements work. You pick a day and you cut time in two. Everything before midnight on December 31 – or whatever day the company ends its fiscal year – shows up on the 2010 income statement. Everything after midnight shows up on the 2011 income statement.
Which raises a question.
Where does all that income go?
Into the retained earnings account.
A business is like your kitchen at home. You cook and you eat. Some days you cook more than you eat. Other days you eat more than you cook. How?
Leftovers.
Whenever you cook more than you eat you stick the leftovers in the fridge. And whenever you cook less than you eat – you take those leftovers out. So what are leftovers worth?
Let’s be honest. When you stick something in the fridge, do you really know if and when you’ll eat it? Or do you sometimes end up putting it in there, ignoring it the next day, and then the next – and pretty soon you’re taking out week old chicken, sniffing it and wondering: “Which day was the teriyaki?” Into the trash it goes.
Same thing with retained earnings. They’re no guarantee of quality. They often get wasted. But at least they’re proof of past production. You did once produce more than you consumed.
That’s retained earnings. The fact that you’ve got leftovers in your kitchen doesn’t necessarily tell you whether you can or will eat those leftovers – and it certainly doesn’t tell you anything about how good they’ll be. But leftovers do prove one undeniable fact: you once cooked more than you ate.
Retained earnings are a business’s leftovers. And stockholder’s equity is a business’s fridge.
Stockholder’s equity – also called book value – is a company’s assets minus its liabilities. When value investors write about stockholder’s equity they’re usually talking about tangible stockholder’s equity. Stuff you can touch. Not goodwill. But the stockholder’s equity shown on a company’s balance sheet includes goodwill.
Now – assuming you know the accounting equation – you’re probably thinking this retained earnings stuff is pretty pedantic. Meaningless t-crossing and i-dotting done to balance the books.
The accounting equation looks like this:
Assets = Liabilities + Equity
In other words, all assets are supported by either creditors or owners. This makes sense. And it’s why the Z-Score – a stat meant to predict a near-term bankruptcy – uses retained earnings/assets as one of its key ratios. The higher retained earnings are relative to assets, the healthier a business tends to be.
Why?
There are a couple reasons for this. Obviously, since assets are supported by either owners or creditors, the more assets a company funds through its owner’s capital the less it has to fund through creditor’s capital. The less it has to depend on the kindness of strangers.
So, companies with higher ratios of retained earnings-to-total assets tend to be companies that borrow relatively little compared to their size.
Kind of. Actually, the equity-to-assets ratio would be the best indicator of the amount of owner’s capital in the business – and by inversion – the relative lack of promises made to creditors relative to the business’s size.
What’s interesting about the use of the retained earnings-to-total assets ratio in the Z-Score is that most financial analysts – in fact, almost every single financial analyst from the first half of the 20th century – would use the debt-to-equity ratio or the equity-to-total assets ratio or the tangible equity-to-total assets ratio. Whatever they’d use it would involve shareholders’ equity instead of retained earnings.
Retained earnings is an equity account. But it’s not the only equity account. So it would seem – logically – that retained earnings should be less informative than the sum total of all of a company’s equity. In other words, the ratio of book value (net assets) to total assets sounds like the best choice for checking a company’s financial health?
Is it?
Well, the Z-Score is a particular type of predictive metric based on using 5 different ratios in combination. It’s not meant to use just one number. So, the fact that the Z-Score uses retained earnings divided by total assets as one of 5 parts to make a bankruptcy prediction doesn’t necessarily mean retained earnings are all that important.
However, there are other very good reasons for thinking that retained earnings are more important than they appear to be.
Granted, some very safe companies have negative retained earnings. This is an odd circumstance affecting companies like Microsoft (MSFT, Financial) which are clearly super safe companies despite their negative retained earnings. This problem isn’t unique to retained earnings. There are public companies with negative tangible book value too. In all of these cases, the culprit is usually some unique intangible advantage the business has that allows it to operate with little or no tangible equity. Businesses where cash flows into the company’s coffers before being reported as earnings are particularly susceptible to this odd occurrence of being both a super safe company and yet have no retained earnings. Nonetheless, it’s a rare phenomena which you won’t see among net-nets.
That’s what this article is about. Not just retained earnings. But retained earnings as it relates to net-nets.
Why do retained earnings matter for net-nets?
Everybody knows that tangible asset measure matter for net-nets. That’s the reason value investors are interested in the stocks. They see these low, low price-to-tangible book, price-to-current assets, price-to-quick assets, and price-to-cash ratios and they salivate.
