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 (NASDAQ:GMCR), Netflix (NASDAQ:NFLX) and Soda Steam (NASDAQ: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 (NYSE: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.
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.
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 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 (NASDAQ: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 (NASDAQ:AAPL), which is the king of all margin-expanding companies:
We all know what has happened to the stock of Apple.
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."