Value Traps

[KCLarkin]

Its very often that these things are mentioned in the annual report, so just reading can give you an edge.

 

Conference calls and investor day presentations are also great places to find these "hidden values". If something is statistically cheap, everyone can find it easily. But qualitative information that is not yet priced into the stock is harder to screen for.

[jawn619]

I give up, How? I'm curious to know

 

 

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?

[peter1234]

I give up, How? I'm curious to know

 

 

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?

My guess: They introduced a new model (System z), so people stopped buying the old one and waited for the new one to come out.

;)

Sales of System z mainframes were up nearly 70 percent in the quarter:

http://www.eweek.com/c/a/Finance-IT/IBMs-Q4-2010-Profits-Driven-by-Hardware-Software-Growth-Markets-433045/

[KCLarkin]

I give up, How? I'm curious to know

 

 

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?

My guess: They introduced a new model (System z), so people stopped buying the old one and waited for the new one to come out.

;)

Sales of System z mainframes were up nearly 70 percent in the quarter:

http://www.eweek.com/c/a/Finance-IT/IBMs-Q4-2010-Profits-Driven-by-Hardware-Software-Growth-Markets-433045/

 

Okay, so let's say that Mr. Market believes that IBM's revenue is down because the cloud is killing their mainframe business. Mr. Market doesn't pay much for dying businesses.

 

But what if revenue is down for other reasons? Maybe they are in a soft spot in their mainframe product cycle? What happens when they launch the next model of System Z?

 

My point is that you (Jawn) are presuming that IBM is a value trap because the stock is down. It might be a value trap but you can't rely on Mr. Market to make that decision for you.

 

http://basehitinvesting.com/thinking-differently-the-most-important-contrarian-behavior/

[jawn619]

My thoughts on why all of my previous stated investments were "value traps"

 

Conn's was trading at fairly cheap multiples considering they were growing at 20% a year. I knew they did a lot of businesses by lending to subprime customers but I was willing to overlook how bad that business model is because i was so enamored with the numbers.

 

PBR was a value trap because when i got in the P/B was low, P/E low, and great dividend yield

My mistake was that I didn't look at the cash flows. PBR has negative free cash flows and has a HUGE amount of debt that they used to pay the dividends.

 

IBM is probably the hardest for me to understand if i'm making a mistake well. It might not be a value trap at all but if i had a spectrum of

Value Trap--------------------Overpaying  i think IBM would be closer to the value trap side of it. I don't know what the market view on it except that it's seen declining revenues for a while now.

 

I guess i've learned from my mistakes, I just wish I hadn't learned them firsthand through my wallet. =/

 

 

[augustabound]

IBM is probably the hardest for me to understand if i'm making a mistake well. It might not be a value trap at all but if i had a spectrum of

Value Trap--------------------Overpaying  i think IBM would be closer to the value trap side of it. I don't know what the market view on it except that it's seen declining revenues for a while now.

 

What was your reason for buying it?

[yadayada]

Conn's did not look exactly cheap at 10x earnings (or more depending if you bought it above 30$).

[jawn619]

I saw an opportunity to buy a stock that warren buffet has 12% of his portfolio in at a price lower than his.

 

IBM is probably the hardest for me to understand if i'm making a mistake well. It might not be a value trap at all but if i had a spectrum of

Value Trap--------------------Overpaying  i think IBM would be closer to the value trap side of it. I don't know what the market view on it except that it's seen declining revenues for a while now.

 

What was your reason for buying it?

[jawn619]

Conn's did not look exactly cheap at 10x earnings (or more depending if you bought it above 30$).

 

I bought it just under 30 and that i also followed David Einhorn into it.

[yadayada]

if you buy something at 10x earnings, you better know the business well. I mean you are asking how to avoid valuetraps when you didn't do the work. I would start with that.

[Uccmal]

One reason I do the work beyond the very basic is to help me stay in my conviction.  In 4 years I have likely read what would amount to thousands of pages on Bac, and Aig, including each and every financial release.

 

Right now I have shifted my focus to understanding the oil industry from all different perspectives.  This adds to work I did in 2006/07 on the same. 

