Value Traps of Smart Value Investors

Smart investors, who try to buy low to sell high, look for what they perceive as bargains that the general market does not see. Originally under the founders and authors of their seminal text first published in 1934, Security Analysis, Graham & Dodd * focused on finding both bonds and stocks selling below their intrinsic value. In the early days this was focused on finding securities not only below their properly adjusted book value, but when possible below their “net-net” levels. “Net-net” was shrinking book value to just cash, and easily selling current assets versus all liabilities. While some of these opportunities do exist today, they are extremely rare in a world of so much electronically sorted published data. More often than not these opportunities are found in the distressed securities world when there are insistent sellers who must be out of the named issuer quickly.

(*) I took my securities analysis under Professor David Dodd.

With the disappearance of a large number of net-net opportunities, well trained investors looked for additional opportunities. These investors led by Ben Graham himself, Warren Buffet, and Irving Kahn, found additional ways to pick winning stocks. This coming Friday, Irving is to receive a Lifetime Achievement Award from the New York Society of Security Analysts, celebrating his 105 years of successful life and contributions. What these gentlemen did was to move the goal post forward from a current price/value relationship, to valuing a future price significantly above the current price. One of the keys to this analysis is that the future value was available today at a reasonable price. Thus, many value oriented managers today look for (future) growth at a reasonable price (GARP).

Reasonable price

There are two critical elements to the determination of reasonable price. The first is a high expectation that the future earnings will be realized. Usually this belief is based on some events happening that are anticipated to be positive for the stock in question. The chances that the good news will work are measured, in my mind, as execution risk. More on this risk later as part of the discussion on value traps.
The second critical element in determining reasonable price is: reasonable compared to what? In this case there are two approaches. The first, favored by leading value investors is relative to returns available currently from US Treasuries. If one expects, as I do, that interest rates on US Treasuries to rise to adjust for inflation and a decrease in the relative perceived safety of US paper compared with other assets, then a value stock buyer needs a substantially higher expected return than the current nominal rates. The second approach as to reasonable price is to examine the specific expected return compared with some concept of market. This relativistic approach believes that the market is mispricing the specific opportunity and will correct this undervaluation at the time of the expected sale.

Memorial Day vantage point

In the United States we celebrate Memorial Day on Monday. Our blog community includes members from at least 18 other countries, thus I need to avoid aiming all of my thinking on the US. This country, along with numerous other countries, looks back at least once a year to celebrate all of those who gave their lives, and I might add their innocent youths, to protect their country from those who wished to dominate them. On days like this I become a bit retrospective thinking not only of those we have lost, but also of their lost opportunities. As a confirmed investment addict, in time, my mind shifts to lost opportunities in stocks. I think about those who have fallen and in too many cases not to rise again. Just as our military leaders study the past battles to learn how to avoid the ensuing casualties, I look at the history of stocks to see what I can learn that is useful going forward.

Good Analysts/Portfolio Managers/Fund Selectors

William Shakespeare puts the words in the mouth of Marc Antony in describing the assassins of Julius Caesar who are standing before him, “So are they all, all honorable men...” Many good investment people have fallen into a way of thinking, that at least for some time has proven to be value traps. Since no one that I know has always had only winning positions, we all can learn from a retrospective look at our analytical skills with the hope of reducing the number of casualties in our portfolios.

Looking Back at Value Traps

Ford (truck sales), GM (slowing car buying economies in China and US plus a politically motivated seller), Sears (under-investment in desirable inventory), Intel (missing the switch to tablets), Microsoft (demand slowdowns in the developed world), Dell (adding new products and services without fixing the old and thus missing revenue estimates), Johnson & Johnson (not doing good enough in products and certain developing countries) is a brief list of what has proven to be value traps. Within the parenthesis after the company name is an extremely brief highlight of its perceived problem. In each case the companies are large with substantial assets, including well known names and reputations. Many have been followed for years by very bright analysts and portfolio managers who now have the responsibility for these stocks at current prices that don’t represent the values they perceived. In most cases, what they failed to weigh sufficiently was the execution risks imbedded in the names. Some of the problems were beyond management controls, e.g. the twin slowdowns in the economies of the two biggest car buying markets: China, (the largest) and the US. In a number of cases managements dropped the ball in not having the right products at the right prices. As not all investors fell into these traps, it is quite possible some were skeptical of the execution hurdles.

One of the recurring traps that people fell into was looking at the cash on the balance sheet and deducting it from the price of the shares and dividing the result by the earnings of the company to show how “cheap” the stock was priced. There are three reasons that this has proven in some cases to be a mistake. First in a number of instances a good bit of the cash is overseas and they do not account for the tax costs of bringing it back home. (In some cases the overseas cash has to stay put to satisfy various commercial and regulatory needs.) Second, we know from studying portfolio managers that carry large cash positions on the way down, through the bottom, and only recommit cash after a significant advance. In this example, cash is just too comfortable. Third, there is a risk that operating managements will make mistakes in the use of their hoarding, e.g. bad acquisitions of companies and/or securities.

Duration risk

In the standard analysis of future value, one needs to assign a period of time between the present and the recognition by the market of the enhanced value. Assume that today’s price is $5 and the expectation is that its future value is $ 10. If the recognition period is one year, the annual rate of return is 100%. Using the same metrics, but assuming that the duration of the recognition period is 100 years, the annual average rate of enhancement is 1% per year. What has proven to be the admitted problem for the believers is not that their expectations are misplaced, but it is just taking too long.

Now what?

