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A Simple Way to Spot Value Traps: Nokia, RadioShack and RIMM
Posted by: GuruFocus (IP Logged)
Date: July 18, 2012 10:26AM

Dr. Paul Price wrote an article called Wake-Up Calls Often Come Too Late. He discussed the collapses of the stock prices with Green Mountain Coffee (GMCR), Netflix (NFLX) and Soda Steam (SODA). As pointed correctly out by Adib Motiwala, value investors are rarely hurt by companies like Green Mountain Coffee, Netflix and Soda Steam. The reason is simple. These stocks are usually traded at extremely high valuation and value investors would normally avoid the situations like these. Value investors are much more likely hurt by the stocks like Nokia (NOK), RadioShack (RSH) and Research-in-Motion (RIMM) as these stocks have been traded for very low valuations. Value investors thought that they were buying into value, while they were actually buying into value traps. The valuation just gets lower, and lower.

Spotting value traps has been discussed extensively. Our columnist The Science of Hitting wrote an excellent piece: Avoiding Value Traps: A Four Question Test. While asking questions such as “What are the odds that this company will not be around ten years from today?” or “What is the company’s sustainable competitive advantage?” will certainly help you avoid value traps, but you cannot always get a straight answer for those questions.

One easy way to avoid getting hurt by the companies such as Nokia (NOK), RadioShack (RSH) and Research-In-Motion (RIMM) is to look at their profit margins. We will look at each case below:

RadioShack (RSH)

This is the annual gross margin of RadioShack:



Clearly, RadioShack’s gross margin has been in consistent decline since 2004. The decline of the profit margin eventually dragged the company into its recent loss. While RadioShack’s profit margin was declining, its earnings per share (EPS), the most important indicator to Wall Street was relatively stable for years as the company continues to buy back shares:



Eventually the stock lost more than 90% over the last five years.

Nokia (NOK)

If RadioShack is relatively easy to avoid as it is a retailer without clear competitive advantage, Nokia was once a household name for cell phones. The stock has lost 95% over the past five years. How could value investors avoid investing in Nokia as the stock was traded at a reasonable P/E ratio of 10 in 2008? Evidently some of the value Gurus we track did buy into Nokia.

Again, let’s look at the profit margins of Nokia:



Nokia’s gross margin has been in steady decline. The rate of decline is about 3.36% a year over year for the past 10 years. While its gross margin was declining way before 2007, its revenue and earnings per share kept climbing:



Investors were celebrating the increase of the revenue and earnings and pushed the stock price to $40. But the decline in profit margin eventually took the company to a deep loss. The stock is now traded at less than $2.

Research-In-Motion (RIMM)

Research-In-Motion is a high-profile case as renowned investor Prem Watsa bought into the company and sits on the company’s board. The stock was traded at above $140 in 2008. It has since lost more than 95%, traded at single digits and still sinking.

Again let’s take a look at its gross margin:



While BlackBerry was a must-have in the corporate world, the profit margin of Research-In-Motion has started to decline. This was well before Apple (AAPL) released its first iPhone. Again as pointed by Adib, value investors did not buy into RIMM while it was traded at $140 because the P/E ratio then was 45. Value investors bought into RIMM while it was traded at $30-40 because the P/E ratio was at 10. This was in 2009 and the decline in profit margin had been happening for three years.

Why You Should Avoid Margin Decliners?

The reason is simple. The company is losing its price power or it never had price power. Competition is eating into its market.

Will the profit margin of these companies ever recover sustainably? That is a “too-hard” question. We should avoid situations where we have to answer this question.

Will these companies ever become good investments? They may. But not until they become net-nets.

The Power of Margin Expansion

On the other hand, if a company can expand its profit margin, it has a competitive advantage. A good example here is Apple (AAPL), which is the king of all margin-expanding companies:



We all know what has happened to the stock of Apple.

What’s Next?

GuruFocus will release a feature called “Warning Signs” which will warn you about the problems a company may have, including margin declines.

In the meantime, our new “All-In-One Screener” allows you to screen for the companies that can expand profit margins or those with declining margins. Those with expanding profit margins (think Apple) at reasonable prices will mostly likely be rewarding. Those with declining margins (think RIMM, Nokia) are probably good short candidates.

Try our “All-In-One Screener.” A new version was released this week and it now has more than 120 filters including one called "Gross Margin Growth Rate."



