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Summary There are two definitions of net-nets: Buying stocks at below two-thirds of net current asset values (NCAV), and purchasing stocks trading under net-net working capital, a revalued version of NCAV. I offer some general principles and caveats that apply in the case of both low P/NCAV net-nets and low P/NNWC net-nets. My exclusive research service, Asia/U.S. Deep-Value Wide-Moat Stocks, provides watchlists and profiles of net-nets, net cash stocks, low P/B stocks and sum-of-the-parts discounts. Defining Net-Nets Two different “versions” of net-nets have evolved from the teachings of Benjamin Graham in his two books “Security Analysis” and “The Intelligent Investor.” The first definition of net-nets involves comparing the net current asset values (current assets – total liabilities) (NCAV) per share of stocks against their share prices and buying them if the P/NCAV ratios are below two-thirds. The second definition of net-nets, more commonly known as net-net working capital (NNWC), makes an attempt at “revaluing” NCAV with the following adjustments: +100% of cash and short-term investments +75% of accounts receivables +50% of inventories -100% of all liabilities Both definitions of net-nets try to incorporate a margin of safety for the collectability risk of accounts receivables and the salability of inventories to a certain extent (the former through an arbitrary discount assigned to the net current asset value; the latter via specific discounts for accounts receivables and inventories). Most deep value net-net investors tend to use the first definition of net-nets, P/NCAV, in their search for potential investment candidates, as the screening for low P/NNWC stocks is more difficult in reality (compared with low P/NCAV stocks). Firstly, there is a greater likelihood of data services providers getting the calculation of accounts receivables wrong since a significant number of companies tend to lump accounts receivables and other receivables and may not provide the necessary disclosure to differentiate between them. If one incorporates all receivables (including non-operating receivables) in the calculation of low P/NNWC net-nets, he or she may be overstating the value of NNWC. Secondly, simply taking 100% of cash and short-term investments at their face values may not be the wisest thing to do since the market values of short-term investments will fluctuate and not all cash are unencumbered and excess in nature. Thirdly, the 25% and 50% discounts assigned to accounts receivables and inventories respectively may not be appropriate for all companies. For example, some companies may have customers which are MNCs or government-linked where the probability (and history) of defaults is close to zero, so even a 25% discount for accounts receivables is considered harsh. On the other hand, for companies which sell products with short lifecycles and shelf lives and are witnessing growing inventory days, a 50% discount for inventories may be simply too little. The second definition of net-nets, buying at less than two-thirds of NCAV tries to solve this problem by assigning a blanket 33% discount to all the current assets on the balance sheet. Stocks Trading At Low P/NCAV But High P/NNWC Continuing from the discussion above, it will be intuitive to conclude that stocks trading at low P/NCAV ratios but high P/NNWC are likely to have lower margins of safety since the “quality and quantity” of assets are questionable. I provide two examples of such stocks for illustrative purposes below. I focus on assessing the margin of safety for the stock (comparing net current asset value against net-net working capital) rather than the stock’s investability as a net-net. STR Holdings (NYSE: STRI ), a provider of encapsulants to the photovoltaic module industry, appears on the net current asset value screen as a net-net trading at 0.32 times P/NCAV, but it will not qualify as a net-net if one considers its P/NNWC ratio of 1.5. This is because STRI’s current assets include income tax receivable and other current assets amounting to $8.3 million and $4.7 million respectively, which I do not include in the calculation of NNWC. Hong Kong-listed Xinjiang Tianye Water Saving Irrigation System Co. ( OTC:XJGTF ) (840 HK), a company engaged in the design, manufacturing and sales of drip films, PVC/PE pipelines and drip assemblies used in water saving irrigation system, is valued by the market at a P/NCAV of 0.64 times, but its P/NNWC ratio exceeds 2 times. This is largely due to the fact that inventories and accounts receivable contribute 63% and of 16% of Xinjiang Tianye Water’s current assets respectively and are therefore heavily discounted based on the net-net working capital formulae. The full list of 75 U.S. and Asian low P/NCAV (less than 1) net-nets trading at high P/NNWC (greater than 1) ratios, which should warrant greater attention to their underlying asset values, is available exclusively for subscribers of my Asia/U.S. Deep-Value Wide-Moat Stocks exclusive research service in a separate bonus watchlist article. Assessing The Real Margin Of Safety For Net-Nets There are some general principles and caveats that apply in the assessment of the margins of safety for both low P/NCAV net-nets and low P/NNWC net-nets. One of them is the collectability risks relating to accounts receivables. Accounts receivables are near-cash in nature as long as they do not become bad debts i.e. customers default on payment. One can assess the collectability risk of accounts receivables for a specific stock in terms of the trend in accounts receivable days, the credit payment terms for customers, the credit strength of major customers, the adequacy of current provisions for bad debts and the potential for further write-downs on the receivables. Another point to take note of is the salability risk of inventories. Under normal conditions, the costs and selling prices of inventories are relatively stable. In reality, rising raw material costs, changing customer preferences and lack of bargaining power with suppliers and customers could lead to overstocking, loss-making finished products, and eventually write-downs on inventories. Similarly, cash and short-term investments are not always as “safe” as they appear to be. The accounting values of short-term investments such as stocks, bonds, hybrid securities, structured products are typically mark-to-market with huge volatility in their prices and values. In addition, not all of a company’s cash balances are unencumbered and excess in nature since some cash may be set aside for security deposits or working capital purposes. Also, if a net-net is loss-making, the market may be discounting the future cash burn into its share price. For readers interested in learning more about the background of net-nets and specific Asian names, they can refer to my articles on Hong Kong net-nets and Japanese net-nets here and here respectively. Note: Subscribers to my Asia/U.S. Deep-Value Wide-Moat Stocks get full access to the watchlists, profiles and idea write-ups of deep-value investment candidates and value traps, which include net-nets, net cash stocks, low P/B stocks and sum-of-the-parts discounts. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.