[Uccmal]

There is a story about Buffett in Snowball, and Lowensteins Book:

 

Warren met a crusty old school guy at an annual meeting who was a client of Ben Graham.  Crusty asked Buffett why he had bought some stock and Buffett answered that he bought it because someone else (might have been Graham) had bought it.  The guy made fun of Buffett and thoroughly embarrassed him into never having that as his answer again. 

 

I nearly blindly followed "gurus" into stocks way back. There is no chance I would do that now.  I have been around long enough to realize that the majority of people have no idea what they are doing.  Ask Bill Miller why he was top heavy financials in 2008.  Ask Einhorn why he was chairman of New Century just prior to going into bankruptcy - he got sued and settled out of court.  Ask Prem Watsa about Canwest Global, sfk/fbk pulp, Lindsey morden cunningham whatever.  Ask Buffett about his shoe companies.  Not saying that the above have no clue, its just that we all do the best we can with imperfect information. 

[Scorps]

There is a story about Buffett in Snowball, and Lowensteins Book:

 

Warren met a crusty old school guy at an annual meeting who was a client of Ben Graham.  Crusty asked Buffett why he had bought some stock and Buffett answered that he bought it because someone else (might have been Graham) had bought it.  The guy made fun of Buffett and thoroughly embarrassed him into never having that as his answer again. 

 

I nearly blindly followed "gurus" into stocks way back. There is no chance I would do that now.  I have been around long enough to realize that the majority of people have no idea what they are doing.  Ask Bill Miller why he was top heavy financials in 2008.  Ask Einhorn why he was chairman of New Century just prior to going into bankruptcy - he got sued and settled out of court.  Ask Prem Watsa about Canwest Global, sfk/fbk pulp, Lindsey morden cunningham whatever.  Ask Buffett about his shoe companies.  Not saying that the above have no clue, its just that we all do the best we can with imperfect information. 

 

+1

[siddharth18]

Lots of good information in this thread and I don't want to sound as if I'm pontificating, as I'm still learning. But one of the questions I ask myself before buying is - What would happen if the stock price dropped by 50% without any news? Would I still hold it or even increase my position? Or Would I sell? If you answered "NO" to the first question, it means you don't know enough about the company and you need to research more.

 

I learned a lot by reading about Dr. Mike Burry. He's one of the true outsider, who thought like an outsider from Day 1 and always thought independently. Read his letters to investors and how he made money. If I recall correctly, by the time he was done researching a company, he knew more about it, than anyone on Earth. And that research is what will give you the conviction to stick to your thesis when everyone is panicking from the mark-to-market losses.

 

In the stock market, you're competing with all sorts of people - idiots and geniuses. You better know at least more than the average participant or else you'd have no hope.

 

Oh and about buying something simply because Einhorn and Buffett buys it, ask yourself this:

 

Will Einhorn or Buffett call you if/when they sell?

 

Is the position an equal % of your assets as theirs?

 

Are you aware of all their hedges for a particular position? (and I'm not just talking about direct hedging via derivatives, but also indirect hedging - like investing in oil producer but also owning a company that benefits from cheap oil)

 

Do you even know if they'll be right for that particular position?

 

Will you have other winners in your portfolio like them, if this specific pick backfires?

----------

 

We all make mistakes...but the smart ones learn from them and promise to never repeat them...

[kevin4u2]

There is no such thing as a value trap.  There is reality and fantasy.  When reality doesn't align to your estimate of value, your value was wrong.  Try again next time. 

[Fat Pitch]

There is no such thing as a value trap.  There is reality and fantasy.  When reality doesn't align to your estimate of value, your value was wrong.  Try again next time.

 

+1

[merkhet]

So that's why I asked you when you bought into various companies

 

You've owned Conn's for less than 9 months. How would you know if it's a value trap yet?

 

It might be too soon on IBM too. What if it's an AutoZone or something?

