In our final digest of “Modern Value Investing: 25 Tools to Invest With a Margin of Safety in Today's Financial Environment,” we look at ways of protecting ourselves from value traps, those seeming bargains that turn out to be capital killers.
Author Sven Carlin argued that 90% of cheap stocks are cheap for a reason, anything from incompetent management to commodity cycles. Yet, that’s the field value investors must plow, in search of cheap stocks with good fundamentals.
He sums up his approach to avoiding value traps this way: “Never try and catch a falling knife. Wait for it to hit the ground then pick it up.” The term “falling knife” is used in the financial community to denote a stock that has experienced a fast price drop, and it is a cliché that one should never try to catch a falling knife.
Here are his 10 rules:
1. Start by determining whether the stock has fallen because of a temporary problem or a structural problem. A temporary problem might occur in a growth sector where there is product price volatility and oversupply or undersupply problems. Structural problems, on the other hand, are deep and hard-to-fix problems; for example, newspaper companies in an age of digital advertising.
2. Know your psychological biases and think as rationally as possible. Carlin noted it is quite reasonable for investors to think too quickly when stock prices move quickly. They get caught up in the mood of the moment and fail to commit time to make a rational decision. Think of the many investors, and institutional investors, that buy as bubbles are forming and sell at a loss when the bubble bursts. If you are tempted to buy a falling stock, ask yourself whether you are anchoring this new price to a previous price, a bias for which many investors are susceptible.
3. Distinguish between short-term overselling and long-term trends. Carlin advocated for careful analysis. However, he did not reference a technical indicator known as the relative strength index, which graphically shows if a stock is overbought or oversold (often temporarily). In the bottom section of this GuruFocus chart, we see the RSI for Caterpillar (CAT, Financial):
When a stock falls below the lower line (red, 30) it is considered oversold and a buy prospect if the fundamentals are good. When it rises above the upper line (green, 70) it is considered overbought and a potential selling opportunity.
The relative strength index can be added to any GuruFocus chart by clicking on "Technical Indicators" and choosing RSI in the "Indicators" drop-down menu. The default setting is 14 days, but that can be adjusted to select longer or shorter periods. More information about the indicator is widely available online.
4. Specialize in the stock or its sector. According to Carlin, any serious value investor can do work as good as, or even better than, that of the Wall Street analysts. In his words, “Wall Street might seem like an impenetrable castle, but the more you learn about it, the more you will see that it isn’t so deep and diligent value investors can find their place in the sun, especially with stocks that are poorly covered because Wall Street can’t gain good fees on a small cap for example.”
5. Diligently watch your risks. If you have done your homework, you will have a reasonable estimate of intrinsic value and margin of safety.
6. Extend negative trends. Carlin discussed this in connection with risk management and urged investors to assume a negative trend continues until it reaches the worst-case scenario. Once it hits that low point, it may become a buy candidate if it has an adequate margin of safety.
7. Diversify so that no single failure will hurt too much. Additionally, Carlin liked to improve his odds: “Even if your batting average is 50%, with proper diversification your returns should be positive. Let’s say you buy 10 falling knives. Of those 10, 5 double in the next year, 2 go nowhere, and 3 go bankrupt. Your return is still 20% which is excellent even if you were right only on 50% of the stocks.”
8. Stick with the plan, and don’t sell too soon. If you bought a falling knife at a rational price, do not sell it after its first big price increase. Wait for the stock to hit your intrinsic value and even then you might consider holding for the long term if the fundamentals remain strong. There is also the potential for good news to compound, which could lead to extraordinary returns.
9. Say no when appropriate. There are always many opportunities in the market, especially when there is a recession. Carlin wrote, “Learning how to say no in the stock market is of extreme value. You might miss out on some returns, but you’ll miss out on even more losses.”
10. Demand a robust margin of safety. This rule gets us back to the basic common sense of value investing: Value for shareholders must be significantly above the current stock price.
Carlin concluded the chapter with these words: “The point is that with falling knives, we should dedicate the same amount of time and effort into analyzing our behavior in relation to the situation as much as trying to rationally analyze the situation itself. When knowing oneself and the company that is analyzed, you will increase your batting average which is the most important thing in investing.”
(This article is one in a series of chapter-by-chapter digests. To read more digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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