Value Traps

[jawn619]

As a beginner investor, It seems like i am gravitating towards these value traps. Does anyone have any tips to avoid making these mistakes? Or a mental model for thinking to avoid these bad situations?

 

Examples

I followed Einhorn into CONN,

Bought PBR on the basis of a low P/E ratio-but sold out before the big bloodshed.

And am currently in IBM

[Kraven]

As a beginner investor, It seems like i am gravitating towards these value traps. Does anyone have any tips to avoid making these mistakes? Or a mental model for thinking to avoid these bad situations?

 

Examples

I followed Einhorn into CONN,

Bought PBR on the basis of a low P/E ratio-but sold out before the big bloodshed.

And am currently in IBM

 

You will get a lot of replies to this I'm sure.  In advance, I will summarize them for you.

 

"Buy BRK!  Let Warren and Charlie do the work for you.  I have 99.95% of my portfolio in it (the remaining .05% is split evenly between FFH, MKL and IBM).  I sleep great.  If the market closed so that only Methuselah was around when it re-opened I would be thrilled.  It's going to be $300,000 soon!"

 

"Buy FFH!  Let Prem do the work for you.  I have 99.95% of my portfolio in it (the remaining .05% is split evenly between BRK, MKL, BBRY and IBM).  I sleep great.  It's going to compound at 15% a year guaranteed.  It's going to be $1,000 soon!"

 

"Buy SHLD!  Let Eddie do the work for you.  I have 99.95% of my portfolio in it (the remaining .05% is dry powder to buy more when it falls a bit).  Eddie is a genius's genius.  I sleep great.  It's worth about a million billion dollars."

 

"Buy BH!  Let Biglari do the work for you.  I have 99.95% of my portfolio in it (the remaining .05% is to buy copies of Maxim as soon as they hit the shelf to read while I eat at Steak & Shake).  I sleep great.  Sardar is a misunderstood genius."

 

"Forget all of those other guys.  They don't know what they're talking about.  You have to buy something no one knows about like MKL, L or LUK.  If you do what everyone else does, you'll get the same results."

[AzCactus]

As a beginner investor, It seems like i am gravitating towards these value traps. Does anyone have any tips to avoid making these mistakes? Or a mental model for thinking to avoid these bad situations?

 

Examples

I followed Einhorn into CONN,

Bought PBR on the basis of a low P/E ratio-but sold out before the big bloodshed.

And am currently in IBM

 

You will get a lot of replies to this I'm sure.  In advance, I will summarize them for you.

 

"Buy BRK!  Let Warren and Charlie do the work for you.  I have 99.95% of my portfolio in it (the remaining .05% is split evenly between FFH, MKL and IBM).  I sleep great.  If the market closed so that only Methuselah was around when it re-opened I would be thrilled.  It's going to be $300,000 soon!"

 

"Buy FFH!  Let Prem do the work for you.  I have 99.95% of my portfolio in it (the remaining .05% is split evenly between BRK, MKL, BBRY and IBM).  I sleep great.  It's going to compound at 15% a year guaranteed.  It's going to be $1,000 soon!"

 

"Buy SHLD!  Let Eddie do the work for you.  I have 99.95% of my portfolio in it (the remaining .05% is dry powder to buy more when it falls a bit).  Eddie is a genius's genius.  I sleep great.  It's worth about a million billion dollars."

 

"Buy BH!  Let Biglari do the work for you.  I have 99.95% of my portfolio in it (the remaining .05% is to buy copies of Maxim as soon as they hit the shelf to read while I eat at Steak & Shake).  I sleep great.  Sardar is a misunderstood genius."

 

"Forget all of those other guys.  They don't know what they're talking about.  You have to buy something no one knows about like MKL, L or LUK.  If you do what everyone else does, you'll get the same results."

 

I would probably skip SHLD.  For starters it's probably a good idea to read The Intelligent Investor.  Also, the fact that you have a paper loss does not necessarily mean the stock is a poor investment.  While I do not own the names you mentioned maybe CONN will appreciate in the next 2-3 years. In terms of mental models Poor Charlie's Almanackwould probably be a good book to purchase. 

