Money and Finance

Whitman, Diz on net-nets

From the book Modern Security Analysis: Understanding Wall Street Fundamentals:

Our definition of net nets is taken from Graham and Dodd’s Security Analysis, but with a few twists. Graham and Dodd relied on a GAAP classified balance sheet to definite current assets in order to ascertain if a common stock was a net net. We use our own judgment rather than GAAP classification to definite current assets in order to decide what is a liquid, that is, a current asset.

While Graham and Dodd seem to have invented the idea of net nets, we use that idea with a number of modifications based on our discussion earlier in this chapter.

First, we are not interested in net nets unless the company is extremely well financed. A large quantity of current assets, especially if they consist of inventories, costs in excess of billings, or receivables from less than creditworthy customers, probably cannot help the common stock of a company that cannot meet its obligations to its creditors. Second, many current assets classified as current assets under GAAP are really fixed assets of the worst sort. Take department store merchandise inventories. If the department store is to be liquidated, merchandise inventories are indeed a current asset, convertible to cash within 12 months at prices that conceivably could be close to NAV, although much less than NAV may be realized if the merchandise is disposed of in a GOB (going out of business) sale. On the other hand, if the department store is a going concern, merchandise inventories are a fixed asset of the worst sort. The merchandise inventories have to be replaced, are hard to value, and are subject to markdowns, obsolescence, shrinkage, seasonality and misallocation. The Toyota Industries portfolio of marketable securities seems to be much more of a current asset than department store merchandise inventories even though, for GAAP or IFRS purposes, Toyota Industries’ marketable securities are not considered a current asset. Third, the Graham and Dodd formulation does not account for off-balance-sheet liabilities that may, or may not, be disclosed in footnotes, nor do Graham and Dodd take into account excessive expenses or losses. We capitalize such expenses or losses, and we add them to liabilities. Fourth, Graham and Dodd only seem to recognize partially that certain fixed assets, such as property, plant and equipment, can sometimes create cash. For example, under Section 1231 of the U.S. Internal Revenue Code, the sale at a loss of such assets used in a trade or business, usually gives rise to an ordinary loss for income tax purposes. In that case, a corporation may be able to apply the loss first to reduce current year taxes and any excess loss might be used to get quickie cash refunds from the IRS with regard to taxes paid in the prior two years.

The identification of net nets does not appear to be difficult. Cheung Kong Holdings, The Wharf Holdings, and Capital Southwest, discussed earlier in this chapter, are clear examples of Graham and Dodd net nets. The toughest problem by far, is to identify managements and control groups of these net nets who are both able and conscious of the interests of outside, passive, minority investors. This problem notwithstanding, the investor using a fundamental finance approach can obtain large margins of safety by restricting his purchases to issues selling at steep discounts from readily ascertainable NAVs from highly creditworthy issuers with good prospects for increasing NAV in the future at rates of 10 percent per annum or larger.

When all is said and done, however, we owe an enormous debt of gratitude to Graham and Dodd for introducing the concept of net nets.

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