In Security Analysis Graham writes:
Since the chief emphasis must be placed on avoidance of loss, bond selection is primarily a negative art. It is a process of exclusion and rejection, rather than of search and acceptance
My view of net-nets is similar to Graham’s view of bonds. The net-net investor, presuming he has screened out non-net nets, has already extracted the primary positive signal of good returns, namely low NCAV relative to market cap. Other qualities typically associated with good stocks: dividend, continuous record of positive earnings have not been shown to improve net-net returns.
And so the art of the net-net investor is primarily a negative one. What he should be doing is trying to avoid scams and companies that are not “real” companies. His process is one of exclusion.
Geoff Gannon has an excellent article on this which explains the general sort of things in investor should be on the look out for:
In my process there are a few practical guidelines I have found. In general you should avoid:
1) All Chinese reverse mergers and avoid HK listed stocks. Avoid all companies domiciled in China or with operations primarily in China
2) Companies having an abnormally large number of subsidiaries. See here for examples.
3) Companies which have increase share outstanding by more than 10% in the last 12 months
4) Companies that are looking to raise more capital either in the form of debt or equity
5) Companies which have gone or are in the process of going dark
6) Companies which discuss how they are trying to satisfy creditors in their financial statements.
7) Companies who shares have been suspended from trading or are being investigated by a regulator like the SEC.
Basically with net-nets the story should be that the company is boring, out of favor, has ample liquid assets, low debt and is deeply undervalued. Anything that contradicts this story, e.g. large share issuance, should be a red flag.
What I am attempting to do with the criteria above is avoid scammers. Some of the rules above sound overbroad and arbitrary e.g. Avoid all Chinese companies. But my reason for making them is sound. In practice, the vast majority of net-nets domiciled in China are scams and so you don’t lose a great deal by excluding the whole country.
Similarly there are dark companies which make sense as investments but again you are not gaining much by including them while you are eliminating a large number of duds by excluding them. Disclosure: I do have a few dark companies I have invested in based on the blog, http://www.nonamestocks.com/.
On occasion I will use positive screening criteria as a second pass on my exclusionary criteria and so for example I might invest in a company domiciled in China provided that it issued a dividend. My reasoning here being that a scammer will never give money away. So while I would not use the positive screening criteria under normal circumstances I may use them to include a candidate I would not normally consider. Similar to how a university admission officer may include student with lower SATS if they have other positive qualities like athletic accomplishments.