There’s nothing worse than being a bag holder. Watching shares in the company you once thought could change your life dribbling lower every day –Â 10%, 15%, 25% –Â and your money vanishing can be a psychologically challenging experience. That’s without mentioning the financial pain you may have to endure.
Unfortunately, value investors are more exposed than most to the prospect of bag holding. Buying value means buying out-of-favor companies, and this often means buying stocks that have dropped by a significant amount. When doing this you’re always running the risk that the market may know more than you, and the shares could fall further. Of course, value investors tend to think they know more than the market. Indeed the whole strategy is built on the concept of believing you're better than the market so there is bound to be some overlap here.
The question is, how do you make sure that you don’t end up being a bag holder? There is no definitive answer to this question, but there are some investment criteria you can put in place to try and make sure that you are not caught unaware by the market.
Don't be a bag holder
First and foremost, cash is probably the single most important antibag holder metric. First of all, a company’s cash flow can tell you much more about the business than the profit and loss statement.
Profit and loss figures can be easily manipulated, but cash flows are complicated to manipulate significantly. Cash flow figures also tell you a lot about the income statement, specifically whether a company is massaging earnings by manipulating sales.
The second way cash can be helpful is when monitoring a company’s balance sheet. Debt is not always bad. If a company can afford its debt, then a little leveraged is not a bad thing. It is when a corporation cannot afford its debt that problems start to arise. When I say "cannot afford," I mean that when the company can no longer pay its obligations as well as interest costs from operating cash flow, you have a problem.
If a company cannot pay off its debt with cash when it falls due, then it becomes reliant on creditors. Creditors are generally cyclical; if they don’t want to loan money to a company when it needs it most, you will have a problem. In most cases, a company will be able to roll over its debt, but I’m not talking about most cases. I’m talking about the contrarian situations when a stock price has already fallen a significant amount, and creditors might already be spooked.
Cyclical margin of safety
Alongside cash, the second factor that will likely help you try and figure out if a stock is a future bag holder candidate is the nature of its business.
There are two things to look out for here. First of all, you need to establish whether the business is cyclical and if the company is suffering from cyclical or structural problems. Second, you need to understand whether the company has the edge over its competitors, giving it pricing power or an economic moat.
Enterprises that operate in cyclical industries can succeed and produce huge returns for investors if they have a scale edge over competitors. The commodity industry is the perfect example. Those miners with the largest economies of scale and best assets can survive through the ups and downs of the industry, acquiring struggling peers at the bottom of the cycle and then growing even larger as earnings recover.
Of course, there’s still more risk with these cyclical type businesses than there is for companies that do not operate in cyclical industries, do not have structural problems and have pricing power. Coca-Cola (KO, Financial) is the prime example.
The bottom line
Overall, the market is full of bag holding candidates, but by following the above advice, you’ll be able to improve your chances of sidestepping these potential mines. It is possible to find good companies trading at bargain prices; you just have to be willing to put in the extra effort.
Disclosure: the author owns no share mentioned.