 

Good luck.

 

David

[yadayada]

Buy BRK.  Let Warren and Charlie do the work for you.  I have 99.95% of my portfolio in it (the remaining .05% is spent on porn and cocaine).  I sleep great.  If the market closed so that only Methuselah was around when it re-opened I would be thrilled.  It's going to be $300,000 soon.

[Ross812]

Developing a checklist and staying away from certain industries can help you avoid some value traps.

 

For instance, I don't invest in anything that produces a commodity good: Sugar, pot ash, paper. If the person or company consuming the product is turning it into something else, I'm not interested.

 

Future cash flows are the only thing that matter. Cash on the balance sheet, X assets, a factory worth Y, and patent Z don't mean anything. If the company is losing money and has a lot of assets then you are betting on management being able to efficiently liquidate the company. The second management says we are going to attempt a turn around, run!

 

Does the bear case for an investment make sense to you? Bear case - IBM is not growing anymore because their customers are transitioning away from mainframes. IBM is beginning to offer cloud solutions at lower margins. Can they curb the secular decline in their mainframe business? I don't know so I'm not going to invest.

 

Is the companies industry in secular decline or fundamentally troubled? There is a lot of talk in the OAK thread right now. I don't think the bond market is fundamentally healthy; I don't care to bet that Marks can pull a rabbit out of his hat.

 

I think the number one thing to remember to avoid value traps is past results are not indicative of future profits when considering a turnaround investment.

 

I've made most of my money buying GAARP type investments and layups instead of home runs. Buy Fairfax when it gets kicked out of the international index and falls 15% in a day, Kinder Morgan at 30 when the market indiscriminately sold all pipeline companies because Boardwalk cut their dividend, Marvell when a jury awarded ridiculous damages that would never be paid, Diageo when China came out with their anti corruption charges (Diageo doesn't sell $2000 cognac!), ect...

 

Leave anything that needs a multi-page dissertation to demonstrate how the company makes money to the pros. If you don't understand how they make money, leave it.   

[Liberty]

As a beginner investor, It seems like i am gravitating towards these value traps. Does anyone have any tips to avoid making these mistakes? Or a mental model for thinking to avoid these bad situations?

 

Examples

I followed Einhorn into CONN,

Bought PBR on the basis of a low P/E ratio-but sold out before the big bloodshed.

And am currently in IBM

 

Not to give a serious answer in what is turning out to be a joke thread, but in my experience, people fall in value traps (including me) mostly when they fixate too much on quantitative aspects of a business and forget to properly take into account the qualitative aspects. Something cheap can always get much cheaper, and sometimes IV falls to meet the stock price rather than the other way around, so you need to figure out why the market should value a company differently at some point. Is it a melting ice cube that will just melt faster and faster, with management making the wrong moves and forces outside of the company's control further eroding value, or is it positioned well for growth or unlocking value in some way, with enough levers in management's competent hands, to at least maintain its IV long-enough for Mr. Market to realize that it's cheap?

 

Some businesses are just very tough. A good mental exercise is to imagine what you'd do if you were CEO of the company you are considering investing in. Sometimes crossing your fingers and hoping for a favorable environment is the best you can do if you run a capital-heavy, commodity, undifferentiated business in a very competitive industry.

[KCLarkin]

Read as much as you can:

http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/which-5-investing-books-have-been-the-most-influential-to-you/msg175475/#msg175475

 

Mistakes are inevitable -- you are making bets on an uncertain future. But as David mentioned, you need the ability and confidence to distinguish between a mistake and a paper loss. For example, I bought AAPL in 2013. It dropped 27%. I bought more. I'm now up 67%. This year I bought Vistaprint. It dropped 30%. I bought more. I'm now up 74%.

 

Also, investing is like poker. Sometimes you make a bad bet and win. Sometimes you make  a good bet and lose. All you can do is tilt the odds in your favor

[Picasso]

As a beginner investor, It seems like i am gravitating towards these value traps. Does anyone have any tips to avoid making these mistakes? Or a mental model for thinking to avoid these bad situations?

