Notes – How To Pick Net-Nets: Two Philosophies From Geoff Gannon And Gurpreet Narang

Margin of safety demanded depends on the quality of assets and quality of earnings
The subtext of Graham’s 2/3 Rule is that asset values on the balance sheet are inexact
In liquidation, liabilities are real but asset values are questionable
Liquid assets are easily squandered by bad management or bad operating businesses
In addition to discounting assets, look for other positive factors to enhance margin of safety:
- excess cash relative to assets
- high return on invested capital
- ten straight years of operating income
- ample free cash flows
The more liquid the assets, the better the margin of safety
One way to improve upon NCAV is P/NQAV, or Price-to-Net Quick Asset value (cash, securities and receivables)
Discount demanded moves in inverse proportion to:
- quality of assets
- quality of management
- quality of return on assets
Earnings should be backed up by cash flows, preferably with free cash flows
Net-nets should be chosen for inherent cheapness, not a hope for liquidation
Walter Schloss: “A stock well-bought is half-sold.”
Michael Burry: buy at prices “so low that a potential acquirer proposing them would be laughed out of the boardroom”

Best Net-Nets:
- Are around $25M market cap or less
- High insider ownership
- High F-score
Biggest risks for Net-Nets:
- Fraud
- Bankruptcy
- Share dilution
Look for Net-Nets:
- In the US
- With positive retained earnings
- Z-score >3
- Highest F-scores amongst current crop of NCAVs
- Highest insider ownership %
Similarly, avoid:
- Foreign
- Negative retained earnings
- Z-score ❤
- Lower/lowest F-score
- Lower/lowest insider ownership
Magic Formula for NCAVs:
- Rank by F-score
- Rank by insider ownership
Add up the two ranks and choose the highest combined scores
You don’t need upside potential, you need downside protection
Hold them for longer than a year
Take the 10-Q and read it like a credit analyst, asking yourself, “Would you be willing to lend money to this company?”
More by Geoff Gannon at How To Pick Solid Net-Nets