While I am not an economist, I do have two very different observations of future actions. The first is to recognize that all of the listed value traps (and many others), are large market capitalization stocks. As a group, large capital stocks have risen less than small caps. As is my practice I will use mutual fund indices produced by my old firm. Through Friday, Small-Cap Growth funds were up +33.87% for the one year period, whereas Large-Cap Growth funds were up +24.5% and the Large-Cap Core funds +22.31% and Large-Cap Value funds +20.47%. Ever since the market hit bottom, large cap has not been as productive as small cap. In the current period of instability, I believe that there is more comfort in those required to be invested to own large caps. Thus, I would not treat this blog as a call to get out of what has been value traps, but to adjust the underlying analysis as to execution and duration risks.

The other approach on this Memorial Day weekend is to be thankful that we survived the past and to look at the new opportunities that are being created for us. Big winners come from successful big dreamers. I hope to find not those that restore value to their 2007 highs, but ones that see potential doubles and more from here. (If you have any of those, please share them with me.) I expect to find them in successful disrupters of current perceptions.

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Yellow Alert: Second Supply Cycle Growing

As an analyst rather than a statistical extrapolator, my mind searches for what can go wrong thus forcing a meaningful deviation from the current trend. In last week’s blog I headlined the twin concerns of “blood in the streets” and the impact of possible contagion as an aftermath of the civil unrest in Egypt. In terms of the markets in the developed world, the impact of last week has not yet been felt in general. The markets, at least for now, seem to be more insightful than the politicians and the English speaking, liberal-tinged press. What we may be seeing in Tahrir Square in Cairo is no more than 250,000 actors in a manipulated intramural contest between the President and the military establishment to bring about a reasonably orderly succession. Thus far, my initial concerns were at least premature or possibly inaccurate. I recognize that these events can well escalate into more meaningful dangers if new actors are released on to the scene.

As part of my functional worrying about the future, last week’s exercise was useful in highlighting what could go wrong. In the same vein I see significant potential market problems arising beyond the near term investment horizon.

The Two Supply Cycles

Many economists disguised as securities analysts or portfolio managers focus on the national generation of economic data. When the data turns positive they become bullish, even though well functioning markets have discounted these turns and have moved prices from the fundamentally cheap levels into the fairly priced levels that are only attractive relative to past valuations and/or other markets. At this point in time, the number of truly cheap investments has shrunk. Investments are cheap when their entire market capitalization can be acquired at a substantial discount from a readily available price, which includes quickly liquidating the company. The cheapest of the cheap are those that can be liquidated at a profit by just converting their current liquid assets against all of their liabilities. These situations are known as “net-nets.” Net-nets are always difficult to find, but can be discovered in all market environments. There are more of them to be found before the published data on the economies turn positive. As the economic data becomes more robust, confidence returns and people and businesses increase their spending and consumption. This increase in supply of good news meets with the demand driven by investors to make up for lost time in the recession. First, they want to restore their capital base to their former peak loads and second, they recognize the need to grow their insufficient retirement capital funds. The frenzy created by this “ever- growing” supply and demand convinces these economists masquerading as portfolio managers and strategists that they have entered into a long lasting bull market, thus they adjust their policies to take on more risk (which they believe is mispriced in their favor).

There is also a second supply cycle. While dependent upon the first cycle to get started, in modern times this second cycle becomes larger than the first at its peak. When it falls, it produces more financial pain than periodic declines in the first cycle. The second cycle deals with the production of securities, funds of various types, and derivatives to give investors and speculators ways of participating in the primary first cycle. One well known example of this is gold. The size of the “paper gold” market is considerably larger than not only annual gold production and “consumption,” it may well be approaching the amount of gold held by all the central banks. We find paper gold in derivatives like futures, gold backed bonds and now bullion or coin owned by exchange traded funds (ETFs). I am excluding the funds that own shares in gold mining companies which is, in effect, a derivative of the price of gold.

The Current Increase in the Second Supply Cycle

For several months I have been dealing with an accelerating number of private fund offerings in my capacities as a member or chair of institutional investment committees, a professional portfolio manager and private investor. Each of these offerings is focused on emerging or frontier market (a frontier market is less economically developed than an emerging market) opportunities in general or in specific countries. The level of enthusiasm of the promoters and their sales forces is matched with high fees and expenses. These costs are for the privilege of locking our money away for some period of time without addressing a fear of the return of redemption gates beyond the lockup period. We have not yet seen much in leveraged plays being offered through the use of borrowed capital. This would be a possible future sign of a top in the cycle.

At some point, the sheer size of the second form of supply cycle may impact the primary supply cycle. This week we saw larger net dollar redemptions from Emerging Market ETFs than from managed mutual funds of the same sector. The ETF owner is fundamentally a price speculator and/or hedger. Many mutual fund owners expect to invest for the long term, on average beyond three years, to benefit from the perceived longer primary supply cycle. In my book, MONEYWISE, and previous blogs, I have written about the risks created by co-investors. The risk is that they want to get out of an investment at precisely the same time that you do. The rush to the exit (if you can get out at all) will be met with lower prices. The nature of the fund-raising for these new private funds is very performance oriented. Long-term investors like us need to be aware of the co-investor risk from the new players.

What do you Do Now?

• I suggest that one stay with present sound investments and continue to deploy cash reserves.
  
  
• Despite my relative bullishness, one should expect some “air pockets” with sudden sharp declines followed by a general, but not specific return to the upward pressure to get more heavily invested.
  
  
• We should be alert to signs of peaking. If a peak does not occur before, I would expect one by 2013 which will be a politically difficult year for investors. The appropriate mix of strategies for the next three years should include both strategic as well as tactical considerations which is a difficult prescription for many investors.

What do you think?

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