 

Examples

I followed Einhorn into CONN,

Bought PBR on the basis of a low P/E ratio-but sold out before the big bloodshed.

And am currently in IBM

 

There is a special light bulb that goes off in the mind of an above-average investor when something seems fuzzy about an investment.  I know it sounds funny but it is true.

 

That light bulb develops from investing in value traps and learning from your mistakes about what you overlooked or some flawed method of valuation, whether from the expected cash flow or the multiples you assigned to it.

 

If you want to avoid those bad situations you are going to need to look at your mistakes and figure out what went wrong with each.  With IBM I would say it is the focus on the EPS and PE multiple making the stock look artificially cheap.  CONN is a tough one to figure out.  PBR is at the intersection of everything the market hates right now and also tough to figure out.

 

Maybe keep more dry powder and focus on easier targets until you start to understand what went wrong with your previous mistakes.  I personally feel investors get stuck in value traps when markets are overvalued because they have to start digging into questionable businesses at below average valuations to reach for returns. 

[KCLarkin]

Does the bear case for an investment make sense to you? Bear case - IBM is not growing anymore because their customers are transitioning away from mainframes. IBM is beginning to offer cloud solutions at lower margins. Can they curb the secular decline in their mainframe business? I don't know so I'm not going to invest.

 

Jawn, here is a riddle for you:

 

IBM's mainframe business grew 72% YoY in Q4 2010. How did a nearly 50 year old technology grow 72% YoY?

[jawn619]

Thanks everyone for the tips. I've already read all the books suggested (intelligent investor, security analysis, margin of safety, poor charlies almanac etc) but i am only now understanding that a wonderful business at a fair price is better than a fair business at a wonderful price. As for buying BRK, i can't get myself to pull the trigger on buying BRK at 1.5x book value. Even though it's a great business at a slightly expensive price.

[merkhet]

How long have you been in CONN & IBM?

[GregS]

"I am a better investor because I am a businessman and a better businessman because I am an investor." - Buffett

 

Once you've been investing for awhile, you will realize that valuation and financial statement analysis is the easy part. The next step is to learn business analysis and it is a lifelong process. Read widely.

[vinod1]

Stick to boring quality businesses for the first few years as you are earning your stripes. Those businesses that are providing substantially the same products and services for 20 years or more and have a history of good profitability and make sure that you are not paying crazy multiples.

 

Alternatively, a much more simpler option is to stick to businesses in Buffett's portfolio. If you are adventuresome you might consider Longleaf and Sequoia portfolio's as well. That gives you a lot of businesses to understand and practice valuing businesses.

 

Vinod

[yadayada]

Your question is very general here. You are bascily asking, how do i find stocks that not only look cheap, but also go up?

[cobafdek]

No guarantees in investing, even value investing.  To me, the most reliable definition of "value trap" is:  a company going down because of a long-term irreversible secular trend, like Blockbuster Video in this streaming digital media age.  Avoiding these should be "easy," but, like all of the other good advice above, there will be exceptions.  This definition is also pretty restrictive, whereas the term "value trap" is often used in a much broader sense.

 

Consider dropping terms like "value trap" or "catalyst" as being mere clichés.  I've never found thinking about these as useful.  In fact, a good alternative and contrarian definition of value investing is "a style of investing that is prone to picking value traps, and/or stocks with no catalysts."

 

a wonderful business at a fair price is better than a fair business at a wonderful price

 

This sounds great, but to me, another cliché,  Nor will it avoid "value traps."  Most people on this board seem to subscribe to this principle and are able to employ it successfully.  I have neither the skill nor the time to do it, and it doesn't fit my temperament.

 

All value investors try to buy at a cheap price that has a margin of safety.  But that is only one factor for success.  The others are (2) diversification, (3) patience, and (4) luck.  I diversify much more than most on this board, something like 60-100 or more stocks, which takes care of the many that "turn out" to be "value traps."  I also wait 3-5 years or more, which would take care of alleged "value traps" like CONN or IBM.  Looking at my portfolio, you could say it is chock full of value traps with no foreseeable catalyst.  Think "cigar butts" = "value traps."  But it works.