As they should.
But should they also check the retained earnings account?
Yes.
Retained earnings have become an even more important part of net-net selection in modern times than they were in Ben Graham’s day.
Think about it. The problem with shareholder’s equity is that no distinction is made between capital that owners put into the business and capital that the business produced itself and retained.
It’s like looking at a forest and not knowing whether the trees were just planted there as part of some great human undertaking – or whether they’ve been self-propagating for centuries.
In the investment world, this distinction between different types of owner capital – contributed and retained – mattered less. Simply because public companies were funded differently.
The big reason retained earnings matter so much more today when it comes to picking net-net is the increase in speculative initial public offerings. It has become more acceptable over time to take companies public before they have a consistent record of earnings. Sometimes before they’ve ever reported any earnings at all.
These speculative at birth stocks – not fallen angles, but junk from day one stocks – completely undermine Ben Graham’s basic reason for buying net-nets. Graham’s idea was that net-nets are bargains because they are public companies trading for less than an equivalent private business would ever sell for. The reason being that both public and private companies tend to sell for the cash that can be taken out of them in the future. For good businesses, this is almost entirely equivalent to future earnings. For bad businesses, the number is trickier to calculate. But not impossible to estimate within a very wide range.
The widest extent on the cheap side of this range has to be the net working capital of the business. A private business – if it’s profitable in the very long-run – should never sell for less than its liquidation value. By liquidation value, Graham meant a very orderly – slow and steady – liquidation. There’s no reason to rush the liquidation of a profitable business. Only money losing businesses need to be sold fast.
Net-nets are supposed to be mediocre business that will at least earn some money over the long run.
After all, even a very bad business that still earns some small return on capital should be worth at least what it can be liquidated for.
This article isn’t going to get into the issue of whether public companies with poor long-term returns on capital should sell below liquidation value if there’s no hope of a change in control. That might be true. It’s debatable. Investment theorists tend to support the conclusion that the market is somewhat efficient even when it comes to net-nets. Empirical evidence cuts the other way. Net-net outperformance is well-documented in a bunch of different time periods in a bunch of different countries. And yes, plenty of these net-nets are controlled companies or illiquid enough to make hostile takeovers extremely difficult. And even if hostile takeovers were impossible there’s still no situation in which a change in control is literally impossible. U.S. companies can be bought out by their control owners. And there are certain safeguards in place – that while they may not guarantee a fair price to shareholders – do tend to make control owners pay more to take a company private than would be the case if they really could force out their minority partners.
Even if minority shareholders in net-nets do get screwed – they don’t get screwed bad enough to eliminate the initial advantage of buying a stock at less than its net current asset value.
There are really only 3 serious threats in net-net investing: fraud, bankruptcy, and time. Time is the most common and usually most serious threat. But that’s a topic for another day.
Regardless of the theory, the long-term history of actual net-nets show that the upside far outweighs the downside. The risk of these stocks languishing forever under the thumb of control owners who care nothing about returns on capital and refuse to liquidate the business turns out in practice to be rarer and less permanent a problem than it appears in theory. A big reason for this is that even if owners are uninterested in increasing returns on capital themselves – their competitors are often interested in abandoning businesses that have abysmal returns on capital. As a result, there’s a decent chance that poor return on capital businesses will eventually see some improvement in their returns on net working capital even if the owners are unwilling to liquidate the business. Once earnings tick up, the market will recognize this fact and perhaps even give extra points for the now positive trend. And the buyer of these Ben Graham bargains will be vindicated.
Not all the time. But more times than not.
However, there is one scenario where this most certainly does not hold true.
What if a net-net has never turned a profit?
This idea was unthinkable in Ben Graham’s day. After all, how could a company go public if it didn’t earn any money?
And why would a business continue to operate if it was losing money year-after-year? The private, control owners wouldn’t stand for it. And public investors didn’t have an appetite for the shares of permanently money losing businesses. So, there was no money in operating a loss making business forever. Not for managers. Not for promoters. Not for owners.
Today, money-losing businesses go public all the time. And that completely changes the calculus for everyone. Now there’s an exit strategy for owners. Now stock options in money losing businesses are worth something. Now there’s a reason to keep losing money year after year as long as there’s some hope Wall Street will one day pay a pretty penny for the butterfly this ugly business becomes.
It sounds silly. But it’s sometimes justified. Maybe money losing businesses should go public. Maybe some investors should gamble on them.