[BG2008]

A few lesson from my personal investing experience

 

1. Tape Bruce Berkowitz's 10 item checklist next to your computer monitor. Every time you buy something, ask your self if it pass all those simple checklist

 

http://www.marketfolly.com/2012/03/bruce-berkowitzs-basic-checklist-for.html

 

2. Accept the fact that early on, you will not understand a lot of the businesses.  Very few people can figure out IBM as a novice.  Pick on easier to understand businesses.  I still avoid mining, O&G, financials, tech, etc till this day.  There's no shame in admitting you just don't know.  Sometimes, certain business may seem easy, but they are actually very hard to understand and even harder to predict, i.e. retail turnarounds, etc.  Yes, you can hang out at Wetseal or Ruby Tuesday all day long, but it's hard to know if their customers will come back and increase their purchases.  Only invest in companies that you understand or in situations where the valuation is so beaten down, i.e. 2x FCF that you have a lot of room for error.  10x FCF is tough to figure out.  Investing in smaller simpler companies can be helpful in the beginning. 

 

3. Mentally play out what you would do if prices drop?  What could cause it?  Would you be happy if prices dropped?  If yes, you maybe onto something.  Will you have cash set aside?  How would you scale into and out of the trade?

 

4. Either management team is shareholder friendly or there is an activist who will watch over them, otherwise avoid.  This point cannot be stressed enough.  You can have a ton of cash on the BS, but if management team is hell bend on blowing it on bad acquisitions, you better make sure there's an activist who will instill capital displine. 

 

5. If there is no catalyst for 3-5 years, what will happen?  Buying at 3x FCF means the BS will have cash that exceeds the market cap.  If the underlining business will be worth 3x as much because of growth etc, then you're onto something.  If no price movement in 3-5 years is a terrible scenario, might want to avoid

 

6. Conviction and really knowing your name - I'm partial to concentrated bets.  You might be different.  My edge in investing is that "if the price goes up, I make money.  If price goes down, I know exactly how much the company is worth and I view it as a bargain and I add to the position."  If you 're not confident with your analysis and you do not have conviction, it's tough to stomach the price drop.  You start guessing and it's emotional torture.  In short, if you do not have conviction, either avoid or size it small.  A different way of thinking is that "if it's not worth sizing it big, then it's not worth doing the trade." 

 

Hopefully, these are helpful. 

[yadayada]

So that's why I asked you when you bought into various companies

 

You've owned Conn's for less than 9 months. How would you know if it's a value trap yet?

 

It might be too soon on IBM too. What if it's an AutoZone or something?

I very briefly looked at it, but wouldnt you have to answer certain questions, and then be quite certain you are right? For example I see costs have gone up, causing profits to fall and the stock price to drop. This does not necesairly have to be a bad thing, but you gotta be able to answer these questions:

 

So why have costs gone up?

Will costs go up further relative to revenue?

What are the odds revenue keeps growing at this pace?

What will margins look like 3-5 years from now?

 

You will answer a lot of questions about the qualitative side of the company here. In the end these things trade on earnings and on how certain/uncertain things are. Wouldn't touch this thign with a 12 foot pole if I couldn't answer these questions well.

 

Also if you copy of good investors, I would do it blindly. So I would either copy them, or figure out how to see what their highest conviction idea's are and take those (judging by size, and how large the market cap is).

 

I wouldn't do much work on them if I did this, I would rely on the skills of those investors. Or if I did do work on them, I would make sure I understood them well. Not do a half ass job.

 

So sort of a binary aproach.

[petec]

My thoughts on why all of my previous stated investments were "value traps"

 

Conn's was trading at fairly cheap multiples considering they were growing at 20% a year. I knew they did a lot of businesses by lending to subprime customers but I was willing to overlook how bad that business model is because i was so enamored with the numbers.

 

PBR was a value trap because when i got in the P/B was low, P/E low, and great dividend yield

My mistake was that I didn't look at the cash flows. PBR has negative free cash flows and has a HUGE amount of debt that they used to pay the dividends.

 

IBM is probably the hardest for me to understand if i'm making a mistake well. It might not be a value trap at all but if i had a spectrum of

Value Trap--------------------Overpaying  i think IBM would be closer to the value trap side of it. I don't know what the market view on it except that it's seen declining revenues for a while now.

