Dangers of Value Traps

Transcription

1 CHAPTER 14 Dangers of Value Traps A S WE CAN EASILY SEE, the stock market fluctuates greatly. The market moves like the seasons and constantly rotates between the underpricing and overpricing of securities. The basic emotions of fear and greed are what drive this phenomenon, from the extremes of exuberance during prosperous times to the lows of despair during crisis. This is directly what the terms bear and bull market are derived from. It s a peculiar balance, like the sun and the moon or the ying and the yang. Oftentimes, it s obvious to see which direction the bias is pointing. Now, these forces naturally create price discrepancies. Businesses that are essentially worth the same this week and next week can trade at very different values, depending on market sentiment. This is what creates an advantage for the patient value investor. Value investing bases its philosophy on the adage buy low, sell high. It depends on individuals in the market to act in a crowd-like fashion, grossly overvaluing some stocks while vastly underestimating others. Many times, the underlying assets are worth the same, but just the public perception of those

2 VALUE TRAP INDICATOR assets has changed. Because we know that these market values fluctuate uncontrollably and constantly, we can feel confident that investments that are undervalued will eventually return to their net present value. In fact, the lower the price we pay for these businesses, the less chance of us being wrong about a company s undervaluation. Unless of course we run into value traps, which I spend the rest of the book showing you how to avoid. Just as stocks can exaggerate the optimism by rising to bubble proportions, stocks similarly crash to newer and newer lows. Like the famed billionaire Jim Rogers once said, Markets often rise higher than you think is possible, and fall lower than you can possibly imagine. As searchers of value, it s only a matter of time before we come across stocks that are just doomed to fall indefinitely. These stocks just keep falling in price and seem more attractive the farther they go down, but the net effect to the investor is akin to trying to catch a falling knife. You re going to get hurt. Even worse, some of these stocks eventually go bankrupt. In any strategy attempting to buy undervalued companies, you re bound to come across many stocks whose prices are falling. At times, the falling price is legitimate as the business really is deteriorating. Other times, the falling price is just another market emotional roller coaster where people are unfairly reacting to a company s predicament. The hardest part about deciphering between these two situations is that many value traps will disguise themselves as value plays. Other than one or two minute details, a legitimate value opportunity will oftentimes have the same appearance as a value trap. The numbers in a certain financial statement may still look good, and many classic value-investing equations may still check out. It was this exact predicament that urged the creation of the Value Trap Indicator. The time of the duped investor needs to end.

3 Dangers of Value Traps When major events like the Enron bankruptcy or AIG bailouts shook the investing world, many value investors got burned alongside the rest of the public. Truthfully, the topic of value traps is not brought up by the famed value investor legends. Everybody wants to talk about how to maximize analyses and optimize basis points, while glossing over the obvious risks and worst-case scenarios. This negligence has happened over and over again, even most recently with the sub prime mortgage bonds and CDOs that went bad and destroyed the hedge funds and big name Wall Street brokers. Ask how this could have possibly happened, and you ll get the same answer from the careless fund managers-- they overlooked the potential risk. With a tool like the Value Trap Indicator, you ll no longer have to worry about whether your latest value pick is a trap or in trouble. The indicator picks up on warning signals long before they have a chance to do serious damage to your portfolio. With the impact of financial losses to annual return numbers, this benefit may be the greatest of all. THE VALUE TRAP INDICATOR The Value Trap Indicator is a numbers based approach to avoiding dangerous value stocks while still discovering undervalued opportunities for maximum returns. This indicator was formulated based on extensive research on the last 30 major bankruptcies from the S&P 500. Because the greatest weakness of a value investing strategy is the value trap, this indicator is an attempt at avoiding such risks, thus greatly increasing chances of higher returns. This emphasis on avoiding major losses is for a good reason. In fact, losing money while investing requires higher gains just to break even. As losses mount, the required gain to offset a loss becomes higher than the loss itself.

4 VALUE TRAP INDICATOR For example, a 10% loss requires an 11% gain to break even. While that s not that serious, consider the gain needed on a bigger loss. A 50% loss requires a full 100% gain, double the percentage move, to offset. A loss of 75% needs a full 300% gain, or a 4x bagger, just to recover back to the initial amount. It doesn t take much experience in the markets to understand how much harder it is to find a 300% gainer than it is to lose 75%. The Value Trap Indicator draws from seven different categories, consisting of common stock market valuations and metrics. The key to the success behind this indicator is that it draws from common numbers that every public company is required to submit to the SEC. As such, companies regulated by the SEC will all have a Value Trap Indicator value. This protects the investor from most possible fraud, as these numbers are audited by professional accountants. Additionally, the investor has a consistent and unemotional foundation to analyze any stock. A numbers based approach like this one will not fall victim to investor biases, market sentiment, or public perception. The numbers don t lie, and they help keep us rational in an irrational world. The indicator is also effective because it doesn t discriminate based on industry. While it is true that in general you want to compare financial ratios within industries, the Value Trap Indicator bypasses this requirement by considering all aspects of the financial statements. For example, it is generally accepted that software companies have much lower capital costs than say an oil company. As a result, the average debt to equity ratio in the oil industry will probably be higher than the software industry. However, because oil companies are more leveraged, they will likely have a much easier time at creating earnings, thus lowering their earnings multiples much lower than a software company. So you can see there

