They're not around much anymore, especially following bull markets. But Ben Graham's net-net working capital opportunities are a classic special situation worth remembering.
In a net-net situation, an investor estimates a liquidation value for a company, then tries to pay a fraction of that value in the market. Ben Graham loved these types of situations, defining the net-net value as:
Cash and short-term investments + (0.75 * accounts receivable) + (0.5 * inventory) - total liabilities
Graham looked for companies whose market values were less than two-thirds of that net-net value, for two reasons. First, he wasn't sure he would receive the full value for accounts receivable and inventory before paying off the creditors. Second, he wanted to make sure he had a margin of safety to fall back on, in case it didn't work out. After all, if the market valued the company this low, something was certainly wrong with it.
Graham's idea was to bet on a situation with asymmetrical odds. In such situations, the probability of losing money is fairly high, but the magnitude of any loss would be small. However, the potential payoff is large, despite having a lower probability of success. That's why these situations are special and worth looking for, even today.
An endangered species
Net-nets aren't completely dead, but they're tough to find today. And good luck ever finding one that meets Graham's two-thirds value rule! Plenty of value managers out there know about them and aren't afraid to commit capital as soon as they pop up, even at small discounts to their value.
Should we give up on them? No way. Net-nets are an important tool in the value investor's toolbox, because they can be very lucrative.
I checked the archives from the end of 2002, and found a few interesting situations that have done quite well, and a few that really haven't done much of anything at all.
Another example is Internet and mobile search technology company Infospace
You win some, you lose some
I'm not here to sell you on the idea that net-nets are sure things. Optical-networking products maker Sycamore Networks
Another stock from the end of 2002 that shows up on today's list is order-fulfillment software company Selectica
I hope you see the power of Graham's thinking. Even if the businesses don't improve, the downside of a net-net can be limited. If you're patient, you may even be able to beat the market by a little bit if you're patient.
You can see a potential net-net prospect today in CallWave
One company on the list that does not fit the net-net mold is Plug Power
The Foolish bottom line
It's good to get back to your roots once in a while. That's why I wanted to share some thoughts on Ben Graham's net-nets. These special situations, while somewhat rare, offer investors a unique way to increase returns while taking on less risk. That's a combination we can all use.
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Retail editor and Inside Value team member David Meier learned about evaluating great companies and special situations at Wake Forest. He does not own shares in any of the companies mentioned. He is currently ranked 675 out of 25,209 investors in The Motley Fool's CAPS rating service. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.