But not the followers of Graham.
And some money losing businesses from the internet boom are now well-established, profitable businesses. The market isn’t wrong to buy these money-losing businesses. The price may sometimes be wrong – that’s a different issue.
But Amazon (AMZN, Financial) was once a public company with no history of profitability. Today, nobody doubts Amazon’s ability to earn buckets of cash. In fact, the company is now one of the established stalwarts of American business. It’s not the least bit speculative. Though again – the price may be – but that’s a different issue. An issue that can afflict any stock. At a certain price, GE and Coke were certainly speculative. Not because they were unworthy of being public companies but because the public bid their stock prices to absurd levels.
What does this have to do with net-nets?
A lot.
Net-nets are never speculative favorites when they actually become net-nets. But a small group of net-nets were once speculative favorites. Or at least they were able to be taken public riding some short lived fad or some wave of market froth that let a company that had no history of profitability – and perhaps had no real chance of being sold to a private buyer – to be unloaded on the public.
This undermined Ben Graham’s basic reason for buying net-nets. A net-net that has never earned a profit may never be worth more alive than dead. That’s the whole idea behind buying net-nets. You buy something at a price below its value in death (liquidation) and you get any future fruits of its life for free.
But when a business isn’t just losing money this year as part of some cyclical downturn – but actually has never earned any money, or has lost more than it’s made over the years – that’s a different story. That’s not really a net-net at all.
At least it’s not a stock Ben Graham would buy.
There’s no reason to believe a perennial money loser is worth more alive than dead. It might well be worth more if you pulled the plug today and shut down this foolish venture.
That’s why retained earnings matter.
Retained earnings tell you that a business has retained more in earnings than it has paid out. Obviously, that guarantees that the business has – over its lifetime – actually earned more money than it’s lost. It could have paid out dividends too. But it’s certainly grown through self-funding.
And that’s the key to finding a business that is worth more alive than dead.
Retained earnings are an indicator of the past. They are no guarantee of the future. Legislative changes, technological changes, cultural changes, and a slew of other things can and do destroy the earning power of once prosperous companies.
Net-nets can go belly up.
That’s why you should use the Z-Score and the F-Score when picking your net-nets the same way you would when picking below book value stocks.
But retained earnings are especially important when choosing net-nets.
Over the last 6 months or so, GuruFocus’s Ben Graham Net Current Asset Value Bargains Newsletter has developed two – and only two – hard and fast rules for picking net-nets. One: never buy a net-net with negative retained earnings. And two: never buy a Chinese net-net.
Why did the newsletter come to these two – rather common sense – conclusions?
Practice.
If you buy enough net-nets you start to notice patterns. The most important pattern you notice – the one that’s toughest for new net-net investors to understand – is that the upside doesn’t really matter. Only the downside. Every net-net – by virtue of being a net-net – has upside aplenty. The problem is accidentally picking one of the net-nets that has a downside of roughly 100%.
Those deadly downside stocks tend to appear in two corners of the net-net world:
1. Chinese net-nets
2. Net-nets with no retained earnings
If you side-step those two landmines and focus on picking the safest, simplest net-nets from among the few dozen – currently – that satisfy those criteria, you can earn market beating returns even while investing in up to a dozen net-nets. That’s pretty wide diversification for an approach that tends to provide market beating returns in the vast majority of years.
A lot has been written about the risks of investing in Chinese net-nets specifically and Chinese stocks generally. Especially reverse merger stocks. Those frauds have gotten a lot of press. Even appearing in places like Bloomberg and The New York Times.
That makes sense. Frauds grab headlines.
But risky businesses headed for bankruptcy are every bit as dangerous to an investor’s health as outright frauds.
And nobody out there is writing about retained earnings.
Nobody is mentioning the simple fact that not all net-nets are equal. Some have a history of profits. Some have a history of losses.
Which do you want to own?
The Ben Graham Net Current Asset Bargains Newsletter sticks to net-nets with positive retained earnings.
That’s what Ben Graham would do.
And that’s what you should do too.
[url=http://www.gurufocus.com/newsletters.php#nl1]
Retained earnings are one of those odd little items nobody pays attention to. Folks new to accounting often get confused by retained earnings – thinking it’s some kind of asset account. Like it holds cash or something. It doesn’t.
This is one of the places where it helps to have a background in accounting. In the first couple weeks of any financial accounting course, they teach you about retained earnings. They show you how the accounting cycle works. And they have you complete closing entries.
