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The Net/Net Way to Find Cheap Stocks

NEW YORK ( TheStreet) -- As a deep value investor, I've long studied, researched, written about and invested in a tiny subculture of the equity markets known as "net/nets."

I also write a blog that is devoted primarily to the topic: stocksbelowncav.blogspot.com.

A net/net is a company that trades for less than its net current asset value, or NCAV.

In other words, such a company's market cap is less than the book value of its current assets. Net current assets equal a company's current assets minus all liabilities. (When applicable, I also subtract minority interests and preferred stock.)

This formula was originally devised by Benjamin Graham, the father of value investing. Graham's terms, however were a little more stringent: He was typically interested in companies trading for less than two-thirds of their net current asset value, a rarity these days.

All else being equal, a company trading at less than net current asset value can be incredibly cheap.

While the NCAV formula accounts for all of a company's liabilities, including short- and long-term debt, it places absolutely no value on noncurrent assets, which include property plant and equipment and long-term investments.

Excluding long-term assets from the calculation can create a safety net of sorts, a situation where you can purchase shares of a company for much less than its book value.

The flip side, however, is that companies may appear to be cheap for good reason, and just because a particular name trades below NCAV does not make it a good buy. Companies in decline can become net/nets, and sometimes they're on the way to bankruptcy.

The net/net formula is so stringent that there is typically a small number of companies that make the cut.

The number is even smaller during a period when the overall market trend is up. In fact, right now, there are just eight companies with market capitalizations greater than $100 million that trade for less than NCAV.

Just two have market caps greater than $500 million.

Technology products distributor Ingram Micro (IM - Get Report), which has a $2.45 billion market cap, is among the largest net/nets I've seen in the dozen or more years I've been following them.

Two weeks ago, Ingram announced that it is buying Brightpoint (CELL) for $650 million in cash. This transaction, when complete, may alter Ingram's balance sheet to the point that it will no longer trade below NCAV. As of the latest quarter end, Ingram had $891 million in cash, or $6.84 per share. The company currently trades at .84 times net current asset value.

The other big name -- big for a net/net, anyway -- is Benchmark Electronics (BHE - Get Report), which has a $753 million market cap.

Benchmark, which provides electronics manufacturing services, currently trades at about .85 times NCAV. The company ended its latest quarter with $257 million, or $4.47 per share in cash, and just $11 million in debt.

Management appears to believe that the stock is cheap, given the new $100 million stock buyback program announced in June.

One of the atypical things about Ingram and Benchmark, in terms of qualifying as net/nets, is that both of these companies are currently profitable.

In my experience, the typical net/net is losing money, and is either trying to turn around and get noticed again by investors, or is on its way to the scrap heap.

One of my recent net/net purchases, Radio Shack (RSH), which many believe is on its way to extinction, is now trading slightly above its net current asset value. It will no doubt be a bumpy ride.

As a deep value technique, net/net investing can be very profitable, but it can also be very risky. I liken it to "dumpster diving." It's certainly not for everyone.

At the time of publication, the author owned shares of IM and RSH.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
Jonathan Heller, CFA, is president of KEJ Financial Advisors, his fee-only financial planning company. Jon spent 17 years at Bloomberg Financial Markets in various roles, from 1989 until 2005. He ran Bloomberg's Equity Fundamental Research Department from 1994 until 1998, when he assumed responsibility for Bloomberg's Equity Data Research Department. In 2001, he joined Bloomberg's Publishing group as senior markets editor and writer for Bloomberg Personal Finance Magazine, and an associate editor and contributor for Bloomberg Markets Magazine. In 2005, he joined SEI Investments as director of investment communications within SEI's Investment Management Unit.

Jon is also the founder of the Cheap Stocks Web site, a site dedicated to deep-value investing. He has an undergraduate degree from Grove City College and an MBA from Rider University, where he has also served on the adjunct faculty; he is also a CFA charter holder.

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