Long-term success in investing comes as much from finding great ideas as from avoiding the duds. The secret formula for successful investing is well-known: find a great business and make sure you don’t overpay for that. Over the long term, your returns will match the returns of the underlying business.
However, what happens when a company in your portfolio suddenly reports slowing growth and weakening margins. Is this the time to review your assumptions about its long-term potential or shrug it off and wait for the next results? You may decide that rising uncertainty demands a lower valuation multiple, but the stock is quick to react to weak numbers and drops by 20%, reducing the multiple. Often subsequent results are disappointing again, and the stock falls further.
Is this the time to quit and call the stock a value trap, or maybe what is needed in this situation is more patience? There are no simple answers, and a lot depends on specific details in each case.
I will briefly review the case of Meta (Facebook) in the second half of this article. But before I do it, I would like to review some common factors that can make a seemingly attractive business a value trap.
What should you look for in a business?
Based on my investment experience, there are at least six reasons for a stock to become a value trap:
- Obsolete products - e.g. Kodak, Blackberry. To avoid this trap, it is better to focus on sectors without fast technological change and actively observe what customers are buying/using.
- High debt - e.g. Sears, GE, global banks during the 2008 financial crisis. Debt boosts ROE and EPS but makes a company more vulnerable during economic slowdowns.
- One-off factors that make recent financial results look stronger (e.g. Fitbit). This could be due to a successful launch of a new product in a fast-changing sector or some other non-recurring factor such as an acquisition that boosts revenue growth but is rarely a reliable growth driver. Favourable tax changes, receipt of the payment from a customer. Shrinking Working capital can often help construction companies to report strong FCF (through positive changes in Working capital). But this is a temporary phenomenon as the underlying business is shrinking and losing value. The moment such a business receives more orders and starts growing, it has to invest in inventories, and its Accounts receivables start growing, which increases Working capital and reduces FCF.
- Strong phase of the cycle - commodity producers, consumer electronics, companies with high fixed costs (e.g. retailers). Commodity companies experience the wildest swings in profitability driven by external factors, with periods of losses often followed by record-high profits and dividends. Consistently growing dividends can be particularly misleading (e.g. Shell during the 2015-2020 period). Large commodity producers try to maintain stable and growing dividends covering them during downturns from debt. Such policy is often unsustainable.
- Fraud (e.g. Wirecard, Follie Follie, Enron) - management can either do something illegal or just ‘cook the accounts’, inflating revenue through sales to intermediaries which did not send the final product and send cash to the main company. Tracking cashflows and Working capital (Accounts receivables) is vital for detecting fraud accounting.
- Poor Management (e.g. Blockbuster, Woolworths, BHS, Enron and GE to an extent). Sometimes management can lack the competence to deal with new problems, but often it also has wrong incentives focusing on beating the next quarter EPS target. Often, managers become overconfident and destroy value through expensive M&A deals, raising leverage to a dangerous level, or ignoring industry trends and threats.
To avoid falling into such value traps, I have created a Checklist that forces me to review such risks.
However, there are many stocks in the grey zone. They are not outright frauds selling obsolete products with stretched balance sheets and poor management, but rather just regular companies facing rising competition, cost pressure, and other challenges.
Psychology as a source of value traps
Rather than seeking signs of fraud inside a business, it can often be more helpful to review our decision-making process and make sure some common biases do not influence us.
Some typical biases include the following ones:
- Loss aversion - losing $100 has a more significant impact on us than winning $100. In real-life experiments, people paid well below $50 to play a coin-tossing game when you can either win $100 or lose $100 (and a player has to decide what price he would pay to play such game). In investing, we tend to sell winners too quickly (to avoid future losses) and stick to losers for too long not to realise a loss hoping the stock could still recover.
- Over-confidence - almost 75% of drivers believe they are above-average drivers. The problem exacerbates if we spend time on a particular topic and consider ourselves an expert in the field. Maintaining consistency at the risk of being wrong becomes more important than seeking the truth. Making our beliefs public also complicates our decision making as we usually avoid changing such opinions (contrary to privately-held views).
- Confirmation bias - once we form an opinion (open a position), we look for evidence confirming we are right and ignoring facts that suggest otherwise.
- Recency bias - recently happened events have a more significant impact on our analysis than far-away situations. Many people overestimated the probability of another terrorist attack after the 9/11 events.