As you know, a balance sheet shows a business’s position at a point in time. And an income statement shows a business’s performance over a period of time. There is no such thing as a balance sheet for the year 2010. But there is such a thing as a balance sheet for December 31, 2010.
Income statements reset. Balance sheets don’t. On January 1, 2011, you can just keep piling up new assets and liabilities on the same old balance sheet you had back on December 31. But that’s not how income statements work. You pick a day and you cut time in two. Everything before midnight on December 31 – or whatever day the company ends its fiscal year – shows up on the 2010 income statement. Everything after midnight shows up on the 2011 income statement.
Which raises a question.
Where does all that income go?
Into the retained earnings account.
A business is like your kitchen at home. You cook and you eat. Some days you cook more than you eat. Other days you eat more than you cook. How?
Leftovers.
Whenever you cook more than you eat you stick the leftovers in the fridge. And whenever you cook less than you eat – you take those leftovers out. So what are leftovers worth?
Let’s be honest. When you stick something in the fridge, do you really know if and when you’ll eat it? Or do you sometimes end up putting it in there, ignoring it the next day, and then the next – and pretty soon you’re taking out week old chicken, sniffing it and wondering: “Which day was the teriyaki?” Into the trash it goes.
Same thing with retained earnings. They’re no guarantee of quality. They often get wasted. But at least they’re proof of past production. You did once produce more than you consumed.
That’s retained earnings. The fact that you’ve got leftovers in your kitchen doesn’t necessarily tell you whether you can or will eat those leftovers – and it certainly doesn’t tell you anything about how good they’ll be. But leftovers do prove one undeniable fact: you once cooked more than you ate.
Retained earnings are a business’s leftovers. And stockholder’s equity is a business’s fridge.
Stockholder’s equity – also called book value – is a company’s assets minus its liabilities. When value investors write about stockholder’s equity they’re usually talking about tangible stockholder’s equity. Stuff you can touch. Not goodwill. But the stockholder’s equity shown on a company’s balance sheet includes goodwill.
Now – assuming you know the accounting equation – you’re probably thinking this retained earnings stuff is pretty pedantic. Meaningless t-crossing and i-dotting done to balance the books.
The accounting equation looks like this:
Assets = Liabilities + Equity
In other words, all assets are supported by either creditors or owners. This makes sense. And it’s why the Z-Score – a stat meant to predict a near-term bankruptcy – uses retained earnings/assets as one of its key ratios. The higher retained earnings are relative to assets, the healthier a business tends to be.
Why?
There are a couple reasons for this. Obviously, since assets are supported by either owners or creditors, the more assets a company funds through its owner’s capital the less it has to fund through creditor’s capital. The less it has to depend on the kindness of strangers.
So, companies with higher ratios of retained earnings-to-total assets tend to be companies that borrow relatively little compared to their size.
Kind of. Actually, the equity-to-assets ratio would be the best indicator of the amount of owner’s capital in the business – and by inversion – the relative lack of promises made to creditors relative to the business’s size.
What’s interesting about the use of the retained earnings-to-total assets ratio in the Z-Score is that most financial analysts – in fact, almost every single financial analyst from the first half of the 20th century – would use the debt-to-equity ratio or the equity-to-total assets ratio or the tangible equity-to-total assets ratio. Whatever they’d use it would involve shareholders’ equity instead of retained earnings.
Retained earnings is an equity account. But it’s not the only equity account. So it would seem – logically – that retained earnings should be less informative than the sum total of all of a company’s equity. In other words, the ratio of book value (net assets) to total assets sounds like the best choice for checking a company’s financial health?
Is it?
Well, the Z-Score is a particular type of predictive metric based on using 5 different ratios in combination. It’s not meant to use just one number. So, the fact that the Z-Score uses retained earnings divided by total assets as one of 5 parts to make a bankruptcy prediction doesn’t necessarily mean retained earnings are all that important.
However, there are other very good reasons for thinking that retained earnings are more important than they appear to be.
Granted, some very safe companies have negative retained earnings. This is an odd circumstance affecting companies like Microsoft (MSFT, Financial) which are clearly super safe companies despite their negative retained earnings. This problem isn’t unique to retained earnings. There are public companies with negative tangible book value too. In all of these cases, the culprit is usually some unique intangible advantage the business has that allows it to operate with little or no tangible equity. Businesses where cash flows into the company’s coffers before being reported as earnings are particularly susceptible to this odd occurrence of being both a super safe company and yet have no retained earnings. Nonetheless, it’s a rare phenomena which you won’t see among net-nets.
