Avoiding Value Traps: A Four Question Test

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Apr 11, 2012
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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.
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