Taking a Boat to Nowhere
Est. Reading Time: 7-10 Minutes
Everybody likes to get a deal. It's in our nature to gravitate to those things that seem too good to pass up.
Now, ensuring that you don’t overpay is a good rule to follow in life and is arguably the most important rule in investing. But, equal attention should be given to the what question as to the how much question.
That is, WHAT specifically are you buying?
Snowblowers gong on sale for $50 is a screaming deal. But if you live in Orlando, FL you might want to pause and ask yourself is it worth buying just because it’s cheap?
In the investment world this is the equivalent of a value trap. Something bought dirt cheap but remains dirt cheap because you won’t find a buyer after you’ve purchased it.
If this were not a risk, simply filtering for the most underpriced securities relative to certain accounting metrics, buying that basket, and then rotating with each new run of the filter would work fantastically well. But that approach is fraught with pitfalls.
Even after doing all the work to locate underpriced value, there are two big headwinds that remain.
That is time and a catalyst to move the price up to its true value.
Graham’s Achilles Heel - Time Kills All Deals
The father of value investing, Benjamin Graham, systematized the approach of finding companies trading below their intrinsic value and profiting on this discrepancy. The approach utilized by himself and David Dodd serves as the foundation for just about all value calculations since.
The idea of value, and a suitable margin of safety, in overly simplified form is this:
If I can buy a company below its liquidation value (net of debts), and sufficiently below so as to give me a margin of safety (i.e. not merely 5% below), then I am effectively buying dollars for cents and the investment is a good one.
There is a lot more that goes into that decision process but for a discussion on value traps that will suffice.
This approach makes sense. To use the snowblower example above, let’s say you happened upon that new $50 snowblower for sale in upper Michigan. It would be a no brainer to purchase it since it would not be difficult to turn a profit by selling it to someone else at a proper price.
But, we do not get such simple opportunities when evaluating businesses and if intrinsic value is not reached fast enough time can make the best value selection mediocre or even a loss in real terms.
With his approach Graham did quite well, beating the market on average by 2.5% from 1934 to 1956, but he had a reoccurring issue with the firm’s investment selections. Many of the selections did nothing after they were purchased and would have to be liquidated after 2-3 years (his internal rule for how long to wait for the price to appreciate).
But if he truly bought $1.00 worth of value for say $0.70 why not keep holding?
The reason is this, the longer it takes for the market to realize the value you have found, the smaller your annualized returns are in real terms. And this decay happens at a startling rate.
The following table shows the annualized rate of return from purchasing $1.00 of value for $0.70 and subsequently selling it at its true value of $1.00 at between one and five years into the future.
Annualized Real Rate of Return
You can see that despite buying something at 30% below intrinsic value, if it takes a little over three years to have the market agree you have dipped into single digit annualized real returns.
But, this does not take into account dividends, which is a cornerstone of value investments.
Unfortunately, dividends do not offer much of a solution to this problem. Not unless they are going to increase dramatically from the point of purchase.
Annualized Real Return - 3.0% Dividend Yield
So, we can see why Graham would dump a stock if it hadn’t realized the value he saw by year three.
The Second Headwind - Lack of a Catalyst
Another headwind that our value selections will have to work against is that of a catalyst. Typically the market has discounted a company’s shares for a reason. While not always valid reasons, they are reasons nonetheless.
The situations value investors love is when a shock to the company occurs that is unrelated to the underlying earnings potential.
An easy example would be when a bank allocates some lump sum to expected potential future losses, like Wells Fargo did in the early 1990’s anticipating real estate write downs.
Wall Street will many times take the exact dollar amount as already lost, adjust expected earnings and subsequently reprices the stock.
What are the chances that management would under allocate and why would an investor expect earnings would not resume after this one-time occurrence had come to pass? (in the Wells Fargo example they had allocated much more than needed)
In this case the catalyst the market was worried about, insolvency, never materialized. Anyone who rightfully saw that the value would remain intact and earning would resume were rewarded. These are slow and down the middle pitches, which are fantastic but not what we are worried about.
The catalyst traps one needs to avoid is when a repricing has occurred due to a fundamental change in a company’s underlying economics and the market needs a GOOD catalyst, as opposed to the lack of a bad one like the Wells example, in order for investors to get back on board.
Take Blockbuster's fall as an example. Around 2001/2002 they were trading north of $25/share or about a $3.7B market cap. As Netflix disrupted their business model first with mailing then streaming their share price steadily decreased.
If only focused on accounting metrics or thinking solely from a liquidation standpoint there were undoubtedly instances where the enterprise probably looked cheap throughout its decline.
But the market would've needed a substantially good catalyst to get back on the Blockbuster bandwagon. Those who bought on the premise of value were betting that the underlying economics of the business model WERE NOT changing or that a management team with no experience within the new paradigm could reallocate capital and adapt to it.
That is a long shot bet to take even if the management HAD tried to pivot, which arguably they did, but then strangely reversed course with a leadership change.
They is one remaining location in Bend, OR which recently had put itself up on AirBnB as an overnight stay experience.
There is something ironic about the last location of a retail giant who was upended by a digital platform now featuring itself on another digital platform that caused a similar stir in its respective industry.
So, if we are looking for companies that may offer what seems like value, but a serious positive catalyst is required, betting on the arrival of that catalyst is a risky proposition and this makes up the bulk of the instances we might call a value trap.
This is endemic in the commodity value opportunities as they are also having to fight the downward pressure of producing ubiquitous products that command no pricing premium. If looking at a commodity value play the commodity itself should also have a likely positive catalyst (or at least a reason for price stabilization to hold) as the best commodity business can still be forced lower if the company can’t command a pricing premium.
Get a Sail for You Value Boat
How might we avoid these two headwinds and make sure our value boat is capable of going somewhere?
To solve for the time dilemma, earnings are your cure all.
This is based on the idea of expanding intrinsic value. That is, if a company continues to trade at below its intrinsic value, we can accept this if its intrinsic value is rising. We would love the market to close the gap on that value, but if it never does, the price rising in conjunction with increasing earnings is palpable.
How does this occur?
Let's say a company trades at 30% below what we've calculated as intrinsic value, and we buy expecting to make a good amount realizing that delta. If the market never provides us the true intrinsic value, but earnings increase, and it continues to trade and the same discount to intrinsic value we will be protected as the market will track earnings growth at that discount.
Naturally we'd love the market to realize the true value, but if it doesn't our outcome now looks far better than the no-growth value trap returns highlighted above.
Annualized Real Return - 12% Earnings Growth
Evaluating whether the business we are about to purchase has a track record of stable and increasing earnings gives us a good chance of ensuring we have this protection.
To be fair, earnings can be manipulated and cash flow is a better approach. But for simplicity and avoiding any accounting earnings will suffice to make the point.
For the issue of underlying company economics eroding, it helps to think in terms of commodity or consumer monopolies.
In asking whether we are about to buy a Blockbuster or a Wells Fargo in the early 1990's we can categorize companies into two broad groups, commodity type businesses and consumer monopolies.
Commodity type businesses do not necessarily mean literally commodities (agriculture, energy, etc.) but rather companies that cannot defend their position from competition, inflation, or have poor reinvestment returns back into their core business.
If a company in question has some of the following qualities, it is a good indicator of a commodity type business:
Poor profit margins
Poor returns on equity
Lots of competition
Lack of brand name loyalty
Excess production within its industry
Profitability depending on tangible assets and not on defensible intangibles (patents, copywrites, etc.)
Erratic profits