Mr. Market: Genius or Fool?

In chapter 8 of The Intelligent Investor, Ben Graham introduces us to the idea of Mr. Market. Mr. Market is your business partner in the stock market, and he’ll offer to buy or sell a stake in the business for a price he quotes. Often the prices he will quote you are sensible. But occasionally, since he is crazy, his quotes will be crazy. All you have to do is sit back, be patient, and pick off Mr. Market when he quotes a ridiculous price. Easy, right?

This parable has led many astray. Mr. Market may be crazy, but since when is it a good idea to pick a fight with a crazy person? Plus, his investment record is pretty good.

Why is that? Mr. Market has many, many advantages over you.

Seventy percent of the market is institutional investors. The big mutual funds and hedge funds have better information than you. They have professional analysts who spend years becoming experts in just a handful of companies. The portfolio managers, if they want to last over time, have to be talented (or lucky).

These funds talk to competitors, suppliers, industry experts, and private companies. They are all over management teams and the sell-side. They meet the CFO so often, they can tell when he sounds more upbeat than usual. They have seen NPD data that suggests that sales are up compared to street estimates. They know that SG&A is supposed to spike in Q1 due to annual raises.

They may have size limitations, but they are often competing in many of the same stocks you are. They also have access to trades you never will. They can trade privates. They get IPO allocations. They can structure asymmetric trades.

In many trading shops, traders have better information flow. Portfolio managers can size positions aggressively. Their capital may be more long-term than you think. They are experts in managing risk.

What about the quants? You have genius PhD’s using supercomputers and way better data to invest with unmatched discipline. They are in every corner of the market, in every security, in every geography. They can trade efficiently. Just because you are in micro-caps doesn’t matter to these guys. Computer algos can scale endlessly to seek out alpha in the smallest nano-caps.

The high frequency traders and quant shops can front-run all your orders. Or take advantage of technicals and your biases because they know what you are going to do.

There are specialists everywhere. Special situation funds arb out market inefficiencies. Medical doctors run healthcare funds. Bankruptcy lawyers run distressed funds.

There are corporate & private equity buyers that know the industry better than you. They can lever up or get sweetheart deals. They can extract synergies or create change through M&A.

There are insider traders (legal and otherwise) that have better information than you. These trades are usually at the expense of the investing public.

Mr. Market is the sum total of all of this activity. Mr. Market works 24 hours a day to beat you. He is massively incentivized to win. Most funds can’t beat him, especially after fees and taxes. Not that this is of any help you.

Oh, and he’s getting better every day.

If you are a small individual investor, I suppose you do have some advantages. You have a wider investment set than most. You usually don’t have pesky clients. And you can try to be longer-term (the big secret!). But even then, it’s not easy to translate these advantages to success.

Since it’s so hard to beat Mr. Market, so why not join him? Vanguard has offered investors this choice. In a low-turnover, low-tax, low-fee way, you can just invest alongside Mr. Market through index funds. Over time, this should lead to decent results.

Are we gonna do that? Nah.

There are ways for the enterprising investor to win at this game (as Jack Schwager’s fantastic books highlight). But whichever strategy you choose seems to come down to one word: discipline. You have to have a plan and stick with it, even as you repeatedly get punched in the face.

Mr. Market is no fool. He is irrational and volatile, but the odds are stacked against us. He regularly beats most challengers. If we want to have a chance at winning this game, we should at least acknowledge that.

Where are the net-nets?

It may have been fortuitous to launch this blog and trading account earlier this year. As markets sold off during the pandemic, a good number of net-nets in the United States and European markets briefly reappeared after a long hiatus.

The rebound in markets means that there are no longer as many net-nets out there. What does this mean for our strategy? For one, we should probably expect lower returns until we find new ideas. Warren Buffett loves to say he could earn 50%+ per year on small sums (in fact, he guarantees it). Unfortunately most of us aren’t him. However, we don’t need to be Warren Buffett to do well in our investments over time.

I don’t expect the NBNN portfolio to change too much until we find new interesting ideas, or our ideas get overvalued. I like most of our names at their current prices. Some are still below their 52 week highs. They will hopefully be decent investments until new ideas come along.

And where do we find these new ideas? As Charlie Munger reminds us, we need to “fish where the fish are.” Value has underperformed so deeply and for so long, there is bound to be opportunity all over the place.

For net-nets in particular, our screens indicate that the biggest pools of fish today are in Japan, South Korea, and Hong Kong. They also exist in OTC/pink sheets. We don’t have the ability to trade in South Korea. So we can cross that off the list. But the other markets are relatively accessible.

We have been trading net-nets in Japan for about a decade. We already own a couple names in Japan. There are scores more interesting names there worth a look. I have not traded extensively in Hong Kong but it looks like it could be equally interesting as many stocks appear to be below 2009 levels.

We will continue to flip through our version of the Moody’s manuals to find interesting opportunities. But absent another sell-off, I wouldn’t be surprised if our portfolio shifts eastward over time.

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.