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A Simple Way to Spot Value Traps: Nokia, RadioShack and RIMM

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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."


Rating: 3.7/5 (30 votes)

Comments

superguru
Superguru - 2 years ago
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.

Koheleth
Koheleth - 2 years ago
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?
superguru
Superguru - 2 years ago


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.

csucag2
Csucag2 - 2 years ago
This article appears to be the opinion of Gurufocus only. What do gurus say about value traps do they confirm what you say?
Adib Motiwala
Adib Motiwala - 2 years ago
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

Adib Motiwala
Adib Motiwala - 2 years ago
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.
varunfriend
Varunfriend premium member - 2 years ago
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

BEL-AIR
BEL-AIR - 2 years ago
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.
Adib Motiwala
Adib Motiwala - 2 years ago
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.

gurufocus
Gurufocus premium member - 2 years ago
Business quality is such an important factor here. If a company's margin is in long term decline, eventually it will slide into loss. Will it turn around over time? it is hard to say.

Is HPQ a value trap? it sure does have the sign, declining margins:



Will the trend reverse? It may. But why do you want to bet on it? There are plenty of higher quality companies out there.

Again, "I would rather buy good business at fair price than fair business at fair business at good price."

Adib Motiwala
Adib Motiwala - 2 years ago
Maybe have a list of companies with rapidly declining gross margins.. the shorts would be interested :)
gurufocus
Gurufocus premium member - 2 years ago
avi_g
Avi_g - 2 years ago
Why look at gross margin only ? What about other margins: operational or net profit ?
JUDS1234567
JUDS1234567 - 2 years ago


Think I have come to the same conclusion Buffet has in regards to quality. A good expert on the subject is Jeremy Grantham. If you ever read his quarterly letters (which I am sure you all doJ) he tends to only invest in high quality. And he also defines it quite often, using SP ratings along with predictable earning and low debt. He even ran back test and found that high quality has not only outperformed from the 60s onward but it did so with less risk. In addition he also mentioned that a portfolio of high quality stocks would have survived the great depression and Japanese bubble while a portfolio of “net net” would have take an enormously long time to even come back to even. Charlie Munger in the art of stock picking also praises the virtues of quality, it’s a great read. He mentions the only times one would avoid this strategy would have been during nifty fifty era which coincidently happened at a major secular top. This type of overvaluation also happened in high quality in 1998 again another secular top. But back to Grantham, I really think he is the authority on quality investment and as he puts it “we all know what quality is”. Finally, I would like to direct any hard core “Grahamites” to one of his quarterly letters where he criticize some of the features of pure value investing as we know it. High ROIC, ROE and ROA along with no loss in EPS and long history of dividend and predictable earnings are all features of quality and one should also look at the Credit rating along with SP/Moody ratings for affirmation on its quality status. And he makes a very convincing point of looking at price to book as a risk factor something of a new paradigm. Some food for thought.

AlbertaSunwapta
AlbertaSunwapta - 2 years ago
Could someone first please define "value trap"?
superguru
Superguru - 2 years ago
My definition of value trap - Company is cheap based on one or more metrics but that base metric like book, earning or revenue keeps falling. For example I buy some company at say 0.7 P/B (cheap) but the book keeps falling that would be a value trap.

Another example would financials in 2007 -2008. Many famed value investors bought financials thinking they are cheap based on relative historical valuation. They kept on getting cheaper and most never recovered.

Edit: In short declining fundamentals and declining IV.
Adib Motiwala
Adib Motiwala - 2 years ago
To start the potential value trap looks cheap on a trailing basis and has a rosy past. Say a low P/E. So the stock looks cheap on an absolute basis, historical basis.

Then, the market gets nervous about the company and the stock price starts to come down and the P/E gets lower. The stock looks even more attractive. But, then the earnings start to come down a bit. Competitive position is eroded or maybe its technology is obsolete. However, the stock price keeps getting lower faster than the 'E' and hence the stock appears as cheap if not cheaper, all the way down. Certainly true of RIMM.

I think it is very important to pay attention to fundamentals and not just look at Price or P/E. As fundamentals deteriorate and its not easy to know if those are temporary, short term or permanent. Unless one has that edge to distinguish that, it may be better off to sell the position.
AlbertaSunwapta
AlbertaSunwapta - 2 years ago
Adib, as you say "As fundamentals deteriorate and its not easy to know if those are temporary, short term or permanent", the thing is that if it looks cheap on a trailing basis, market participants on balance have likely already noted a deterioration of fundamentals or are mistrusting, say, a slow, under-the-radar improvement in the fundamentals. However, if the 'value investor hasn't discovered a reliable mean reverting or better catalyst (anything from short term defeasance tactics to long term socio-economic or demographic trends), he/she is simply practicing faith-based investing and only being trapped by his/her own analysis limitations.

thaman
Thaman premium member - 2 years ago
this article deals with the question of how to avoid a value trap,

in most cases one can simply avoid buying shares in declining industries,

as in the case of retails, and cell phones, and print

where it is clear from everyones day to day experience that APPLE and AMAZON

are offering better products.

its the problem of greed that makes one see more potential value in a declining stock,

that seems to be priced cheap, then in a good business that is priced fairly.

my question is now what? now that you've fallen into a trap, should one take the loss,

and sell his position,or hold the lose while waiting for a "turnaround"? is averaging down really a good tactic for declining stock?

what would you do now with losing positions in RSH, NOK, RIMM, SVU? etc... ?

Adib Motiwala
Adib Motiwala - 2 years ago
Another one happening right now is Lexmark. The P/E keeps getting lower as the price drop is larger than Earnings drop. the div yield gets getting bigger. Balance sheet is good as it has net cash.

However, sales have been flat for a long time and are now falling by double digit in recent quarter....

Value Trap / Business under transformation / Macro Issue..... Any one want to take a shot at this one?

SeaBud
SeaBud premium member - 1 year ago
Poor holders of the "value traps" RIMM and Nokia sure have suffered:

- Rimm shareholders up from the date of this article only 33%,

- Nokia shareholders up from the date of this article by 140%

Confession: I never considered buying Radio Shack as it is a bricks/mortar play that I see as dying - true value issues with no way for earnings to spike (didn't even check its price from this article to today). I considered but did not buy Rimm as their ecosystem, while wonderful, is limited. I bought Nokia, huge, as it was priced below bankruptcy value of its functioning businesses, assets and offered the huge potential payoff of success in China/India. Even if the handset business only became mildly profitable, you could exit with a win.

Value traps offer no escape. I think Rimm and Nok had/have escape plans, it is whether they can execute on them that was the question. Further, both had large cash troves to give their plans time to succeed or fail. I think this article misses on labeling both value traps for that reason.
gurufocus
Gurufocus premium member - 1 year ago
hi SeaBud,

In this article we are talking about value traps when they were much higher. We pointed out that looking at profit margins may help avoid deep losses.

Of course, if the stocks drop enough to be close to book value, it may run up quite a lot from there.

Please leave your comment:


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