#value traps

How Value Traps Can Pull You In and Spit you Out

A post in Institutional Investor highlights a “value trap” that arises when stocks appear cheap but are within a sector that “experience[s] high levels of asset growth [then] collapse.” Examples include U.S. homebuilders just prior to the financial crisis and, more recently, the mining and energy sector. Edward Chancellor (former GMO pro) of Marathon Asset Management suggests that “businesses in…

I got this phrase from the Seth Klarman book on value investing - "Margin of safety". My attempt here is to put this into context of the Indian markets.

Market participants

Overall a large percentage of the Indian markets are owned by FIIs. The number has been steadily rising since 1992 making the markets more and more linked with the global financial system. The percentage of volume on the exchanges is now over 22%. So the gyrations of the market are similar to the global system. Mutual fund penetration in India seems low at 9% of urban households versus 46% in the US. But that is probably because of much lower investment money available to most households and lower banking penetration. The FII volume in India as of Jan 2015 is about 3 times the DII (Domestic Institutional investor) volume which basically means that the institutional activity is driven by FIIs. Overall FII + DII constitute about 80% of the total volume.  This 80% of market activity drives the institutional performance derby.

Short term index beating performance rat race

What makes an asset management company successful? NO the answer is not returns. The answer is assets under management. Given that around 80% of the market trade is in with institutional investors it is not necessary for the largest institutional investor to be the one with the best returns. Returns are the marketing key for each institutional investor. This is why most asset management companies (AMCs) have several funds. The idea is that some fund or the other will be outperforming and that will be used by the sales force to market the product.  This means that all fund managers working for the AMC will be given a key result area to deliver better than market returns year on year, quarter on quarter, month and month - and YES day on day. The most rational way to do that is for the fund manager to play the momentum trades - buy the fad of the day. So instead of investing the manager has pressure to become a fad picker. The investors also have a choice to go in and out of the funds (with a fee ofcourse) which makes capital highly mobile thus increasing the pressure to be ahead of the fads.

Roadblocks for sound institutional money management

Too much information is available and with the advent of the internet it is not possible for a money manager to know everything about even 10% of their portfolio. Most fund houses own several stocks making the task even harder. Research is typically provided by brokerage firms which also have investment banking arms. The research team, although is supposed to be walled off from the investment banking team, has incentive to write reports that favor their clients over others' clients. This makes research highly biased from brokers and should always be taken with a pinch of salt. Given high liquidity requirements of investors - illiquid but high quality assets often get ignored. Most funds are under pressure to be fully invested at all times. This is because there is a fear of under performance if the market rallies. So even when stocks are trading at absurd prices funds are forced to buy. Secondly many managers believe that market timing is the job of the investor putting money into the fund - and their job is to pick companies/stocks. All these factors lead to managers ignoring the fundamentals.

Indexing - invest without thinking

Many a financial literature has recommended investing in index funds as the cost is low and because the average performance of the mutual fund industry is index return minus fees. While this is true if too many people participate in indexing (which they probably are) the stock picking job becomes that of the index maker. Now most index companies will invariable carry a premium to ones outside the indices when there is a bull market and a discount when there is a bear market.

Why is this good for value investing?

Several readers have asked me how I set a grade for the moat? I will try to describe this process and please pardon me if its a bit subjective as that's the nature of the exercise. A moat grading system is required, much like a checklist is required, to keep the analyst or investor unbiased and rational. Without a system like this the analyst might have a tendency to apply his or her own biases to the moat grade - for example if I like to eat a particular kind of food product from a company I might ignore some of the factors such as employee relationships in the moat grading system. Overall the moat grading system currently has 8 factors. Each of these factors is graded at -1, 0 or 1 basically suggesting non-existent or negative moat, weak moat and strong moat in the particular factor. Then the total score is divided by 8 to get a percentage. I have percentage ranges mapped for grades. The factors currently are:

Brand replication cost -  Replication cost has to be taken along with other components of invested capital and of the company 

if it can be replicated in lesser than what the book value suggests to about 20% more than book then its a -1

If it can be replicated with 20% to 50% more than book then its a 0. This is because any company sitting on an asset for a while will probably have a 50% invested capital advantage over a 10 year period.

It the company would take more than 50% or cannot be replicated then it gets a 1 in this category

Brand replication timeline

For example when Facebook received a valuation of 15 Bil for a small stake sale to Microsoft in 2007 people were asking the question about spending 15 Bil to recreate a Facebook competitor. While this was possible to do there was pretty much no one who wanted to spend 15 Bil USD to do this. Also there was the issue of timeline and how long it would take. Interestingly Google plus has a good product but were unable to unseat achieve the reach of Facebook.

Ease of Product/Technology replication - replication scoring as described above applies focused on product or technology

Sales, distribution & customer relationships Replication - replication scoring on sales and distribution.

Vendor relationships - these are important as sometimes companies control supply chains which cannot be replicated. Japanese car companies have mastered the art of creating supply chains that they manage in an excellent manner.

Employee relationships - Most managers would agree that the greatest asset they have is their employees. Some companies like Google or Microsoft have excellent people practices. Most Indian IT giants have excellent people practices.