 

 

 

[ItsAValueTrap]

If subprime lending was within your circle of competence then you would have understood the ways in which a company might hide problems with their loan book.

 

I shorted CONN and I've written about the company on my blog.

[SpecOps]

My biggest tip is never invest more than 5% in a company when you're starting out. You will be wrong at times and if its something like a 20% position then it really hurts. 5% though is manageable.

[Uccmal]

Jawn, Lots of excellent advice. 

 

Unfortunately, its about experience, and internalizing that experience.  And we still make mistakes.  It also depends on your style, which evolves.  If your doing The Ben Graham/Walter Schloss style of buying dozens of beaten down stocks like Kraven, Oddball, or Cobafdek, you have to be well diversified. 

 

If your a concentrator like myself, or Ericopoly, you need to be really prepared to accept the occasional hit and trade around positions often.  Often my conviction grows as my losses mount.  Sometimes it disappears. 

 

No matter what you do, you need a really good understanding of your respective tax code.  I.e take a loss on the common stock, and reinvest in leaps, within the wash period (so you dont miss the turnaround). 

 

More on taxes: I expect that this is going to be a down year from a "real" loss perspective, but I have huge up years behind me.  In Canada, I can push my losses back to past years, and get a tax refund.  Know your local tax code! 

 

Following Gurus, Choose wisely.  They have developed time frames, and strategies that work for themselves:  I have been stung more than once being in something FFh holds alot of.  A few on this board drank Eddie's cool aid, along with him.  A bunch followed Buffett into IBM forgetting that Buffett plays a long game, and that IBM makes up a tiny percentage of Brks market cap. 

[Ham Hockers]

Some good advice from others already.

 

Here's one more thought, though perhaps painful: maybe you aren't a good investor and will never be one. Not saying you are or aren't. But I think there's a tendency to believe that you can become a good investor simply by working at it and following the "rules."

[compoundinglife]

Some good advice from others already.

 

Here's one more thought, though perhaps painful: maybe you aren't a good investor and will never be one. Not saying you are or aren't. But I think there's a tendency to believe that you can become a good investor simply by working at it and following the "rules."

 

Another way to think about what Ham Hockers is saying is  "What is my edge?". Do you have one, do you think you have one? "If you've been playing poker for half an hour and you still don't know who the patsy is, you're the patsy."

 

For example, I know that quantitative analysis is not my edge. I never let myself think that it is. I believe that my edges are ability to deal with volatility, ability to stick to the facts and ignore noise, good judge of character/management and willingness to have a long time horizon.

 

Howard Mark's in an interview once said something along lines of (paraphrasing) "You have to ask yourself, what do I see/know that the market does not?".  Trying to answer that question has been helpful for me.

 

 

[oddballstocks]

Some good advice from others already.

 

Here's one more thought, though perhaps painful: maybe you aren't a good investor and will never be one. Not saying you are or aren't. But I think there's a tendency to believe that you can become a good investor simply by working at it and following the "rules."

 

Another way to think about what Ham Hockers is saying is  "What is my edge?". Do you have one, do you think you have one? "If you've been playing poker for half an hour and you still don't know who the patsy is, you're the patsy."

 

For example, I know that quantitative analysis is not my edge. I never let myself think that it is. I believe that my edges are ability to deal with volatility, ability to stick to the facts and ignore noise, good judge of character/management and willingness to have a long time horizon.

 

Howard Mark's in an interview once said something along lines of (paraphrasing) "You have to ask yourself, what do I see/know that the market does not?".  Trying to answer that question has been helpful for me.

 

I'm not sure you truly need an edge to do well investing.  If you buy something at a reasonable valuation and have no edge and are patient you will do well.  The edge all retail investors have is they don't have a boss looking over their shoulder daily/weekly/monthly making sure they make the numbers. 

