As all long term value investors know, buying stocks at cheap does not necessarily makes you money. A cheap stock can get even cheaper, if the business fundamentals have deteriorates. This is so called “value trap”.
How do you avoid falling into a value trap? As written by our distinguished columnist Geoff Gannon, “You can use something called the F-Score. The F-Score was created by an accounting professor at the University of Chicago. He wanted to use a simple checklist to separate troubled companies from companies that were going to pull through … It’s a list of 9 different questions that can be answered yes or no. If you answer them yes it counts as a 1 and if you answer them no it counts as a 0. It’s basically an on/off switch. You tally up the score and see how the stock does. Most stocks score somewhere between 3 and 7. A few get very low scores like 0, 1, or 2. And a few get very high scores like 8 or 9...”
Among the 9 questions of calculating the F-Score, question number 8 is the change in gross margin. If this year’s gross margin is higher give the stock one point. If last year’s gross margin is higher give the stock zero points.
While F-score is useful, we believe that one reliable way is to look at the long term trend of the gross margin. This can be easily done with the 10-year financial charts at GuruFocus. For instance, in the case of DELL, please go to Dell 10-year financials page. In the area of ratios, click on the line of Gross Margin, We see the history of the gross margin of Dell:
We can see that the long term trend of the gross margin of Dell has been on decline over the past 10-years. It did recover in 2008, but it declined again afterwards. This can be even clearly seen from the operating margin, the 10-year historical chart can displayed by clicking on the row of Operating Margin (%). We got this:
Observing the long term trend of the profit margins can help us from getting excited when the profit margin rebounds temporarily, this may well be what is happening at Dell. The operating margin for the quarter ended on Oct. 31, 2010 was 6.7%, a dramatic increase from 4.8% in the previous quarter. We cannot say for sure that this is a temporary improvement, but this has happened before several times for Dell in the last decade. Just to see it declined again and the loss to investors continued.
For comparison, this is the operating margin of Wal-Mart (NYSE:WMT). The profit margin has been on the rise. The business has the price power that it can protect its profit margins from competitions. It even increase its profit margin as the company becomes more efficient. That is the moat we have been talking about. As the business grows, the earnings grow. If you buy the stocks at reasonable valuations, the stock prices will follow the earnings.
Dell’s profit margin looks quite similar to an industry that we all know is in declining, the newspaper industry. Just look at the gross margin of newspaper company Gannett Co. (NYSE:GCI) below. How similar is that to Dell’s?
As pointed out by Geoff Gannon, buying a really cheap value trap may still make you money if you quickly flip it for a profit. But that requires good timing in both buying and selling, and favorable macro environment, and is REALLY cheap. It is just too much to ask and too hard to do. Therefore, I wouldn’t consider Dell for my portfolio. I rather buy a company that has sustainable or expanding profit margins (moat) and long term revenue and earnings growth, even if it is not that cheap!
Didn’t Warren Buffett say that the best? “I rather buy good companies at fair prices than fair companies at good prices.”