Performance during recessions - This is the big one and is rarely found - Coke being the leader in the space. In India Nestle and Hindustan lever are good examples

Pricing power - Again rarely found. The important thing is that if you are supplying something that has inelastic demand and you can control the price is the ideal situation. Energy companies have a product that has inelastic demand but the pricing is controlled by the market. Companies like Nestle for example have good control on Maggi prices.

Please note that these factors are dynamic and keep changing as I discover new ways in which companies create a moat for themselves. In Mar 2014 this list was only 4 factors and since has expanded to the 8 mentioned above.

It seems that articles about value investing concepts are far more popular on IGValue than company analysis pieces so I am going to try to pickup the pace on the concept articles. Value traps are the number #1 reason for amateur value investors losing money. I have been a victim of several value traps and will attempt to categorize them into a checklist here so that we can all avoid them in the future. A value trap is a stock that seems cheap relative to value but is fairly priced as the underlying business is doing worse than meets the eye. A simplistic example would be a company that drives up earnings in a year by selling some age old property and then claims that they will repeat it year on year. In the company analysis articles I try to cover these points in the Soft factors sections.

1. Compromised honesty

Honesty has always come at a huge premium. Even a slight blemish on the honesty front by management, promoters or employees is almost always a value trap. A dishonest company almost always goes to zero before changing course and that too only happens when the dishonesty drivers are replace a 100%. Staying away from fraud is always a good thing. There is no formula for detecting fraud other than reading the fine print and doing some channel checking. Example: Satyam Computers had fixed deposits on their balance sheets against which interest was not being earned. That was something suspicious that exposed the fraud. Once the old promoters were out and the Mahindra group took over is when the fraud ceased.

2. Too much Optimism

Running a business is not easy. Hubris or delusions of infallibility in a management create a set of unachievable expectations that never end well. It is always better to buy a company that promises little and over delivers.  A subset of too much optimism is missed earnings estimates. Earnings estimates are created by analysts based on data and perceptions given by the company in public communications. They are typically a reflection of what the company is thinking.

3. Bad business

A bad business is defined as one where there is some factor that ensures low margins. Some of these factors could be:

Too much capital chasing a small opportunity

Example: E-commerce in India or specialty small scale healthcare in India has been chased by excessive capital

Inability of the company to increase prices (demand elasticity) 

Example: Auto Parts

Too much supplier control

Example: Lithium ion batteries

Bad payment terms - this is a trap that besets some industries when there is a slowdown

Too much capacity - look for a cost advantaged producer

Outdated products where the technological jump was too high - Examples are numerous but personal computer assembly businesses went out as they were unable to adapt to making laptops

High capital intensity where the company becomes "pot committed" - the company is forced to make sales at bad prices as it has no other choice

Many scrap melting plants go through this when ingot prices fall

Glass manufacturers go through this as glass plants cannot be stopped until end of life

Lack of consistent profits - companies that declare routine losses need to be kept away from.

4. Regulatory issues

Investing in highly regulated industries needs to be done very carefully. For example utilities, government driven oil companies, and others may be used to fund subsidies.

Other regulatory examples include things like FDA bans on Indian exporters of generic drugs. I had looked at Wockhardt pharma at the lows and one can say I passed on it and missed the 20% rally but the FDA ban is something I don't really understand.

5. Doctored financials

This is something on which several books, research papers, journal articles and other media is out there. I recommend reading all of it. Time to time I cover articles on doing this.

A few important ones are:

Cash flow not keeping pace with net income

Ballooning inventories & their valuation

Ballooning debtors

6. Errors on financial websites

Yes! This can be a value trap too. Several financial websites like Moneycontrol, Myiris, Bloomberg, Google finance and others can sometimes have errors. Purely relying on the website for information can lead to disaster. Also the financials as presented by the website and the company can many a times differ. For example Moneycontrol many times nets off the current assets and liabilities and shows it as a single line item on the assets side whereas the company might be reporting the same in greater detail.

7. Insider activity & significant stake buys/sells

The BSE and NSE clearly report insider transactions. Never ever buy a company stock where insiders are selling. On the contrary insider buying in small quantities could also be a value trap. Company buybacks in large quantities are a good thing but sometimes companies can use excess cash to buy back stock just to tell the markets that they believe in their stock.

8. Cyclical industries

Highly cyclical industries also have to be dealt with in a careful manner. Mostly cyclical industries tend to be bad businesses and over the long run don't create much value. Wrongly times large bets on capacity can weigh down heavily on companies.

9. Debt traps

If a company's debt continues to rise over a long time without a commensurate increase in profits or revenue it is most likely a value trap. One needs to be very careful as the company might be overly optimistic on non-existent business opportunities.

10. Government owned companies

PSUs as they are called in India can find themselves in situations where the business interests of the shareholders are put aside for other gains. For example the NPAs start to rise for PSU banks where their mandate shifts to inclusive lending. There are PSU banks who have been know to say that NPAs are not a crime. Overall one has to be aware of the downsides while investing in government owned companies.

11. Lack of focus or overly diversified companies