FOOL ON THE HILL
Quest for Deep Value

The sub-$200 million micro-cap arena offers fertile soil to individual investors hungry for a bargain. Companies this small fly well below Wall Street's radar and can therefore occasionally become dramatically undervalued. "Net Net Working Capital" is a tool to help you sort out some of the best micro-cap candidates for further investigation.

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By Matt Richey (TMF Matt)
March 15, 2002

If you're a bargain hunter with a knack for balance sheets and an interest in sleuthing, you have one of the richest opportunities in the entire investment universe available to you: deep-value micro-caps. I'm talking about the sub-$200 million market cap range where you can find some spectacular values. Why? Because these stocks are too small to be of any interest to the vast majority of professional money managers. As a result, stocks in the micro-cap arena can be very inefficiently priced at times. That inefficiency is our opportunity.

Let me warn you right up front, though: Micro-caps are the jungle of the investment world. If you go in search of these little gems, you're almost certain to stumble across a few, if not many, poisonous reptiles. You'll run into fraudulent pyramid schemes and go-nowhere little companies that exist solely to pay their managers high salaries. You'll also have to contend with the fact that most of these companies, even the ones you might be interested in, are damaged goods. Sales may be down, profits may be temporarily non-existent, and the economics of the business probably are mediocre. Also, don't be surprised if many of the stocks in this arena are below $5 per share. Caveat emptor reigns supreme in this style of investing.

This is emphatically not an investment strategy for the novice. No offense, but if "working capital" is a foreign word to you, please click the link at the top of this page on your way over to Fool's School. But for those of you who are fluent in reading financial statements and willing to go the extra mile in your due diligence, there are rich rewards to be had among micro-cap deep values.

Net Net Working Capital
One of the analytical tools I find most helpful in searching for these deep values is a methodology called Net Net Working Capital (NNWC). Think of NNWC as your machete for efficiently whacking through the micro-cap jungle. This is a Benjamin Graham-style concept that values a company based on the liquid components of working capital, net of all liabilities. Specifically, the NNWC formula is:

NNWC = (Cash & Investments * 100%) + (Accounts Receivable * 75%) + (Inventory * 50%) � Total Liabilities

Basically, what the formula says is that we'll value cash at 100%, receivables at 75 cents on the dollar (because some of them might not be collectable), inventory at 50 cents on the dollar (because of likely discounting when sold at close-out prices), and then we'll subtract out all the liabilities; what we're left with is the company's Net Net Working Capital. Think of NNWC as a conservative estimate of what the company might be worth if it shut its doors, sold everything, paid off its creditors, and returned all the money to shareholders.

We're after companies with a market capitalization less than the sum value of its NNWC. In other words, we want the price of the stock to be less than the per-share value of NNWC. Such companies are priced for the liquidation of assets, with the underlying business essentially being assigned a value of zero. Basically, the market is betting that these companies will die. Yet if you find one with any sort of staying power, there's solid upside potential. Read "staying power" as no or very-low cash burn. Check the cash flow statement to make sure the free cash flow spigot isn't running with red ink. I look for companies that are at least generating positive free cash flow in the most recent quarter.

Risk/Reward considerations
Companies such as this -- with no or low cash burn and selling for less than NNWC -- have a tremendous risk/reward profile. Your risk is very limited because the stock's valuation is based on tangible liquid assets. That's about as solid a foundation as any stock can have.

On the flipside, your reward potential has two components. First, to the extent that you buy at a discount to NNWC, you have the opportunity to profit as the stock returns to a value equal to its NNWC. For example, if you buy a stock that's selling for $2, but it has $4 per share in NNWC, you could earn a 100% gain as the stock returns to $4. That's not an unreasonable expectation as long as the company isn't burning cash.

Second, if you find one of these little companies with the potential for decent profits, you have the opportunity for additional upside as the market eventually prices the company not just on the basis of its NNWC, but also on the value of its future earnings. For example, if you bought a stock for $2, with NNWC of $3 per share and the potential for $0.25 in earnings next year, you could see the stock go to $5 if it were to be valued at 8x earnings ($0.25 x 8 = $2) plus its $3 in per-share NNWC.

Applying the strategy
Probably the simplest way to begin finding some low-NNWC candidates is to use a stock screener (Market Guide has a good one available for free). Sort for stocks based on a low market cap and a low price-to-book value. All NNWC plays have a low price-to-book, so this is a good starting point. With some practice, you'll be able to quickly apply the NNWC formula and find potential candidates.

Bear in mind, however, this is not a mechanical strategy. Finding stocks selling for less than NNWC is only the first step. The real work comes in rooting out which, if any, of these has a stable enough business so that operating losses don't eat away the existing cash and other components of NNWC. In my experience, the best NNWC investments are supported by one or more of the following attributes:

  • Company stock repurchases
  • Insider buying
  • The likelihood of profits within the coming year
  • A consumer brand name
  • An easy-to-understand business

With those thoughts in mind, here are five companies I found that are selling at a discount to their NNWC. Let me emphasize, this is a raw list, not "suggestions" and certainly not "picks." Hopefully, this list will give you an idea of the type of companies you might run across in pursuing the NNWC strategy. (Note: TTM = Trailing Twelve Months; MRQ = Most Recent Quarter; the "Per-Share NNWC" hyperlink gives you access to the financials used for the calculation):

AlphaNet Solutions (Nasdaq: ALPH)
Recent Price (Ask): $2.19
Per-Share NNWC: $3.59
Price-to-NNWC: 0.61
Market Cap: $14.1M
TTM Revenues: $62.5M
TTM Revenue Growth: -30.8%
MRQ Free Cash Flow: $2.6M

Adams Golf (Nasdaq: ADGO)
Recent Price (Ask): $0.45
Per-Share NNWC: $0.70
Price-to-NNWC: 0.65
Market Cap: $10.1M
TTM Revenues: $49.2M
TTM Revenue Growth: 16.0%
MRQ Free Cash Flow: $1.7M

Sport-Haley (Nasdaq: SPOR)
Recent Price (Ask): $4.68
Per-Share NNWC: $5.33
Price-to-NNWC: 0.88
Market Cap: $13.9M
TTM Revenues: $18.5M
TTM Revenue Growth: -14.7%
MRQ Free Cash Flow: $1.3M

ValueClick (Nasdaq: VCLK)
Recent Price (Ask): $2.81
Per-Share NNWC: $2.94
Price-to-NNWC: 0.96
Market Cap: $138.6M
TTM Revenues: $44.9M
TTM Revenue Growth: -30.2%
MRQ Free Cash Flow: $0.3M

Atlantic Data Services (Nasdaq: ADSC)
Recent Price (Ask): $2.39
Per-Share NNWC: $2.41
Price-to-NNWC: 0.99
Market Cap: $31.1M
TTM Revenues: $20.7M
TTM Revenue Growth: -39.3%
MRQ Free Cash Flow: $1.5M

If you find the Net Net Working Capital strategy interesting, I encourage you to practice with these companies by measuring their NNWC on the balance sheet to confirm that it is indeed less than the current market cap. And if you're inclined to do some due diligence on the quality of these businesses, please share your findings on the Fool on the Hill discussion board.

If you're interested in stock screens, check out our Panning for Gold: Find Great Stocks online seminar for more.

Matt Richey wants to give credit to Mycroft Psaras, the former Fool and friend who taught him about Net Net Working Capital. Among the stocks mentioned, Matt holds positions in Sport-Haley and ValueClick. To see his other holdings and contact information, please see his personal profile.