Say Yes-Yes to Net-Nets

 | Sep 13, 2011 | 2:00 PM EDT
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The core principal of value investing is to make investments that carry a satisfactory margin of safety. Simply defined, a margin of safety is the difference between the intrinsic value of the business and the price you pay. The bigger the gap, the higher the margin of safety. Analyzing a business always requires making assumptions about the future, thus, there's an element of uncertainty. The margin of safety helps protect against those uncertainties.

Various methods can be used to derive intrinsic value. The most useful entails forecasting future free cash flows, discounting by an appropriate rate to derive their present value and then taking the sum of those present values and a terminal value. Another simple metric is price-to-book ratio. A business that can be bought below book value is often viewed as selling below intrinsic value. Yet the PB ratio requires a high degree of confidence that the assets are indeed worth book value, but that's a topic for another discussion.

Perhaps the most useful metric that relies on no assumptions is what famed value investor Benjamin Graham referred to as net-current asset value (NCAV) stocks, or net-nets. After the Great Depression, when equities were trading for scraps, Graham invested in stocks where the market cap was below the value of the net current assets. It's a simple calculation: subtract total liabilities from current assets to get net current asset value, then compare NCAV with the market cap.

The effectiveness this approach is its simplicity: Current assets are liquid items like cash, receivables and short-term investments. If the value of those current assets after subtracting all liabilities is worth more than the market value, then you have an incredible margin of safety. If the business were to liquidate, investors stand a good chance of making money because, after paying all its liabilities, the current assets would still be worth more than the market value. As a bonus, a residual value from long-term assets provides further the upside.

But net-nets are virtually non-existent in bull markets. It's only when there is a general aversion to equities that such opportunities slip through the cracks. Because net-nets are often small-caps, any fund of significant scale can't participate. While today's early selloff didn't reach levels to produce any meaningful pure net-net candidates, some interesting opportunities did emerge.

Amtech Systems (ASYS) is one such opportunity. The solar-equipment supplier has a market cap of $100 million. As of June 30, current assets totaled $185 million, of which $73 million is cash. Total liabilities equal $105 million for NCAV of $80 million. The company also trades at 4x earnings. If you strip the cash, the EV is less than $30 million. In the first nine months of 2011, net income was about $20 million.

Audiovox (VOXX) is a maker and distributor of mobile consumer electronics. As of May 31, current assets totaled $299 million against total liabilities of $203 million, or NCAV of $96 million. The market cap is $144 million. Shares trade around $6.20, or a PE of 6. Baupost Group, the value firm run by Seth Klarman, is a shareholder.

Advanced Battery Technologies (ABAT) produces rechargeable lithium ion batteries. As of June 30, total current assets equaled $112 million against total liabilities of $11 million for NCAV of $101 million. The market cap is $99 million and, at around $1.29 per share, trades for 2.5x earnings. Cash per share is $0.97. Insiders own more than 10% of the stock.

Not only are these stocks potentially worth more than their share prices in the event of a liquidation, but all are currently profitable. Good economy or bad, investors could do well owning a collection of these unique securities.

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