Stocks Discussed: RIMM, NOK, RSH, AAPL, GMCR, NFLX, SODA,
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Re A Simple Way to Spot Value Traps Nokia RadioShack and RIMM
Posted by: superguru (IP Logged)
Date: July 18, 2012 11:27AM

great article. I also fell into rimm value trap buying it around 10 as speculative turnaround position. Is Watsa decision influenced by his closeness to rimm founder. only time will tell. It is a jockey and cash with no debt bet just like Sears.


Stocks Discussed: RIMM, NOK, RSH, AAPL, GMCR, NFLX, SODA,
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Re A Simple Way to Spot Value Traps Nokia RadioShack and RIMM
Posted by: Koheleth (IP Logged)
Date: July 18, 2012 12:05PM

Buffett has said that if he can't see where the business will be 10 years from now he won't buy the stock.

I take that to mean that there is no doubt about the company's staying power ie that it will still be in existence -- like the farm and apartment house analogies he makes -- which I suppose go hand in hand with the earnings power and consistent margins.

Can anyone have confidence that they know where RIMM or Radioshack will be in 10 years?


Stocks Discussed: RIMM, NOK, RSH, AAPL, GMCR, NFLX, SODA,
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Re A Simple Way to Spot Value Traps Nokia RadioShack and RIMM
Posted by: superguru (IP Logged)
Date: July 18, 2012 01:40PM


Can anyone have confidence that they know where RIMM or Radioshack will be in 10 years?

I do not know where Apple will be in 10 years either. In high tech it is very hard to see or plan beyond 1 - 3 years time frame.


Stocks Discussed: RIMM, NOK, RSH, AAPL, GMCR, NFLX, SODA,
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Re A Simple Way to Spot Value Traps Nokia RadioShack and RIMM
Posted by: csucag2 (IP Logged)
Date: July 18, 2012 02:37PM

This article appears to be the opinion of Gurufocus only. What do gurus say about value traps do they confirm what you say?


Stocks Discussed: RIMM, NOK, RSH, AAPL, GMCR, NFLX, SODA,
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Re A Simple Way to Spot Value Traps Nokia RadioShack and RIMM
Posted by: Adib Motiwala (IP Logged)
Date: July 18, 2012 06:35PM

While gross margins were falling, on an absolute basis those margins were not bad. I mean 40% gross margins at RIMM fell to 35% and then 30% gross margins. The net margins were not bad even in 2011. I think it was a lot of factors. High quality competition emerged in the form of Apple and Android. Combined with complacent and over confident management and then poor products that kept coming out of the pipeline and then it was a steep drop in market share in a short space.

NOK was making crappy phones for a long time and was hurt on both ends of the spectrum.

Not well versed with RSH but sales had been flat for a long time there. Even though FCF looked good.

In the "Warning Signs", i would recommend watching for flat or declining sales. Also, peak margins are also a big warning sign. That is the opposite problem of "declining margins". If a stock is bought at a seemingly low multiple but margins are peak or unsustainable, then you could be buying at the top. This happened with me in Aeropostale (ARO) last year.

This could be a useful feature and a lot of things could be checked for. Different companies may have different criteria. Rising inventory v/s sales, rising receivables v/s sales come to mind.

thanks
Adib


Stocks Discussed: RIMM, NOK, RSH, AAPL, GMCR, NFLX, SODA,
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Re A Simple Way to Spot Value Traps Nokia RadioShack and RIMM
Posted by: Adib Motiwala (IP Logged)
Date: July 18, 2012 07:59PM

A very current and valid video from Jim Chanos on Value Traps and one idea.

http://www.gurufocus.com/news/182952/jim-chanos-delivers-his-short-thesis-on-hpq

He says he has made a lot of money recently on stocks that appeared 'cheap' but were value traps.


Stocks Discussed: RIMM, NOK, RSH, AAPL, GMCR, NFLX, SODA,
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Re A Simple Way to Spot Value Traps Nokia RadioShack and RIMM
Posted by: varunfriend (IP Logged)
Date: July 18, 2012 10:54PM

I guess we should ask Donald Yacktman since he is holding 11M shares in HPQ ...

this is partially a tongue-in-cheek comment because I am not sure its that easy to predict a value trap just based on looking at one dimension. Value trap in my view is when you buy a profitable buggy whip business just when horseless carriages are introduce. I am not sure if thats happening with HPQ. Atleast I cannot see the horseless carriage version of HPQ. If its the demise of PC business which is 30% of their sales then I suggest it has turned into a more of a commodity business so they are now trying to figure out how to compete through services rather than product.