5 Dangers of Value Traps is an even trade-off regardless of the industry. Though industry averages on financial ratios may be higher depending on the business model, there will always be a balancing consequence that appears elsewhere on the financial statements. As long as all aspects of a financial statement are considered, this imbalance will not go undetected. You ll soon see that this is exactly what the Value Trap Indicator does. Now because of the uniformity of the system, it s only natural that certain industries will be more heavily favored than others. This isn t undesirable. On the contrary, a good investor will recognize that this is a huge benefit. The truth of the matter is that some business models are just better than others. Some industries just have higher demand or better efficiency than others. This is just a fact of life. For example, the current technology information and energy costs firmly confirm that coal is far superior to solar. This is not based on opinion or wishful thinking. In fact, the cost of fossil fuels like coal is many times less than an alternative energy like solar. No matter how much research money gets thrown at solar power, the simple fact that less than 1/10 of the potential energy from the sun is available once it reaches earth can t be ignored. As a result, the process to produce this energy is much more inefficient and costly than simply using fossil fuels. You can imagine that this clear technological advantage gives coal a substantial business advantage over solar. That s exactly right. It should be no surprise that the top coal mining company has a net income of $13 billion, while solar s top company is only $270 million. Until solar companies can fix the gaping hole between the costs efficiencies, this industry will underperform the rest of the energy industries. You see, the Value Trap Indicator will punish an industry that is underperforming for the simple reason that

6 VALUE TRAP INDICATOR the financial ratios for the stocks in that industry won t be adequate compared to the rest of the market. The general U.S. economy grows at a steady pace, and various industries over and underperform that growth during different decades. By utilizing a fair and equal measure for every company regardless of industry, the Value Trap Indicator increases its chances of investing in the booming industries and avoiding the failing ones. In real times of economic turmoil, it s not just one or two companies that are going bankrupt in a struggling industry. When an industry has underperformed for so long and the economy finally buckles, the industry will see mass numbers of bankruptcies within itself, while other strong industries will be perfectly fine and intact. Like with the financial banks in 2008 and the internet stocks in 2000, an industry comparison of financial ratios would ve registered serious losses for your portfolio as you likely would ve held some of the biggest losers. Don t let the industries drive your investing decisions. Hold all industries to a strict standard of profitability, and your portfolio will be rewarded. THE FORMULA BREAKDOWN Now that you have a basic understanding behind the logic of the Value Trap Indicator, here is the accompanying formula. VTI = * (x1 + x2 + x3 + x4 + x5 + x6 + x7), where VTI < 250 is a Strong Buy and VTI > 800 is a Strong Sell. As you can see, the lower the VTI the less risky a stock is. Additionally, each x number corresponds to a category and contains its own calculation and lengthy explanation. Every category is uniquely valuable to the equation, as you ll soon see that even one bad ratio can ruin the whole formula and trigger a Strong Sell. Again, this is to the investor s benefit, as there s been circumstances where a company goes bankrupt after looking extremely attractive

7 Dangers of Value Traps in every financial ratio except one. Sticking to its definition as a true value trap, these are the types of stocks that greatly discourage the investing world yet are easily avoided with a VTI calculation. The second portion of this book will cover 12 of the major 30 S&P 500 bankruptcies since Each case study will uncover the glaring red flags that each company displayed in the years prior to their bankruptcies. As you ll soon see, the Value Trap Indicator would ve been able to prevent investors from investing their capital in each case. Of the 30, the Value Trap Indicator avoided 29 bankruptcy cases for an over 96% success rate. This is an extraordinary advantage to the value investor. By completely negating the worst downside scenarios, the investor is able to both feel at peace with his investments and preserve his capital for better compounding opportunities. Take a look at the Value Trap Indicator figures for each of the 30 bankruptcy cases on the next page. The accompanying VTI numbers for each company are for the last annual report filed before bankruptcy. Although hypothetically investors following the VTI wouldn t have had money in these stocks, you ll see that the VTI still gives investors the ability to withdraw cash from these stocks right before they become worthless. An ability like this is worth more than its weight in gold.

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