It might seem odd to use one of GuruFocus’ Ben Graham: Net-Net Newsletter’s (very) few successes as an example of why net-net investing is so hard. But that’s what I’m going to do today.



I picked GTSI (GTSI) for the Ben Graham: Net-Net Newsletter in June of last year. The model portfolio bought 128 shares of GTSI at $5.02 a share. It also paid a $7 commission which – spread over the 128 shares bought in the account – works out to a total cost of $5.07 a share.



The purchase of real GTSI shares was made in a real brokerage account after the newsletter issue picking the stock came out. So, that isn’t the problem with net-net investing. Anyone who read the newsletter could’ve bought GTSI shares. And they wouldn’t have had to pay any more than $5.07 a share – including commissions. In fact, because the model portfolio made such a small purchase – the per share cost would probably be lower for most investors. And GTSI spent a lot of time under that $5.07 total cost shown in the model portfolio. In fact, investors had plenty of opportunities to buy GTSI – after the newsletter came out – at prices between $4.00 and $5.00 a share. The lowest price shown in the last 52 weeks is $3.82 a share. You probably couldn’t have gotten anything like that. But no one would’ve had any trouble buying shares at around $4.50 quite regularly if you kept faith in the stock.



Okay. So the usual complaint about net-net stocks – that you can pick them but you can’t really accumulate them in an actual portfolio – doesn’t apply here. That wasn’t the problem.



What was the problem?



GTSI now trades at $7.74 a share. There is a buyout offer at $7.75 a share.



Before we go any further, I should point out for those interested in GTSI as a stock that currently trades – and not just as a case study of net-net investing – this $7.75 a share buyout is not a done deal. There is a lawsuit alleging breach of fiduciary duties, etc. And the buyout offer of $7.75 a share is lower than the $8.70 intrinsic value appraisal I gave for the stock back in June 2011 when I picked it for the newsletter. Those are the facts. Draw whatever conclusions you want from them. I have nothing more to say about GTSI as it stands today – this article is a look back at the Ben Graham: Net-Net Newsletter’s investment in GTSI which began one year ago. For more information on GTSI, you should:



· Read all of GTSI’s SEC filings



· Read all of Whopper Investments’ posts on GTSI



· Read all of Frank Voisin’s posts on GTSI



Now back to the previously scheduled post mortem…



There is a buyout offer at $7.75 a share.



If that goes through, investors who got GTSI at the same price as the model portfolio – including commissions – will make 53% on the stock. And they’ll have held it for about a year (longer if they wait for the buyout to go through, shorter if they sold on the announcement).



Let’s call it a 50% profit in one year.



How many readers of the Ben Graham: Net-Net Newsletter actually made that profit?



That’s what makes net-net investing so hard.



The Ben Graham: Net-Net Newsletter has far more past picks in the red than in the green. Now, true they aren’t in the red by 50%. But there are a couple big losers. One of which might end up permanently impaired within the next year or so. More on that stock when it’s turn for a “one year later” treatment comes up later this year (around August I think).



So what is the hard part about net-net investing?



The waiting. With no catalyst in sight – no wonderful future to visualize – you were going to be holding a bad business. Indefinitely. That’s scary.



GTSI was an ugly business. It never earned very good returns on capital. And it probably never will – in any form. But it was cheap. GTSI sold – at quite a few times in the past year – at below its likely liquidation value.



There were three assets that might have value in liquidation – together – at more than the company’s market cap:



1. Cash



2. Receivables



3. Stake in EyakTek



The third one refers to a private – scandal-ridden – company GTSI had a stake in.



Here’s what I wrote about EyakTek back in the June 2011 Ben Graham: Net-Net Newsletter:



GTSI owns 37% of a company called EyakTek. The biggest owner of EyakTek—as the name suggests—is Eyak. Eyak is an Alaska Native Corporation. That’s a special kind of small business under federal government rules. Alaska Native Corporations— we’re intentionally avoiding discussing the politics of this issue here—get super preferential treatment under federal government rules. They can behave like small businesses even when they get very, very big. And they have gotten very, very big. From 2000 to 2008 the amount of federal government spending going to these Alaska Native Corporations went from $500 million to $5.2 billion. The reason for this seems to be that non-native government contractors like GTSI started using these Alaska Native Corporations very aggressively to funnel business to themselves. There are rules limiting subcontracting of government contracts won by Alaska Native Corporations to big businesses like GTSI. Apparently, everybody—and based on what we’ve read in a U.S. Senate report investigating these Alaska Native Corporations, we do mean everybody—ignored these rules.



