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Avoiding Value Traps: A Four Question Test

April 11, 2012 | About:
The Science of Hitting

The Science of Hitting

234 followers
Investing is a curious balance between art and science; value investors, who by their nature are generally contrarian, almost always find themselves debating whether a security is a steal or a value trap. At the same time, if that company is well known, it is likely being ridiculed in the media and showered with contempt in the blogosphere. This is the point of maximum pessimism; and as the great investor John Templeton noted, this is the best time to buy.

When I think of companies that are truly despised, few rank higher than Microsoft (MSFT). As a member of the “old tech” firms that have seen their stocks go nowhere for over a decade due to ridiculous excessive valuations at the turn of the century, scores of investors have come to the (incorrect) conclusion that this company is a dinosaur and is all but dead. As investors know, the reality is that this company has consistently put up attractive numbers, with revenue and earnings per share both increasing double digits (per annum) over the past decade.

But this article isn’t about Microsoft; what I want to address is how to avoid value traps. While this list is in no way complete, it covers a few of the key questions that I believe should be asked before attempting to catch a falling knife:

1) What are the odds that this company will not be around ten years from today? – As I noted in my previous article “Kill the Company,” this is the first question Buffett will always ask: Is there any chance that a significant amount of my capital could be subject to catastrophe risk? As Alice Schroeder noted, if the answer is yes, he just stops thinking; this is a good example to follow.

2) What is the company’s sustainable competitive advantage? – In my mind, this is essentially the same thing as No. 1: What does this company do that all but guarantees its existence 10, 20 and 50 years from now? For Coca-Cola (KO), it delivers a product with unmatched brand equity (partly due to significant economies of scale) via an unrivaled distribution network; in addition, it has levered this success to enter new categories (juices, teas, sports drinks, etc.) in order to all but guarantee its continued growth even if the shift away from CSDs experienced in the U.S. continues in the future.

3) Does the company have the financial strength to ride out a rough patch? This is overwhelmingly important, and has been captured as of late in two high profile examples:

The first is Diamond Foods (DMND), which has been plagued with an accounting scandal: The company was itching to grow a bit too quickly, and now holds $530 million in debt (compared to a market cap of $470 million) compared to marginal profitability. As a result, the company has had to explore strategic alternatives, and will likely need to dilute the current shares outstanding or sell the company as a whole (they are in talks with KKR according to a recent Barron’s article).

Even when adjusting the prior year’s financial statements to account for the misstated numbers, DMND starts to look attractive at the current valuation based on their growth potential and their current earnings power; the minute my eye catches that overwhelming debt load, I’m forced to walk away in fear of what might lay ahead for this company.

On the other end of the spectrum is Nokia (NOK); while the company has gotten clobbered by Apple’s (AAPL) iPhone and Google’s (GOOG) Android operating system, they are fine from a financial perspective. Even after losing more than 1 billion euros last year, the company has net cash of 5 billion euros, leaving them plenty of time to right the ship (now that we abandoned that burning oil rig, right Mr. Elop?) before the balance sheet becomes an issue.

4) Would you LOVE to see the stock fall 50%? – For me, this is the ultimate test for an investment. If you can look at a company’s competitive position within an industry and know that you would love to buy more at half of today’s price regardless of the short-term noise, that’s a good sign in my book (I've been begging for many to do some since I missed out in 2009, but so far, no gravy). If this isn’t true, there are two likely culprits: Either you question the long-term sustainability of the business, or you don’t understand enough about the company to feel comfortable with bouts of volatility. Either way, its probably a sign that you should move on to the next opportunity.

I would love to hear readers’ opinions on what they look at to decipher between attractive investments and value traps, or lessons they’ve learned from traps that have caught them in the past.

About the author:

The Science of Hitting
I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

Rating: 4.5/5 (40 votes)

Comments

marcolanaro
Marcolanaro - 2 years ago
Sometimes I think that a look at the economic environment can help discerning a value trap from great opportunities. Just look at Greece, the index has been dropping in the last few years a lot. Dont' you think, though, that there are some hidden gems there? I believe so and I think that is one situation in which value investors should look. I think that there you have many stocks that we would love to have that have dropped 50% or more.

Last thing, I really enjoy every article you have pubblished, they are excellent in my view.

thank you
batbeer2
Batbeer2 premium member - 2 years ago
It was a pleasure reading this, thanks !
cdubey
Cdubey premium member - 2 years ago
Second Batbeer2. Short, to the point and sweet.
superguru
Superguru - 2 years ago
YHOO, NOK, RIMM and BBY are good examples of companies that fail on first two questions but score 'YES' on the third. Sony is fast moving in that list too.