Apart from reviewing common biases to make sure my thought-process is not affected, I also ask myself the following questions (borrowed from Warren Buffett):
‘Am I ready to own this company for the next 10 years?’
‘Will I be a happy owner of this company if the stock market closes for the next 10 years?’
‘Will I be happy to own this company if its stock dropped 20% tomorrow?’
A reminder from Warren Buffett: ‘A stock doesn’t know that you own it.’ And: ‘You don’t have to make it back the same way you lost it.’
Outside view vs Inside view
Using checklists, journaling, and periodically reviewing one’s biases are essential psychological tools to avoid value traps.
One other important tool is the Outside view. When analysing a particular situation and trying to forecast how it may unfold, we often focus too much on specific circumstances and individual characteristics. For example, trying to predict the winner in a football tournament, we may dive into details about the strengths and weaknesses of each player in each team in this tournament.
The Outside view looks at all outcomes of such tournaments in the past and draws some conclusions from that data set (e.g. Brazil has one 5 out of 21 World cups). Instead of making subjective judgements on a series of individual characteristics, it is more productive to look at history. The base rate tells you how often such a situation has already happened. If it was 80 out of 100, then there is a good chance (80%) it will happen again this time.
I learnt about the Outside view in Phillip Tetlock’s book ‘Superforecasters’ (see my review here).
The most straightforward tool: Too-hard pile
I also often ask myself if I really have an edge in a situation. What is the market is missing, and why there is an opportunity? I ask myself if I know enough about the business and the industry. Sometimes I don’t know enough about a specific sector, but I may have another edge. For example, suppose it is a stable business in a consumer staples sector is facing temporary problems (e.g. Nestle in 2018), despite having a century-long track record of profitable growth. In that case, the company I may take a position as my edge could be patience. As a private investor, I will not sack myself for one or two quarters of underperformance. I consider Alibaba a similar situation where my real edge is patience.
I have also come to appreciate position sizing over time. When my edge is just patience, I want to limit my position size (not more than 5%).
Over time, I have started to appreciate Warren Buffett’s ‘Too-hard pile’. Admitting that we lack sufficient knowledge, expertise or advantage in a particular situation is often the only and honest decision that we can make. In this case, the best course of action is to put the annual report of such a company into a ’too-hard pile’ and move on.
A personal financial trap
Finally, one other source of a value trap is your personal circumstances. Often, we sell stocks when they fall because our circumstances do not allow us to hold them over a longer period. The trap again lies inside us. If you owned a significant position in a stock and did not have much more savings while your salary was spent on monthly expenses, you would have to sell your stock if you lose a job or face other extraordinary costs. Unfortunately, a crisis causing a share price drop and leading to you losing a steady income often happen in parallel. So you end up selling a stock at a lower price at the wrong time.
One solution is having a cash balance that can cover at least 12 months of your living expenses before you start investing in stocks.
In my view, Meta (former Facebook) is an example of an investment opportunity similar to a value trap.
At first glance, it looks like a great business going through temporary problems. The market may have overreacted, sending the stock down with Meta now trading at just 15x PE.
There are many bullish calls on Meta, some of which come from prominent value investors (e.g. Bill Bygren or Mohnsih Pabrai).
However, I admit I lack sufficient edge and cannot predict how the business would look in 5-10 years and because of that, I put it into a ‘too-hard pile’. I find it easier to move on and focus on new opportunities rather than keep trying to build more conviction. One reason is that apart from WhatsApp, I have never used Facebook or Instagram. WhatsApp is not monetised and has many alternatives. There are new exciting tools for business collaboration, such as Slack or Discord. Twitter, Reddit and others seem to be fast-growing community platforms with super loyal and active members.
In early March 2022, Meta’s stock was trading at almost 50% below its peak price ($384) reached in 2021.
Consequently, Meta's PE multiple contracted to just 15x PE.
Meta’s operating margin has been under pressure reaching 37% in the last quarter (Q4-2021), the lowest level in at least four years.
Slowing revenue and user growth have also become a concern.
Being absolutely honest with myself, I admit that I simply don’t know if the company can overcome stagnant user growth with new services and better monetisation. And I also lack visibility over future margins.
To me, the Meta case is just ‘too hard’.