Which brings us to EyakTek. GTSI owns 37% of EyakTek. EyakTek is a small business that sells computers to the government. It’s a very profitable business. EyakTek’s earnings are around $20 million. GTSI’s share of those earnings amounts to around $7 million a year. None of that is included in the stats we’ve been giving you on GTSI up to this point. The return on assets and equity numbers we provided counted only GTSI’s operating income. Not its share of EyakTek’s earnings. Which would amount to around $7 million a year. That works out to around 70 cents per GTSI share. In theory, GTSI’s EyakTek stake alone should be worth more than GTSI’s $5 share price. Eyak—that’s the other owner of EyakTek—made some moves in 2010 that suggest it too thinks EyakTek is worth a lot compared to GTSI’s stock price. EyakTek offered to buy all of GTSI for $7 a share in cash. The offer was later raised to $7.50 a share. EyakTek dropped the offer the second GTSI got ensnarled in the SBA scandal.



All this suggests Eyak thinks EyakTek is worth a lot. Maybe more than GTSI trades for. Maybe GTSI’s stake in EyakTek is worth close to the $7 EyakTek offered for GTSI. Here’s the catch. GTSI obviously doesn’t think so. GTSI had the option of allowing EyakTek to continue doing business after graduating from the small business designation made by the federal government. In other words, GTSI—by virtue of its 37% stake—could decide whether or not EyakTek should liquidate its business instead of trying to compete as a big contractor. The original LLC agreement that formed EyakTek gave GTSI a veto over EyakTek’s continued existence in the case EyakTek graduated from being a small business. GTSI didn’t vote for continued existence. So EyakTek should have liquidated. But it didn’t. Instead EyakTek tried to buy all of GTSI. Since then—as GTSI’s CEO put it—EyakTek and GTSI have “been in an adversarial relationship”. Basically, GTSI has no visibility into EyakTek. They aren’t on speaking terms. In fact, there was a sham meeting of the LLC owners where Eyak squashed GTSI’s attempts to discuss any business other than the liquidation vote, GTSI didn’t vote in favor, and then EyakTek kept operating as if the vote hadn’t failed.



Enter the lawyers. And the arbitrator. And a lot of ugliness. But finally on last quarter’s conference call, GTSI’s CEO said EyakTek and GTSI are now in settlement talks and they hope to have a deal by the end of this quarter. Will they? Who knows?



What if GTSI sells out of EyakTek? What if EyakTek tries to buy all of GTSI again?



It’s hard to say. Think of it as a lottery ticket. For the purposes of this newsletter, we value GTSI at $8.69 a share. That assumes liquidation value for EyakTek. The upside on top of that in a buyout of GTSI’s EyakTek stake could conceivably be several bucks per GTSI share. It could add $5 a share to what GTSI is worth. But it’s such an odd, murky situation we don’t even like hinting at that kind of number. Instead just think of GTSI as being worth $8.69 a share plus a lottery ticket. Not bad for a $5 stock.



First, let’s clear up how the EyakTek story actually ended. GTSI was paid about $2.07 a share for its stake. This was about 3 times EyakTek’s trailing earnings. So, maybe 4.5 times after-tax earnings. Something like that. The P/E ratio they got doesn’t matter. Because of the nature of what EyakTek was – a loophole for doing business with the federal government – I always thought it was worth a miniscule multiple of its past earnings. GTSI carried its EyakTek investment on its books at $1.21 a share. And it got more than that. For my $8.70 appraisal of GTSI – I actually cut the value of GTSI’s investment in EyakTek from $1.21 (under the equity method of accounting) to $1.09 a share to estimate the liquidating distribution GTSI might get if EyakTek was shut down. I figured they wouldn’t settle for less than the liquidating distribution would be worth. And Eyak would offer GTSI more than what the liquidating distribution would be worth if they wanted to keep EyakTek in business.



As it turned out, GTSI got almost twice as much for its EyakTek stake as I assumed. Although, like I said, I had no clue what they would get – and if the relationship was poisonous enough between the two parties they might even end up getting close to nothing. Plus there’d be tons of litigation. It didn’t turn out that way. They settled pretty quickly after I picked GTSI for the newsletter. I think it happened within the next quarter or so.