The Science of Hitting
The Science of Hitting premium member - 2 years ago
First off, thanks for the kind comments everybody!

Marcolanaro,

I agree with you 100%; while most people let market wide drops signal whether or not they should be buying or selling, I think this creates the perfect opportunity to buy businesses that go on sale because of some short term/indiscriminate macro cause.

Superguru,

I'm actually in the process of looking at one of the companies you named; while I don't own it (at this point), be on the lookout for an article in the near future :)
energywonk
Energywonk - 2 years ago
it was a weak spruik for as the author says a dinosaur. some value metrics glossed over. one way to look at microsoft is as the berkshire hathaway of the day. buffett would bleed this company if he had one iota of tech understanding. msft has been done to death and yet it continues to die.
Cornelius Chan
Cornelius Chan - 2 years ago
I understand that NOK is far from failing 1 & 2. As Science intimates, 1 is pretty well a function of 2; whereby NOK, yes, is weak on competitive advantage, is working with the world's #1 software co. to create a third mobile OS that will in time create their moat. In this sense also, RIMM looks screwed.

Also agree with Science that NOK passes 3. The company is down not because its financials are weak, but because they missed the boat on beating Apple to the invention of the smartphone as we know it Agree that their strong financials allows it the resources to take market share with new offerings.

NOK already passes 4. It has fallen much more than 50% at quite a few points between 2007 and now.

Thanks for enriching my value investing knowledge base with your article!
marcolanaro
Marcolanaro - 2 years ago
I am not sure that YHOO, BBY, NOK, or RIMM will ever be able to answer a clear yes on questions number 1 and 2. They are high tech companies, in particular the last two, and their product cycles are really short, just look at Apple which has tremendous success but with products that are not even two years old. I am not sure that in ten years Apple would still dominate, actually I would bet against it. Maybe this sector is to tough for these questions.
jayb718
Jayb718 - 2 years ago
Great questions to keep in mind.

What I try to do is learn as much as possible about the company and think about what it's future might be like, if I can't picture it, then I can't value it. I consider it a value trap until more helpful information shows up or I understand the company better. Until then I'm on to the next one.

Many people have more insight on YHOO NOK RIMM that I do. They will have a clearer picture of their futures, which opens the door to valuing those companies. That's the beauty of the game, no one has to invest in any stock, where the other guy may have the advantage. :-)
onthefringe
Onthefringe - 2 years ago
Too inexperienced to know what a value trap looks like. But I rest easy if I'm convinced the future holds:



Stable Revenues -
Likely to retain or increase: current customers, price, frequency purchased, amount purchased per customer. The customer wants your product . Your competitors aren't likely to steal them or increase the cost of retainment.

[/b][b]Control Over Recurring Costs - Relative to revenues. Don't necessarily need to have direct "control." Just don't want to see it increase unexpectedly or significantly.

A Business That Is Tough To Duplicate - Differentiation in generation of earnings (products, contracts, profile of market served, cash cycle, niche market leader, etc), assets (tangibles or intangibles), or operations (favorable cost structure --> cheaper growth --> larger share of future profit pools --> more capital to reinvest).



Options To Redeploy Capital For Gain
- Google, for example, failed a lot with extensions before Android. But it generated lots of cash protected by a hard-to-replace core business. And its market/industry has plenty room for growth or innovation. It can afford to make mistakes (and learn from them). For any company, doesn't have to be products. Can reinvest in operations, processes, etc.
BEL-AIR
BEL-AIR - 2 years ago
SCIENCE OF HITTING

I love your articles and style...

Keep it up..

As far as tech companies go, I think it is dangerous to invest in any tech company that is in a down turn and trying to be a turn around, as the odds are very much against them, sure there is apple as an example, but for every apple story there is 10 that don't make it.

Can you say Nortel....

It's to tough to predict...

It's better to go with a non tech company with a stable past and easier to understand business, tech changes to fast and many former leaders will simply be left behind if they zig instead of zag....

How about Corn Flakes? It's not gonna change much in the next 10 years...

Can't say that about tech, so no way to know who will be the winners from the losers.

Just think Atari...
The Science of Hitting
The Science of Hitting premium member - 2 years ago
Bel-Air,

Thanks for the comment; and I tend to agree - those companies have a hard time passing #1 & #2

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