Don't Just Buy Any Net-Net

During recessions, with this one being no exception, value investors usually rejoice at the opportunity to purchase stocks at discounts to their net current asset values. That is, stocks that trade for less than their current assets minus their entire liabilities. While purchasing an "index" of net-nets should result in above average profits (if history is any guide), further careful analysis can lead to even higher returns.

Not all net-nets are worth investing in. If the company is burning its assets due to floundering operations, its value (liquidation or otherwise) won't be worth much at all! Consider Shermag (SMG), a furniture manufacturer and distributor. Last year, it had current assets of $48 million and total liabilities of $36 million, yet it was trading at a market cap of just $6 million.

Great value? Hardly. The company has lost about $15 million per year for the last three years. As it burns through its assets in this manner, it quickly erodes any balance sheet value it appears to have. Today, it trades for $300,000, but the drop in value should have caught no one by surprise.

When looking through net-nets, be sure to keep in mind that not all of them offer great value. It takes patience and an understanding of the underlying business to ascertain whether you've found a diamond in the rough.