With tools 18 through 22, Sven Carlin continued to offer tactics that help investors avoid losing capital. The tools are part of the book, “Modern Value Investing: 25 Tools to Invest With a Margin of Safety in Today's Financial Environment.”
Tool 18: Natural cyclicality of an economy
Economy-wide pullbacks are a continuing part of investment life. While investors mostly remember the big recessionary declines of 2000 and 2008, less severe contractions are quite common. Carlin cited information from the National Bureau of Economic Research that shows an American recession has occurred on average every 58 months since 1945. That’s just under five years, meaning bull markets and bear markets arrive quite frequently.
Of course, they never are exactly five years minus two months, nor can investors forecast them. Thus, Carlin urged investors to include recessions in their analyses and, specifically, to create a model for intrinsic value that will account for changes in revenue, costs, earnings, debt and cash flow in a downturn.
That analysis should include the performance of similar companies in past recessions, including the behavior of their margins. If the overall analysis shows no danger of bankruptcy, there is a margin of safety. With that, check the cyclically adjusted price-earnings, or CAPE, ratio for the intrinsic value.
On the buy side, the average recession lasts only 11 months, but that is long enough to scare many other investors who will then sell at cheap prices, fearing further declines or a permanently low price. Given that 11-month average duration, value investors must act relatively quickly; as Carlin wrote, “there is time to analyze stocks but also don’t wait too long as the stock market usually anticipates a recovery.”
The author added a caution: These situations often produce value traps, apparent bargains that turned out to be cheap only because there were real and serious problems. Avoiding them is just as important as finding true bargains.
First, not all bargains are bargains. In many cases, the company has been in trouble and is unmasked when a recession hits because of factors such as stronger competition, lack of growth, management issues or sectoral weakness. These are stocks that may not go up in value when the market recovers.
Carlin added, “Avoiding a value trap is easier said than done but it’s important to discuss as owning a value trap might lock up precious capital for long periods of time and have a huge opportunity cost for your portfolio.”
Tool 19: Future catalysts
A catalyst is an anticipated event that could drive up the stock price in the future. Catalysts include takeovers, new or increased dividends, improved earnings, more effective business operations, cyclical turnarounds, asset sales and political changes. The presence of a catalyst can offset, to some degree at least, the potential for a value trap. Careful value investors will insist there is a high probability the catalyst will occur, and that it will unlock value.
To find potential catalysts, listen to or read transcripts of conference calls, stay on top of sector trends, watch for relevant market developments and run analyses that project potential changes in the fundamentals.
Tool 20: Secular declines
Another tactic for avoiding value traps and loss of capital is avoiding secular declines in a sector. An example of a secular decline would the long-term, downward pressure on oil prices because of new technologies (for example, shale oil and shale gas). At the same time, American oil and gas companies are operating in a secular bull market because of low interest rates.
As this example suggests, investors should carefully analyze supply and demand forces as well as have some knowledge of the broad trends in the sector and the outlook for the products of a company. One type of situation to avoid is buying a company in a very competitive sector that is also experiencing a secular downtrend. That would be tantamount to walking into a value trap.
On the other hand, as Carlin noted, “When there is a bargain in a growing sector or one with wide moat business, then the likelihood of the stock being a value trap is much lower. This is because sooner or later the business environment will change.”
Tool 21: Insider activity
Generally, when senior management invests in their company’s stock, it is considered a sign of confidence. But it could be a mixed message, since management may be buying to cover up internal weaknesses. A better indicator, then, would be the buy-sell ratio, particularly if less-senior managers are involved because they cannot afford symbolic gestures as much as senior managers.
It is also important to distinguish between stock purchases from vested options and what Carlin called “real stock market purchases.” Further, only purchases at the full market price should be considered real insider activity.
The author acknowledged that finding information about middle management’s stock transactions would not be easy, but suggested to investors they review annual reports and Securities and Exchange Commission filings.
Tool 22: Is the dividend sustainable?
A dividend that is not sustainable also warns of a value trap, just as a dividend increase might be viewed as a catalyst. On the negative side, if the company’s products are selling for less, cash flow will be reduced, pulling down the sustainability.
There is also the matter of market sentiment: “the market hates dividend cuts, thus if there is the likelihood for more dividend cuts, this could create a value trap even if the stock is already trading at a huge discount to its intrinsic value.”
But there is room for contrarians; Carlin gave the case of Peter Lynch, who liked to buy companies after they cut their dividends. Lynch believed capital would be managed better after a dividend cut, leading to improved financial results as well as the potential reinstatement of dividends.
How can we tell if a dividend is sustainable? The author urged investors to look at the company’s cash flow statement. It will show how much cash was generated, and how that cash was allocated. Key issues include financing costs, capital expenditures and the strength of the operating cash flow.
Carlin recommended beginning with the price of the company’s product(s) and subtracting the cost of making it (them), then analyze how each of these factors is affected by the business environment. After accounting for costs, is there any room for dividends?
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
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