A Basket of Cheap Stocks

Building a Net-Net portfolio

Disclaimer:  None of what I write is a recommendation to buy or sell a stock. I am an internet stranger writing about random businesses with no successful track record in investing. This is a selfish endeavor to grow as an investor myself and to document my research as I do not have a good memory. Please do your own research before buying a stock.

If you like reading pdfs, here is a pdf version of this writeup.

Net Nets

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I am very new to net-net investing, so take anything I say in this post with a pinch of salt(a whole truck load of salt actually). However, I am someone who has been fascinated by the net-net strategy of building a portfolio, so I wanted to try it out and see the results for myself. As Mohnish Pabrai often says, cloning is a very powerful mental model in life. Most of the positions(all of them actually) in my portfolio have been cloned from another investor smarter than myself and this net-net portfolio is no different. However, I hope to add some more unique insights in a few cases(if not all) and I also hope to reciprocate to this wonderful community by sharing an idea of my own someday.

First, I would like to thank DirtCheapStocks for helping me in formulating a net-net strategy through his writings and also for sharing a net-net idea with his subscribers recently. I would also like to thank AltayCapital for generously sharing his Japanese net-net portfolio picks for free on his substack. Lastly, I would also like to thank StonksValue for gracefully sharing his net-net portfolio on his substack. Any mistakes in this post are purely mine and any good ideas are from these smart investors mentioned above.

All of my investments in the past have been concentrated bets(think 10% or so of my portfolio) based on some deep fundamental analysis(at least I thought I had done some ‘deep enough’ research). So this net-net way of investing, almost purely based on financials, is something very new to me. However, I was pumped when I got to know how ridiculously cheap some of these net-nets were and loved picking this basket of stocks.

Warning: The basket of stocks mentioned in this post are microcaps which may be illiquid, so any trades should be placed as limit orders.

Net-Net Strategy

So, what were my criteria in picking this basket of stocks? I went over all Japanese net-net stocks which are a part of AltayCapital’s portfolio and looked for the following: 

• A low Price to NCAV ratio

• A low EV to Net Income ratio

• A low Price to Book ratio

• Net cash position or Very low debt at the least

• A Profitable history in most of the last 15 years or so

• A low EV/NI even when Market cap converges to NCAV

The following table summarizes my picks and their different financial metrics:

NOTE:

1. I picked Toso(5956) even though it has a higher EV/NI value when market cap converges to NCAV - this is because operating margins currently were on the lower end as compared to the range of the last decade. So, a lower than normal net income could potentially be the reason EV/NI appears high. I may be wrong about this, either way it is pretty cheap on a P/NCAV basis(0.55).

2. I could not get a position in Nankai Plywood(7887) as the share price was pretty high and the Japanese market rule to buy at least 100 shares did not let me take a 1% bet, given that my portfolio size is pretty small.

All of the above picks except one had ROEs(after excluding excess cash from equity) of more than 7%, which was not bad at all. My favorite of them all - Sanko(6964) - has a net cash position of ¥7.7B, a market cap of ¥5.5B, a PE ratio of 7.9(a negative EV/NI ratio) and an ROE of ~15%.

As far as position sizing is concerned, I divided my picks above into two categories - ones with massive cash buffers(Net Cash > Total Liabilities) and the rest. Note that the rest of stocks also mostly have net cash positions, even though these were not massive, when compared to total liabilities and as a percentage of NCAV. I took a 2% position in Sanko, which met all of the criteria mentioned in the beginning of this section, had a massive cash buffer and was very cheap on a P/NCAV basis. I took a 1% position in the remaining ones.

I had also taken a 2% position in another US net-net stock, which I cloned from DirtCheapStocks. I am not mentioning the name here as it is behind a paywall on his substack. This one had a P/NCAV ratio of about 0.7, a massive net cash buffer, EV/EBIT of 2 and extremely consistent profitability. This one has already run up about 25% since I bought it 3 months back.

When would I sell these? I would probably sell the stocks in this basket as and when they become priced closer to NCAV and the stock is no longer a net-net.

From AltayCapital’s portfolio, I could find some net-nets with massive cash buffers and which were extremely cheap on a EV/NI basis but had P/NCAV values above 0.8 in many cases - I restricted myself to stocks which were very cheap on a P/NCAV basis(below 0.6 in most cases), and on a EV/NI basis, even though some of their cash buffers were not too big in relation to their total liabilities.

For the set of stocks with massive cash buffers, I only bought those with a P/NCAV of less than 0.7 and for the rest, the maximum P/NCAV I was willing to pay was 0.6.  Small differences in P/NCAV result in larger differences in expected returns. For example, just increasing P/NCAV from 0.6 to 0.7 implies expected returns decreasing from 66%(1/0.6 = 1.66) to 43%(1/0.7=1.43) and P/NCAV increasing from 0.7 to 0.8 causes expected returns to decrease from 43% to 25%(1/0.8=1.25).

Thoughts on Currency

The Japanese Yen has devalued significantly against the US dollar in the last 3-4 years and remains a key risk for my net-net portfolio. However, this risk is managed by the fact that these Japanese net-nets only make up a small portion of my overall portfolio. So I can handle big movements in Yen against the US dollar. I am neither bullish nor bearish on the Japanese Yen, I just do not know enough to comment and I feel I am well positioned to handle bad scenarios like the Yen going down 50% against the dollar.

I wanted to be conservative and did not want to add leverage by borrowing in Yen to hedge my currency risk. I understand that borrowing Yen against such a small portion of my overall portfolio most likely will not kill me, but I also feel I do not understand the risks associated with margin funding very well.

NOTE: 

A PFIC is a non-U.S. corporation that has at least 75% of its gross income coming from passive income sources or at least 50% of the company's assets are investments that produce passive income. Some of these stocks mentioned above are pretty close to being a PFIC. Sonocom(7902) has about 48% of its assets in cash and for Nisshin Group Holdings(8881), this number is again close to 48%. Maybe in the coming quarters, these numbers may go above 50% but the IRS looks at averages of these numbers over 4 quarters in a year to make this classification.

The IRS has ominous tax laws and reporting guidelines for PFICs that it does not make sense for an individual investor to own these as a US resident(in case it crosses the 50% threshold). However, these laws do not apply, in case these are bought through a retirement account(an IRA or a 401k). I am currently a non-resident for US tax purposes, so it makes sense for me to own these.

None of the above is tax advice. Please consult your own tax advisor.

Concluding Thoughts

As of today, my net-net portfolio consists of the Japanese net-nets mentioned in this post and another one in the US(cloned from DirtCheapStocks). I believe these are extremely cheap and am excited to see how they play out in the future.

This is just a start and I may be adding more net-nets into my portfolio in the future as I come across more stocks that meet my net-net criteria.

As I am about to post this, the Nikkei index is down 5% today(!) and 10% in the month(in Yen terms). My Japanese net-net portfolio is down about 5% in Yen but only down 0.3% in USD terms as the exchange rate moved a bit favorably. I would be watching closely and waiting for any opportunities that the recent volatility may throw up!