Don't Fall Into Value Traps Like Weight Watchers

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Aug 20, 2015
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A lot of Weight Watchers (WTW, Financial) must have lost a lot of weight over the past two years from holding the stock. It is a value trap that investors can avoid if they pay attention to the most of important warning sign of value traps – long term profit margin decline.

A value trap is a stock that appears to be cheap but its value is in continuous decline.

Being price sensitive, value investors lost much more money from value traps than from overpaying stocks. Because a value trap’s value is always in decline, the original margin of safety disappear over time. The investment may incur permanent losses.

We discussed value trap extensive a few years back. We now like to remind our subscribers again. As we pointed before, a simple way to avoid value traps is to watch its profit margins. This worked very well for companies like Blackberry (BBRY, Financial), RadioShack etc. It can be applied to companies like Weight Watchers too.

This is the operating margin of Weight Watchers. We can see that it has been in long term decline.

03May20171011081493824268.png

Because of the declining profit margins, its revenue and net income have four stages in the process of deterioration.

  1. As revenues (TTM) grow, earnings (TTM) also grow, but at a slower pace. This is WTW was during years 2000-2006.
  2. As revenues growth slows down, earnings are flat. This is WTW was during years 2006-2012.
  3. As revenues growth slows further, earnings start to decline. This is WTW was during years 2012-2013.
  4. Both revenue and earnings decline. This is WTW was since 2013.

You can see this from the chart below.

03May20171011091493824269.png

Investors had plenty of time to sell the stock long before it enters the final stage if they pay attention to the indication of a value trap – the long term decline of profit margins.

We would like to repeat what we said value trap before:

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-net, even then they can continue to destroy value and be dangerous.

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, Financial), which is the king of all margin-expanding companies:

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

What’s Next?

GuruFocus has a Premium feature called “Warning Signs” which warn you about the problems a company may have, including margin declines. If you are a Premium Member, you can check those out.

In the meantime, our “All-In-One Screener” allows you to screen for the companies that can expand profit margins. Those with expanding profit margins (think Apple) at reasonable prices will mostly likely be very rewarding.

Try our “All-In-One Screener.” it now has more than 200 filters including one called "Gross Margin Growth Rate." It now supports Customized Filters too.

This is just one of the many features we have with GuruFocus Premium Membership. You will find much better investment ideas with these powerful tools. If you are not a Premium member, we invite you for a 7-day Free Trial.