So if I was so conservative in valuing EyakTek, why was I so wrong in valuing GTSI? I put intrinsic value at $8.69 a share and yet it’s being bought out for just $7.75 a share. Does that mean the buyout price is too low?



Maybe. I don’t really think the buyout adds or subtracts much value from what GTSI shareholders already had. It’s just an event. A way of getting the market price of the stock to reflect what shareholders already owned. It’s not like the offer “created” value. Or like GTSI shareholders are getting a good deal. It’s not a particularly good sale price. The buyers will do fine from a price perspective. The quality of what they’re buying is where they will either end up making money or losing money – depending on what they do with it. But the buyers got a fine deal on price.



Before the deal was announced, GTSI shares were trading at $5.30. After the deal was announced, they were trading at $7.72 a share. So, the buyer and Mr. Market had two different appraisals of the company. I had a third – and that was about $8.70 a share. That was not an overly conservative appraisal. I would never have suggested buying shares of GTSI at $8.70 a share. Only that you might get a chance to sell them at $8.70 a share in the future. It was a best guess as to what the company was really worth in June 2011. And I’d stick by that estimate. My appraisal in June 2011 was 73% higher than GTSI’s stock price at the time. The buyout offer – a year later, with some intervening events – turned out to be 54% higher than the June 2011 stock price.



This highlights the importance of Ben Graham’s margin of safety principle. I was off by quite a bit. I appraised GTSI at 12% higher than what a control buyer actually offered. I was wrong. But Mr. Market was wronger. He guessed 35% lower than what a control buyer offered. And that was just in June 2011. Over the next year, Mr. Market would guess anywhere from 30% to 50% lower than what a control buyer would eventually offer for GTSI.



Now, it could be argued that the really hard part of net-net investing is figuring out when some event like a buyout is going to happen. If GTSI hadn’t been sold to a control buyer in the next year – but instead five or six years down the road, an investor’s annual return in GTSI would’ve turned out very differently.



This is especially true because GTSI’s actual business is mediocre. And that’s a generous description. At best, holding GTSI just gets you long-term bond-like returns. Nothing better. Value does not build in a shareholder’s favor at GTSI. There was a one-time gap between price and value – the value was anywhere from 50% to 100% higher than the stock price at various points over the last year. The issue was when you would get that 50% to 100% return.



In fact, this might even be more important than whether you bought GTSI at a little higher than the Ben Graham: Net-Net Newsletter did – say $5.30 a share – or a lot lower (say $4.00 a share). That was obviously important. But if you buy a net-net within one year of its being bought out – you’re often going to do all right regardless of the exact price you pay.



There’s a big gap between $5.30 a share and $4.00 a share (pretty much the range GTSI had been trading in before the announcement). But it’s the gap between $7.75 a share and $5.30 a share that mattered most.



So time matters. But focusing too much on time could be a problem in net-net investing. In fact, I think it is. And we can demonstrate that with a little annual return math.



If you bought GTSI at a price of $5.30 a share right before the buyout happened – which is pretty much the highest price you could’ve paid in the last year – and then the buyout actually didn’t happen for a full five years, what would your annual return be?



Well, $5.30 invested today that turns into $7.75 in five years is an annual return of 7.9% a year.



When you think of net-net investing, you probably think of big risks and big returns – and there are both. So you probably want more than 7.9% a year. But I actually don’t expect the stock market to do any better than that for you over the next five years. So, getting stuck in GTSI for five years and bought out at $7.75 at the end of that period would’ve been pretty close to a market-matching investment. That’s my view. We’ll see. Maybe stocks will return 10% or 15% or 20% between 2012 and 2017. But I think it’s a lot more likely they return about 8%. No more.



If GTSI had been bought out in four years, your annual return would be 10% a year. If it had been bought out in three years, your annual return would be 13.5%. If it had been bought out in two years, your annual return would be 20.9% a year. And if it had been bought out in one year – as it actually was – your annual return would be 46%.



All of this assumes you paid pretty much the highest price at which GTSI traded before the buyout. A price of $5.30 a share was actually higher than where the stock usually traded over the last year. Trust me – it was in the red for most of the time after I picked it for the newsletter.



And all of this assumes the potential buyout value of GTSI would neither grow or shrink over time. That’s clearly wrong.



But over the last 10 years, the growth in GTSI’s value – and yes, intrinsic value probably grew, I’d peg the very uneven growth at maybe 2% a year – was hardly enough to offset the risk of a permanent and catastrophic loss in the stock. Something from which an investor couldn’t recover.