That’s what this article is about. Not just retained earnings. But retained earnings as it relates to net-nets.
Why do retained earnings matter for net-nets?
Everybody knows that tangible asset measure matter for net-nets. That’s the reason value investors are interested in the stocks. They see these low, low price-to-tangible book, price-to-current assets, price-to-quick assets, and price-to-cash ratios and they salivate.
As they should.
But should they also check the retained earnings account?
Yes.
Retained earnings have become an even more important part of net-net selection in modern times than they were in Ben Graham’s day.
Think about it. The problem with shareholder’s equity is that no distinction is made between capital that owners put into the business and capital that the business produced itself and retained.
It’s like looking at a forest and not knowing whether the trees were just planted there as part of some great human undertaking – or whether they’ve been self-propagating for centuries.
In the investment world, this distinction between different types of owner capital – contributed and retained – mattered less. Simply because public companies were funded differently.
The big reason retained earnings matter so much more today when it comes to picking net-net is the increase in speculative initial public offerings. It has become more acceptable over time to take companies public before they have a consistent record of earnings. Sometimes before they’ve ever reported any earnings at all.
These speculative at birth stocks – not fallen angles, but junk from day one stocks – completely undermine Ben Graham’s basic reason for buying net-nets. Graham’s idea was that net-nets are bargains because they are public companies trading for less than an equivalent private business would ever sell for. The reason being that both public and private companies tend to sell for the cash that can be taken out of them in the future. For good businesses, this is almost entirely equivalent to future earnings. For bad businesses, the number is trickier to calculate. But not impossible to estimate within a very wide range.
The widest extent on the cheap side of this range has to be the net working capital of the business. A private business – if it’s profitable in the very long-run – should never sell for less than its liquidation value. By liquidation value, Graham meant a very orderly – slow and steady – liquidation. There’s no reason to rush the liquidation of a profitable business. Only money losing businesses need to be sold fast.
Net-nets are supposed to be mediocre business that will at least earn some money over the long run.
After all, even a very bad business that still earns some small return on capital should be worth at least what it can be liquidated for.
This article isn’t going to get into the issue of whether public companies with poor long-term returns on capital should sell below liquidation value if there’s no hope of a change in control. That might be true. It’s debatable. Investment theorists tend to support the conclusion that the market is somewhat efficient even when it comes to net-nets. Empirical evidence cuts the other way. Net-net outperformance is well-documented in a bunch of different time periods in a bunch of different countries. And yes, plenty of these net-nets are controlled companies or illiquid enough to make hostile takeovers extremely difficult. And even if hostile takeovers were impossible there’s still no situation in which a change in control is literally impossible. U.S. companies can be bought out by their control owners. And there are certain safeguards in place – that while they may not guarantee a fair price to shareholders – do tend to make control owners pay more to take a company private than would be the case if they really could force out their minority partners.
Even if minority shareholders in net-nets do get screwed – they don’t get screwed bad enough to eliminate the initial advantage of buying a stock at less than its net current asset value.
There are really only 3 serious threats in net-net investing: fraud, bankruptcy, and time. Time is the most common and usually most serious threat. But that’s a topic for another day.
Regardless of the theory, the long-term history of actual net-nets show that the upside far outweighs the downside. The risk of these stocks languishing forever under the thumb of control owners who care nothing about returns on capital and refuse to liquidate the business turns out in practice to be rarer and less permanent a problem than it appears in theory. A big reason for this is that even if owners are uninterested in increasing returns on capital themselves – their competitors are often interested in abandoning businesses that have abysmal returns on capital. As a result, there’s a decent chance that poor return on capital businesses will eventually see some improvement in their returns on net working capital even if the owners are unwilling to liquidate the business. Once earnings tick up, the market will recognize this fact and perhaps even give extra points for the now positive trend. And the buyer of these Ben Graham bargains will be vindicated.
Not all the time. But more times than not.
However, there is one scenario where this most certainly does not hold true.
What if a net-net has never turned a profit?
This idea was unthinkable in Ben Graham’s day. After all, how could a company go public if it didn’t earn any money?
And why would a business continue to operate if it was losing money year-after-year? The private, control owners wouldn’t stand for it. And public investors didn’t have an appetite for the shares of permanently money losing businesses. So, there was no money in operating a loss making business forever. Not for managers. Not for promoters. Not for owners.