 

I guess i've learned from my mistakes, I just wish I hadn't learned them firsthand through my wallet. =/

 

My take would be that none of these passes the quality sniff test.  IBM might, but there are clear problems.  PBR is a corrupt government ministry with a cash flow problem.  Conn-well you said it yourself.

 

My view is if you buy quality cheap and it doesn't go up for a while it doesn't matter, especially if it pays a good dividend.  If you buy crap cheap and it's doesn't go up, you're left with...well...crap ;)

 

Edit: I should add that for me a quality stock needs most of the following characteristics: it'll probably last forever, it'll probably grow a bit, it has and can sustain high returns on capital, it doesn't need to spend much capital, and management are good at allocating capital.  Clearly if it can allocate a lot of capital to growth at high returns that's great, but I'll take longevity of cash flows over growth of cash flows any day, ceteris paribus.

[Zorrofan]

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.

 

 

LOL - that was funny!!  ;D

[KCLarkin]

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

 

It looks like a portfolio of these value traps bought the day you posted this would be looking pretty good right now:

https://www.google.com/finance?chdnp=0&chdd=1&chds=1&chdv=1&chvs=Logarithmic&chdeh=0&chfdeh=0&chdet=1430856000000&chddm=37927&chls=IntervalBasedLine&cmpto=NASDAQ:CONN;NYSE:IBM&cmptdms=0;0&q=NYSE:PBR&ntsp=1&ei=_slIVcmOHdCkqQGgq4HoAQ

[abyli]

There is no value trap, only wrong stocks. Lots of value investors bought Citigroup after it fell 50% in great recession. Does it mean Citi stock was value trap? Value investor can easily get interested in things that looks cheap or down 50%, but that is wrong way to look at it.

 

What you should do is to think yourself as someone who just came to earth and ignore past prices.

 

First, ask yourself, do I really understand the business, especially its business model. That is your most important margin of safety. If you do not understand the business, how do you know it is cheap? To me, that is the concept of margin of safety.

 

Second, you need to check the company culture. Without right culture, the good business will not last long. Then you check the company's management team, check past records of the CEO. How CEO talks in conference call, how CEO thinks about shareholders?

 

After you understand the business, then you ask yourself, do I buy this company as a private business if the market is closed for 10 years? If the answer is still yes, then you buy the stock.

 

In a sense, what Ben Graham or Warren Buffett did in early days was NOT value investing. Value investing means you pay less and get more. What kind of value investing is it if there is not much value  left in the company? :-)

 

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

[theasiareport]

Seeing that Graham maintained pretty much the same investment style throughout his career... at what point did he transition out of "investing" into "value investing"?

 

 

In a sense, what Ben Graham or Warren Buffett did in early days was NOT value investing. Value investing means you pay less and get more. What kind of value investing is it if there is not much value  left in the company? :-)

 

[netnet]

 

In a sense, what Ben Graham or Warren Buffett did in early days was NOT value investing. Value investing means you pay less and get more. What kind of value investing is it if there is not much value  left in the company? :-)

 

Provocative and interesting...and wrong.

 

I think that I see the point you are trying to make, that Buffett (NOT Graham) went to quality businesses, influenced by Munger and Fisher. But, to say that the greatest value investor, Buffett, and the founder of the field, Graham, are or were not value investors, well let's say it's more than a stretching of the truth.

 

Going to first principles, value investing is paying less than the asset you are buying is worth. That's it, buying a dollar for 80 cents. So when you buy a really cheap, but crappy company, the proverbial cigar butt, you buy it because it has a few puffs left, not because it is a soggy mess--in other words, it has to have more value left--the puffs.  Buffet started doing that after he read Intelligent Investor.  Not to be pedantic, but if you haven't read it yet, you should try.  Graham just did not believe in paying up for quality, his preference was a great price for a fair business, rather than a fair price for a great business.

 

Paraphrasing Buffett's own words, you could say that "Even though  buying a cigar butt business is a basic strategy of many value investors, this can be value destroying, because time is the enemy of bad businesses."  Less catchy, still provocative and true, sometimes.