The Most Important Traits of Value Traps

One of my favorite equity investing topics which combines fundamental and technical analysis is the infamous ‘value trap’. You will often times hear fundamental value guys talk about “it’s cheap on a normalized earnings basis” or “it’s trading below book value with a big juicy dividend that pays you to wait” or maybe you’ve heard this one before “We expect them to earn $4/share next year which makes the stock historically cheap on a forward P/E basis”…..blah blah blah. It sounds good doesn’t it? In fact if you turned your brain off and decided not to think any further you might actually go buy a few of these stocks.

The problem is that finding value stocks that aren’t value traps is a lot harder than screening for a few attractive fundamental valuation metrics and then looking at sell-side analysts forward year EPS estimates to confirm that the stock does indeed offer growth at a reasonable price. Before I delve into a couple of concrete examples I was prompted to write this post after reading Jim Chanos’ latest presentation “A Search for Global Value……TRAPS!”¬†wherein Chanos lays out some common characteristics found in value traps:

 

The first two are particularly important and actually tie into one another – if you use past years’ performance to value a cyclical business by projecting previous results into the future you risk being completely blindsided by a cyclical downturn. The same holds true for companies that are heavily reliant on narrow product lines. I would add one more bullet to Chanos’ list – value traps often have charts that look like this:

 

Can you guess which stock this is? I’ll give you a hint, the company has a narrow production line in a highly competitive space………

It’s $RIMM, the stock that will go down in the value trap history books as being one of the greatest value traps of all time. I was always amazed at the number of confident analysts and value guys who would talk about $7.50 of earnings per share and all the new products the company was coming out with. Yet they couldn’t answer simple questions such as: What will RIMM do when every young person owns an iPhone? Most people I know have an iPhone for personal use and a Blackberry for work, what will happen when corporations approve iPhones for work use? Doesn’t RIMM seem to be getting farther and farther behind the technology curve to $AAPL and $GOOG? etc. etc.

The value guys who got trapped in RIMM were blinded by the numbers, backward looking numbers no less. When the numbers even stopped looking good they changed their bullish RIMM call which was originally predicated solely on value to a ‘contrarian value’ call when the stock got clobbered time and time again after reporting disappointing results and continuous market share losses.

The current value traps are more of the cyclical variety, coal ($KOL) and energy ($XLE) names that have had huge earnings power during the salad days of yesteryear. However, now these sectors face daunting challenges and a rapidly changing global macroeconomic landscape – Chanos identifies a few value trap candidates in this arena $CNX and $PBR. Coal in particular is a major battleground right now with bulls pointing to a bottom in natural gas prices, the fact that coal is still the cheapest fuel available, and the extent to which these stocks have been beaten down over the past year. Meanwhile, bears say that coal prices have further to fall, environmental regulation in the US will continue to damage coal demand, and natural gas is the fuel of the future for power plants around the globe. From my perch both camps have strong arguments and coal is simply too difficult of a call here.

 

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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