 

There are only a few places in the market where one can get truly superior information.  And even then I'm not sure it matters much.  I've had superior information on a few companies, but having less information vs more wouldn't have made a difference in the outcome.  Buying cheaply and being patient is all that mattered.

[Liberty]

I'm not sure you truly need an edge to do well investing.  If you buy something at a reasonable valuation and have no edge and are patient you will do well.  The edge all retail investors have is they don't have a boss looking over their shoulder daily/weekly/monthly making sure they make the numbers. 

 

There are only a few places in the market where one can get truly superior information.  And even then I'm not sure it matters much.  I've had superior information on a few companies, but having less information vs more wouldn't have made a difference in the outcome.  Buying cheaply and being patient is all that mattered.

 

Having an edge doesn't have to be just informational. I think what you describe is an edge (patience, a different approach, focusing on fundamentals, etc).

[compoundinglife]

Some good advice from others already.

 

Here's one more thought, though perhaps painful: maybe you aren't a good investor and will never be one. Not saying you are or aren't. But I think there's a tendency to believe that you can become a good investor simply by working at it and following the "rules."

 

Another way to think about what Ham Hockers is saying is  "What is my edge?". Do you have one, do you think you have one? "If you've been playing poker for half an hour and you still don't know who the patsy is, you're the patsy."

 

For example, I know that quantitative analysis is not my edge. I never let myself think that it is. I believe that my edges are ability to deal with volatility, ability to stick to the facts and ignore noise, good judge of character/management and willingness to have a long time horizon.

 

Howard Mark's in an interview once said something along lines of (paraphrasing) "You have to ask yourself, what do I see/know that the market does not?".  Trying to answer that question has been helpful for me.

 

I'm not sure you truly need an edge to do well investing.  If you buy something at a reasonable valuation and have no edge and are patient you will do well.  The edge all retail investors have is they don't have a boss looking over their shoulder daily/weekly/monthly making sure they make the numbers. 

 

There are only a few places in the market where one can get truly superior information.  And even then I'm not sure it matters much.  I've had superior information on a few companies, but having less information vs more wouldn't have made a difference in the outcome.  Buying cheaply and being patient is all that mattered.

 

I think we are somewhat saying the same thing. I identified being patient (long term horizon) as an edge. An edge does not need to be superior information, a better algo or superior analysis. You could argue that being patient is not an edge or advantage but I believe it is because so many people have a hard time executing on it or are not able to execute on it due to their contraints. So when looking at an investment you may ask yourself "What is my edge/advantage over the market?" and the answer may simply be "I am willing to be patient". 

 

Nate, I think understanding what advantages you have is important. Especially because for most of us being patient and not time constrained is the biggest if not the only advantage we have.

[Uccmal]

My edge sure isn't quantitative.  After eliminating for basic solvency, all of my big successes have been qualitative.  I dont even pretend to be be able to comprehend BAC, JPM, or FFH 8 years ago.  All I ever needed to really know was pretty binary in nature.  Will they stay in business at near their present size, Y or N?  If the answer is yes then good things will probably happen.  This is not to say that I dont analyze companies - I certainly do, but beyond the binary analysis the rest is just comfort food. 

 

I am able to buy when others are selling, or more succinctly when others HAVE to sell. 

 

 

 

 

[frommi]

While studying Mecham i noticed that you should ask yourself why something is mispriced in the first place or what can change in a business that makes it a mispriced stock at the current price. Often a business that looks expensive is not expensive when you factor in a mean reversion of margins, price increases or something else. Its very often that these things are mentioned in the annual report, so just reading can give you an edge.

 

Kraven made fun of it, but i think one of the safest ways to learn is to make a watchlist with BRK, FFH and MKL and just buy when bookvalue is near 1.1 and sell when it is above 1.7 or whatever number you think is appropriate. Then take the other half of your money and try to find mispriced bets and learn by doing. When you buy something you have to have the conviction to not sell for at least a year. When you can`t get to that point you probably don`t know enough about that business and have to read more.