The Pitfalls of Net-Net Investing

Net-Net investing can be very rewarding. The academic backtests show strong annual returns that trounce the market. But in the real world, investing is messy.

Take a look at Key Tronic Corporation for example. We had written about them earlier this year (KTCC). The stock has recently rebounded after the company posted improved results.

This chart shows the stock price over the past 12+ years compared to its Net-Net value per share. Because Key Tronic has not returned capital via a dividend or share repurchase, this is a pretty good indicator of the value the company has built over a decade.

The goal is to buy as far below the orange line as possible.

Overall we see steady improvement in the company. The falloff in the 2015 period was due to an expensive acquisition. The recent decline in net-net value was due to the lease accounting change. Net-net value has grown about 6% annually since 2008 excluding the accounting change.

Imagine if you had bought the stock around $3 in mid-2008. You might have thought, “Sure, the economy is rough. But the stock is down 50%+ from its recent peak. And it’s a decent business.” So you dive in.

And ultimately it was a good deal. A short two years later, you are sitting on 100% gains.

But the drawdown you faced while holding the stock over that two years was epic. The stock dropped to below $1 in early 2009. Within six months of your investment, you had lost over 2/3 of your money. The economy was in a crisis. Given Key Tronic’s debt outstanding, you may have worried about insolvency. It was not a fun time to own small, levered companies.

It worked out. But it was painful to hold.

A similar situation happened in early 2019. After the stock went nowhere for years, it dipped below Net-Net value in early 2019. Let’s say you bought around there. After twelve months, and in the middle of the COVID selloff, you were down 50%. The news was not good: demand was uncertain and plant were being shut down.

At today’s mark you are up 40-50% in eighteen months.

All of this agony is for a reasonably successful Net-Net investment. Others in your portfolio will be duds in that you lose money or the stock goes nowhere for years. It will feel worse to own these. And you’ll have the occasional name that’s a disaster.

To be a successful Net-Net investor, you have to be comfortable owning non-sexy stocks. Most people will think you’re crazy if you explain why you own the stocks that you do.

You have to do your own research. You need to believe the company will be around and sustain it’s Net-Net value. You’ll need to have faith that the strategy will continue to work, despite the drawdowns.

For this reason, I suggest you stay reasonably diversified if you choose to invest in Net-Nets. And once you do the work and make your investment, it’s best not to look too closely.

Any style of investment is difficult. It requires commitment to the strategy, and discipline in executing it. Following a Net-Net strategy is no different.