How to avoid nasty value traps

By Larry MacDonald
Globe Investor Magazine Online, June 19, 2008

Bill Miller beat the S&P 500 index 15 years in a row, from 1991 to 2005, but the market is beating him now. Indeed, in 2008, just about anybody with a portfolio of stocks is ahead of the legendary stock picker at mutual-fund company Legg Mason Inc. His Value Trust Fund has fallen nearly 20 per cent year-to-date.

The scuttlebutt in online forums said Mr. Miller is ensnared in a value trap. In 2006 and 2007, he passed on energy stocks and loaded up on home building and financial stocks when they were cheap - only to see them tumble even further as the subprime-mortgage market derailed and pulled down Wall Street investment dealers.

But the characterization could be premature. Value investing is not about returns generated in a quarter, or even a year. It's about investing for the long term, with horizons of at least three to five years.

A value trap is a bargain stock that fails to recover within a period of at least three to five years. The worst cases go to zero in a bankruptcy. Mild cases drift aimlessly, leaving the stockholder no further ahead than when purchased.

How to avoid them?

"I think the key is not to get caught up in the value metrics and to try to get a feel for the operating business," said value investor Ben Stadelmann of the Contra the Heard investment newsletter. Mr. Stadelmann also writes for the GlobeinvestorGOLD website.

In other words, there is more to being a value investor than looking for low readings on price-to-earnings, price-to-book-value and other value ratios. One has to also assess if there has been a fundamental shift in the company's business or environment - i.e. to determine if the troubles are temporary or permanent.

It's difficult to do, said another value investor, ABC Funds portfolio manager Irwin Michael. "It's not as clear in the beginning as it is later on," he said. "There is an old saying: 'You never know a stock until you own it.'"

That is why illiquid, small-capitalization value stocks are danger zones for him. "When you realize it's a value trap, who are you going to sell to?" he asks. Also watch out for management teams that are entrenched at a company and just looking to keep their salaries, he said. Often they don't care about the stock price.

Norm Rothery, chief investment strategist at Windsor, Ont.-based investment research and counselling firm Dan Hallett & Associates Inc., recommends investors avoid value traps by using a nine-point system developed by Joseph Piotroski, professor of accounting at Stanford University. According to his system, returns on assets and cash flow from operations should be positive. Also, there should be momentum in fundamentals: For example, gross margins and debt should be changing for the better.

Still, it's inevitable that even the best of the value practitioners will stumble into value traps on occasion. A case in point could be Mr. Miller with his bet on housing and financial stocks.

House prices in the United States are falling at rates not seen since the 1930s; nationally, they are down an average 14.4 per cent year-over-year, according to the latest S&P/Case-Shiller Home Price Indexes.

Such a once-in-a-generation decline throws all the customary value benchmarks out the window. When home builder stocks began trading close to book value, it was a classic buy signal for bargain hunters. But the ongoing slide in house prices progressively marked down homebuilders' land holdings and, in turn, book values.

And an end to the writedowns is not yet in sight. Inventories of houses for sale remain near record levels, continuing to exert downward pressures on prices. In fact, experts in financial bubbles, such as Yale University professor Robert Shiller, are forecasting declines of 20 to 30 per cent over the next five to 10 years.

In the case of financial stocks, collapsing house prices undermine their balance sheets because loan portfolios have large exposures to the real-estate sector. As these loans go sour and banks slip below mandatory capital requirements, they need to restrict lending and/or obtain more capital by issuing additional shares (dilution risk) and debt (leverage risk).

Credit contraction has a magnified impact on banks earnings. If regulatory capital requirements are 5 per cent, then a bank can lend out $100-million on $5-million of capital. Just having $2.5-million of those loans go bad cuts a bank's capital in half and requires a cut in the loan portfolio by half to $50-million, or more capital.

Capital sufficiency concerns are compounded by other problems. Loss provisions for non-performing loans are bound to escalate and hit earnings. Plus, highly profitable lines of business have disappeared and don't look like they will be back for some time, notably securitization of mortgages, car loans, and other debt.

"The financials appear to be a broken business model, like dot-coms were earlier this decade," said Ken Kam, manager of the San Mateo, Calif.-based Marketocracy Masters 100 Fund. They may recover, but it could take many years.

Canadians have seen a number of value traps in recent years. Grocery store Loblaw Cos. Ltd. is in a price war with Wal-Mart as the latter expands into groceries. Newsprint maker AbitibiBowater Inc. and media companies CanWest Global Communications Corp. and Torstar Corp. are struggling with a shift of audiences to the Web. Several companies in lumber and automotive sectors are ailing.

"The thing I find fascinating about value traps is they always seem to be easier to spot when they are someone else's investment," Mr. Stadelmann said. When he read that Mr. Michael had bought Sea Containers Ltd. and Mr. Rothery had bought Ainsworth Lumber Co. Ltd., he shook his head in disagreement. Although Sea Containers' stock was trading below net asset value, Mr. Stadlemann didn't see it as a buy because "the enterprise was in a death spiral, with poorly performing businesses and way too much debt."

As for Ainsworth Lumber, the company had a high debt load and business prospects were not promising given the U.S. housing boom appeared to be near an end.

When he and his Contra the Heard partner, Benj Gallander, averaged down on forestry company AbitibiBowater Inc., another distinguished value investor, Ross Healy of Strategic Analysis Corp., wanted to "call us up and scream: "Don't do it!"

"I guess it's wise," Mr. Stadelmann concludes, "to get other people's opinions on your ideas."

Special to The Globe and Mail