The irony of investing is that it typically works out best when markets look their worst. Currently, things don’t look good.
So with that in mind, let’s find out where we are in the market cycle. To paraphrase Howard Marks, if we know where we are in the cycle, we can better prepare for what comes next.
I thought I’d approach this from a different angle. Rather than guess what the Fed might do or where inflation and interest rates are going based on past history and how it might affect the market today, let’s look at “irrational” stock prices.
The best way to track irrationally priced stocks is with an old Ben Graham strategy that has largely gone out of style. He looked for companies trading below their liquidation value. In rational markets, that shouldn’t happen. Yet, it does.
Graham’s “Net-Net” strategy looks for companies with a market cap below its net current asset value. Current assets are typically the most liquid assets a company has: cash, money owed to the company (accounts receivable), and finished products not yet sold (inventory). And the net current asset value is found by subtracting total debt from current assets.
So net current asset value is a rough approximation of a company’s liquidation value. In theory, investors should never sell shares below this number since buyers are getting “free” money in return.
Here’s a simplistic example. Say you can buy a company with $1 million in net current assets for $600,000, would you do it? That’s a 40% return if you sold off everything and collected a cool million. It’s like buying dollar bills for 60 cents. Of course, the returns are even better if the business is viable.
In fact, Graham used the strategy extensively from the 1920s into the late 1950s. It worked so well, that Walter Schloss, Warren Buffett, Peter Cundill, and others picked up the mantle.
Unfortunately, its popularity eventually led to its demise. It’s not that Graham’s Net-Net strategy no longer works. It does. The problem is a lack of supply worth buying. Investors are quicker at finding these stocks before they become Net-Nets, which largely eliminates them from existence in U.S. markets.
Except, when the market experiences a major crash.
The first chart shows the number of Net-Net stocks (excluding OTC) available from 2000 to today in the U.S. The second chart shows the same number of Net-Net stocks as a percentage of the total number of stocks trading in the U.S. There are no additional screening filters beyond stocks trading below their net current asset value.
It’s important to point out that many of the companies represented above have no earnings, little or no sales, and are burning through cash. So fair warning: most aren’t worth owning.
But a handful of the companies do have sales, earnings, and a viable business. Some added metrics are needed to filter those out like a history of earnings or positive operating cash flow, little to no debt, piles of cash, and not replenishing that cash with frequent additional stock offerings. Keep in mind that none will be long-term investments. They’re bought to be sold.
This gets us to why the chart above is useful. The chart tracks the amount of irrational pessimism in bear markets because Net-Nets are not normal. They only show up when emotions run high. So if Net-Nets can be found in large numbers, it’s a sign that other stocks are likely on sale.
Why is this important? Bear markets, while painful, are buying opportunities. The chart, while not a timing tool, offers you a sense of where we are in the current market cycle.
If you overlayed a chart of the S&P 500 (SPY) over either chart above, you’ll notice how the last two spikes in Net-Nets coincide with the Dot-com crash and the 2008 financial crisis, with smaller corrections and crashes scattered in between. A zoomed-in version of that from 2000 to 2010 with the SPY overlayed looks like this:
The recent spike in Net-Nets likely puts us closer to a market bottom than a top, assuming we haven’t seen it already.
That said, nobody knows what happens next. The market could quickly revert like it has the past few years or it could drag out due to unforeseen events as it did in the early 2000s.
Still, had an investor blindly bought a broad market index fund in the 2001 and 2009 bear markets and held on they’d be better off 21 and 13 years later, respectively. That suggests that the current spike is good news for long-term investors. Buying the broader market when Net-Nets spike has been a winning strategy over the long run.
Last Call
- Inflation and Capital – J. Zweig
- Trying Too Hard – M. Housel
- The Biggest Mistake an Investor Can Make – Compound Advisors
- Reversion to the Mean: The Real Long COVID – Luttig’s Learnings
- Is This Another Tech Bubble Bursting? – Recode
- What Should Accompany Stocks: Cash or Bonds? – J. Rekenthaler
- Crisis Investing in Europe – Verdad
- Why a Small Candy Shop is Warren Buffett’s “Dream” Investment – The Hustle
- The Colorful History of Haribo Goldbears, the World’s First Gummy Bears – Smithsonian
- So You Want to Be a Bootlegger – Saturday Evening Post