Today, money-losing businesses go public all the time. And that completely changes the calculus for everyone. Now there’s an exit strategy for owners. Now stock options in money losing businesses are worth something. Now there’s a reason to keep losing money year after year as long as there’s some hope Wall Street will one day pay a pretty penny for the butterfly this ugly business becomes.
It sounds silly. But it’s sometimes justified. Maybe money losing businesses should go public. Maybe some investors should gamble on them.
But not the followers of Graham.
And some money losing businesses from the internet boom are now well-established, profitable businesses. The market isn’t wrong to buy these money-losing businesses. The price may sometimes be wrong – that’s a different issue.
But Amazon (AMZN, Financial) was once a public company with no history of profitability. Today, nobody doubts Amazon’s ability to earn buckets of cash. In fact, the company is now one of the established stalwarts of American business. It’s not the least bit speculative. Though again – the price may be – but that’s a different issue. An issue that can afflict any stock. At a certain price, GE and Coke were certainly speculative. Not because they were unworthy of being public companies but because the public bid their stock prices to absurd levels.
What does this have to do with net-nets?
A lot.
Net-nets are never speculative favorites when they actually become net-nets. But a small group of net-nets were once speculative favorites. Or at least they were able to be taken public riding some short lived fad or some wave of market froth that let a company that had no history of profitability – and perhaps had no real chance of being sold to a private buyer – to be unloaded on the public.
This undermined Ben Graham’s basic reason for buying net-nets. A net-net that has never earned a profit may never be worth more alive than dead. That’s the whole idea behind buying net-nets. You buy something at a price below its value in death (liquidation) and you get any future fruits of its life for free.
But when a business isn’t just losing money this year as part of some cyclical downturn – but actually has never earned any money, or has lost more than it’s made over the years – that’s a different story. That’s not really a net-net at all.
At least it’s not a stock Ben Graham would buy.
There’s no reason to believe a perennial money loser is worth more alive than dead. It might well be worth more if you pulled the plug today and shut down this foolish venture.
That’s why retained earnings matter.
Retained earnings tell you that a business has retained more in earnings than it has paid out. Obviously, that guarantees that the business has – over its lifetime – actually earned more money than it’s lost. It could have paid out dividends too. But it’s certainly grown through self-funding.
And that’s the key to finding a business that is worth more alive than dead.
Retained earnings are an indicator of the past. They are no guarantee of the future. Legislative changes, technological changes, cultural changes, and a slew of other things can and do destroy the earning power of once prosperous companies.
Net-nets can go belly up.
That’s why you should use the Z-Score and the F-Score when picking your net-nets the same way you would when picking below book value stocks.
But retained earnings are especially important when choosing net-nets.
Over the last 6 months or so, GuruFocus’s Ben Graham Net Current Asset Value Bargains Newsletter has developed two – and only two – hard and fast rules for picking net-nets. One: never buy a net-net with negative retained earnings. And two: never buy a Chinese net-net.
Why did the newsletter come to these two – rather common sense – conclusions?
Practice.
If you buy enough net-nets you start to notice patterns. The most important pattern you notice – the one that’s toughest for new net-net investors to understand – is that the upside doesn’t really matter. Only the downside. Every net-net – by virtue of being a net-net – has upside aplenty. The problem is accidentally picking one of the net-nets that has a downside of roughly 100%.
Those deadly downside stocks tend to appear in two corners of the net-net world:
1. Chinese net-nets
2. Net-nets with no retained earnings
If you side-step those two landmines and focus on picking the safest, simplest net-nets from among the few dozen – currently – that satisfy those criteria, you can earn market beating returns even while investing in up to a dozen net-nets. That’s pretty wide diversification for an approach that tends to provide market beating returns in the vast majority of years.
A lot has been written about the risks of investing in Chinese net-nets specifically and Chinese stocks generally. Especially reverse merger stocks. Those frauds have gotten a lot of press. Even appearing in places like Bloomberg and The New York Times.
That makes sense. Frauds grab headlines.
But risky businesses headed for bankruptcy are every bit as dangerous to an investor’s health as outright frauds.
And nobody out there is writing about retained earnings.
Nobody is mentioning the simple fact that not all net-nets are equal. Some have a history of profits. Some have a history of losses.
Which do you want to own?
The Ben Graham Net Current Asset Bargains Newsletter sticks to net-nets with positive retained earnings.
That’s what Ben Graham would do.
And that’s what you should do too.
[url=http://www.gurufocus.com/newsletters.php#nl1]