Historically, GTSI had done better than the last 10 years. And if Ben Graham’s quote from the Roman poet Horace is to be believed – perhaps it is not only the stock that would rise again in people’s perceptions but actual business conditions as well. It’s very possible. Maybe GTSI could earn 6% a year on its book value one day. I doubt it could do much more over a full decade.



Over the last 20 years, GTSI’s average return on equity was 6%.



A 6% build in intrinsic value hardly compensates a shareholder for the risk taken by owning a business like GTSI – a business which often has operating margins around 1%.



So, really we were always talking about a pretty simple proposition. The business may earn a return. Or it may not. What little return it manages to earn is unlikely to compensate shareholders beyond the risk they are taking holding the stock. This is not a buy and hold investment. It is nothing that will “snowball.”



But the stock price was wrong. It did not value the company at anywhere near its value to a control owner. Mr. Market was probably leaving anywhere from a 50% to 100% upside on the table when he offered to sell GTSI to you in the past year.



So, the question was – how long would it take for this gap between price and value to close:



1 year: 46%



3 years: 14%



5 years: 8%



10 years: 4%



And that’s what a lot of net-nets look like. You think a control buyer would pay 50% (or more) for the whole business – but you see no reason why he’d do that now. If he comes along in a year, you’ll make 40%. If he comes along in a decade, you’ll make 4%. All the while you’ll be taking the risk of owning a lousy business.



Is it worth it?



In my experience, yes. It is worth it in theory. But, for the vast majority – I don’t know if it’s 95% of investors or 99% or 99.99%, but it’s not 50% – net-net investing is an emotional impossibility.



I don’t know how many readers of the Ben Graham: Net-Net Newsletter owned GTSI. One reader did email me about it. But he’s an experienced net-net investor. Someone with the right psychological make up for this sort of thing. Certainly far ahead of most investors in terms of being able to own a mediocre business without an obvious catalyst slowly drift down in price for the better part of a year – and then, bang! Make a 40% return in one day.



So is net-net investing hopeless? Should you just give up?



If you don’t think you like net-net investing now – yes, you should give up. There’s no point in sticking around and trying to train yourself to love it. You won’t. Move on to something else – otherwise, you’ll lose a lot of money in net-nets.



If you think you really do like net-net investing – and you can imagine yourself owning things like GTSI, I do have two pieces of advice:



1. Put 100% of your focus on buying and 0% of your focus on selling



2. Put 100% of your focus on the downside and 0% on the upside



As my 12% misappraisal of GTSI shows – versus Mr. Market’s 30% to 50% misappraisals – it’s often not that hard to value a net-net better than the market. But valuing a net-net is not what makes you money. You have to buy a net-net and you have to hold a net-net.



Some people can value net-nets really well. But they don’t actually end up buying them. Other folks buy and sell net-nets so rapidly they accumulate a long list of stocks they once owned that eventually got bought out – a year or three after they had already sold them.



You want to be there for the buyout.



Now, of course, many net-nets do not get bought out. And the truth is that if Mr. Market had changed his perception of GTSI such that the stock traded at $9 a share – there probably wouldn’t have been any buyout at all.



That’s fine.



Yes. It means you might have had to sell to realize a return. I’m not against selling net-nets. But I am against watching net-nets like a hawk. I don’t think it’s necessary. If you pick them right in the first place, a quick check up once a year is all the time you need to spend revisiting your already-owned net-nets. The rest of your time is better spent finding new ones.



And that’s the hardest part of net-net investing.



Waiting.



It’s really easy to find net-nets. It’s a little bit difficult to actually have the stomach to buy them. And it’s emotionally impossible for most people to actually hold net-net long enough to get paid.



And here we’ve been talking about a stock you only needed to own for a year.



Folks like Ben Graham and Walter Schloss – great net-net investors – often held net-nets for closer to four years.



How’d they do it?



My theory is that they were always nibbling on a new net-net. Buying little bits of new stuff. Accumulating 100 net-nets. But never at once. So they could always focus on buying something cheap. And they didn’t have to worry about selling so much.



They really did have faith that somehow price and value would converge. That they’d get paid one day for buying at two-thirds of intrinsic value.



That faith is the hardest part of net-net investing. I think it’s easiest to have faith like that if you don’t focus on it. If you focus instead on a process that keeps you finding new net-nets and minimizes the temptation to sell what you already own.



Visit Geoff at Gannon On Investing

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