The variable that is missed in most analysis is time. Is Chanos's timeline the same as Yacktman's probably not. Can Chanos make money over the next 2 years shorting HPQ and Yacktman make money over the next 10 going long - why not?

All goes back to Heisenbergs principle of uncertainty, it is highly improbable to be able to predict what will happen and when it will happen accurately and consistently ... so just play the odds when they are in your favor within a process that has been shown to work for you



Stocks Discussed: RIMM, NOK, RSH, AAPL, GMCR, NFLX, SODA,
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Re A Simple Way to Spot Value Traps Nokia RadioShack and RIMM
Posted by: BEL-AIR (IP Logged)
Date: July 18, 2012 11:16PM

I would say this is one of the most important topics as a value investor, and one topic we should spend more time on, all of us....

We see something that looks cheap so we buy, it turns out that it is a trap for all the reasons mentioned above.

I have alot of friends on this sight, also on other value investing sights.

It is amazing how they fail to value companies properly and pay to much right off the bat or buy companies with bad fundamentals or falling fundamentals..

They hang on until they lose 75% thinking they are right, then they even average down, but in the end they get scared.... wise up and sell at massive losses.

Seems the very best investors out there can see a trap and can bet the farm when they do see true value, few seem to have this ability to analyze and value a business to this degree, you must really be able to read and understand accounting...

It is not just one ratio or the other, it can be different for different companies or a combination of many factors.

Second you must have the patience to wait for value and then have the guts to put big money when the time is right.

Before I go I just want to say this, in the last few years, how many companies outside of the great 2009 crash trully did get cheap and were easy to spot?

Fact of the matter is it does not happen often, you must wait for crashes to find the truly great companies that are undervalued.

The fact is it is very very hard to find such great companies at any one tine, the field is full of mines during normal bull markets.....

When Stocks do get cheap during bull markets usually more than not do so for a reason.


Stocks Discussed: RIMM, NOK, RSH, AAPL, GMCR, NFLX, SODA,
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Re A Simple Way to Spot Value Traps Nokia RadioShack and RIMM
Posted by: Adib Motiwala (IP Logged)
Date: July 19, 2012 12:57AM

Some good points bel-air.

Buying just because something looks cheap on trailing valuation metrics is asking for trouble. I have made that mistake a few times. Along with cheapness, I look for few other elements such as

1) Balance sheet strength : I prefer strong balance sheets with little to no debt and ideally excess cash. HPQ failed this test and hence i was able to pass up on it easily. Now, this was before the big crash from the $40s. I looked at the balance sheet of dell, intel, cisco, microsoft and wondered why HPQ had so much debt and when all the others had a large portion of their market caps in cash. (RIMM passed this balance sheet test)

2) ROIC / ROE : Quality test: ROIC is one of the two metrics used by the magic formula. It makes a lot of sense to me. ROE is fine but when looking at leveraged companies, you cannot use ROE. Also, ROE rises with buybacks. Hence, i look at both but primarily at ROIC.

3) Capital allocation : What does management do with the FCF that it generates? Dividends? Increasing dividends over time? Buybacks? At what prices? Acquisitions? What kinds of multiples paid? Di-worsify? HPQ and Dell battled over storage company 3Par i think it was 2 years back? multiple bids and huge premium was paid at an insane valuation. Both Dell and HPQ failed this test. In fact CSCO failed this for many years till it supposedly got wiser. But i am still not sure about CSCO and hence I sold my shares of CSCO that i had in my personal account. Intel has shown good dividend growth for a decade now and its payout is not puny. Also has been doing buybacks. Though all these companies have granted options and buybacks have really not had the effect that IBM had.

Despite doing home work, you will have some losers in your portfolio. what i noticed with Don Y is that RIMM was a tiny 1% position. HPQ was 2%. You can see his over weight positions. They are companies like PEP, PG that are going to be around for a long time (if not forever).

I think spending more time on the competitive landscape and obsolescence risk is equally or more important than just the basic financial metrics. I under estimated how fast things could change for RIMM and paid a heavy price for it. Price did not matter. it has been decimated and its products are almost obsolete.

Interested to see what folks think of retailers such as Staples (SPLS), GameStop (GME), BestBuy (BBY). GME also faces some of the challenges faced by RIMM in terms of technical changes. It also faces AMZN which is a big one by itself. SPLS expanded to Europe and that has not worked for it.



Stocks Discussed: RIMM, NOK, RSH, AAPL, GMCR, NFLX, SODA,
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