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Spotting Value Traps Early (Part 2)

5 June 2022

Many investors rightly focus on their process rather than on the final outcome as they accept that the future is unpredictable. I am definitely one of those investors. I focus on what I can control: my research process, emotions, and decision-making system.

However, I noticed that such a mindset leaves me somewhat complacent about periodic blow-ups that usually happen every year with at least one stock in my portfolio.

Alibaba could be one such example (I bought it in October last year and it is down 45% since then).

Netflix, which I have not owned, is another example, although it is probably better to be called a Growth trap.

Having reported disappointing Q1 results (losing subscribers and guiding for an even more significant drop in its subscriber base in the subsequent quarter) it has seen its shares dropping 20% overnight. Year-to-date, Netflix is down a staggering 67%.

Netflix Share Price Performance
Source: Google Finance

The question is how to minimise the number of stocks in your portfolio with negative surprises. How to spot the first cracks in the business model or just subtle changes in a competitive position of the business early on?

Current solution

The three tools I have used to reduce the above risks have been the following:

1. Valuation - I avoid expensive companies or companies that have various ‘accounting red flags’ (e.g. debt rising faster than revenue, high growth in share count, rising working capital relative to revenue, low FCF conversion, generally low returns on capital, heavy reliance on M&A to support growth).

2. Circle of competence - I try to learn as much as possible about the sector before buying a company in that sector. Ideally, I would like to learn how the industry works from the people who work in that sector. I avoid businesses which I cannot understand (the product or business model).

3. Diversification - Berkshire Hathaway is my largest position with about 25% weight in the portfolio, but overall I have about 15 stocks, not 1 or 2. I could be OK with holding most of my portfolio in just one Berkshire stock, but I believe there should be better opportunities for an investor managing a small amount of capital.

I also discussed how to avoid Value Traps in one of my earlier posts (click HERE). I pay special attention to the balance sheet to avoid companies with a dangerously high level of debt and companies with obsolete products (e.g. Kodak, Blackberry). Also, various one-off and cyclical factors, lousy management and fraud are often associated with value traps.

However, nothing from the above could be directly applied to Netflix, a company with exceptional management led by a founder who launched the video streaming revolution.

Five Stages of Decline: Jim Collins framework

I do not think the list of signals I present below is complete and sufficient, but it could be a good starting point. The list is almost entirely based on the work of Jim Collins, a well-known expert on corporate strategies and an author of several best-sellers like Good to Great and Built to Last. I have only read parts of his books and have listened to a few podcasts with Jim Collins (planning to read his entire book collection over the summer).

In one of his books, How the Mighty Fall, Jim Collins has introduced the concept of Five Stages of Decline, which include:

Five Stages of Decline (Jim Collins)
Source: Jim Collins from jimcollins.com

1. Hubris born of success;

2. Undisciplined pursuit of more;

3. Denial of risk and peril;

4. Grasping for salvation;

5. Capitulation to irrelevance or death.

You can read Collins’ article, which describes this framework in more detail HERE and a more detailed summary HERE.

Using this concept and adding my own experience in investing, I have come up with the following list of signals to watch out for. I have added my comments on how relevant the signs are for Alibaba to decide if it could be a value trap.

I. Communication

It is essential to take notes of any changes in management communication.

The first type of poor communication is when the company starts attributing its success to some general factor rather than a particular process, product or technology. If management does not know the specific differentiating factor for the success of its product/service, there is a high chance that it will lose its market position to competitors.

Jim Collins brings the example of an inadequate and reasonable explanation for success by management. A bad explanation:

“We are a great company because we do these specific things.”

A good explanation:

“We’re successful because we understand why we do these specific things and under what conditions they would no longer work.”

The second lousy signal in communication is when management starts ignoring the role of luck in a company’s success.

The third one is denying reality, blaming temporary factors like a weak economy, labour shortage, cost inflation etc. Management is not willing to accept responsibility for the emerging problems.

The fourth signal relates to financial disclosure. The main issue is conflicting accounts, regular re-statements, and plenty of adjustments which are hard to reconcile. A former equity analyst, Scott Davis, describes his experience analysing GE financials in his book ’The Lessons from the Titans’: “We struggled to find any consistent way to model out the company’s earnings or even compare its risk profile with others. The reported numbers were constantly changing, and it took multiple days or weeks just to reconcile the differences, if you could at all. And just when you felt like you were looking at solid financial comparisons, the company would alter its disclosure, and we would have to start all over again.”

The fifth and last signal in communication is when management starts being arrogant, dismissive of critics and obsessed with avoiding negative publicity. In the same book ‘The Lessons from the Titans’ the authors share many examples of how GE scrutinised every media comment and made sure their company was reported on positively. The same applied to research reports. Once, Scott Davis, who covered GE stock, sent the IR team his draft for fact-checking. Soon after, he received a call from IR asking him to drop the report altogether. This is how he described the threats he has received if he decided to publish the note:

“If not, the team would use all its power to squash my credibility, including leveraging CNBC anchors (GE owned CNBC within its NBC unit) to attack my findings. The caller also raised the possibility that GE management would elevate its dissatisfaction with me all the way to the top of Morgan Stanley’s executive team.”

How relevant is this for Alibaba?

I would flag that the two possible issues are complex financials and not always a specific explanation of its success formula and strategy. While core statements are clear and changes in net cash reconcile with cashflow statements, the interrelation of different entities of the Alibaba Group and various inter-company arrangements are very complex. There is also a complex relationship between Alibaba and Ant Group. Alibaba pays various fees to Ant over $2.2bn a year, receiving c. $1.2bn fees from Ant.

Other than those two issues, I find Alibaba’s communication generally fair. The country they operate in may be less tolerable to criticism, but the company itself looks much more reasonable. I am unaware of any stories that would be even slightly close to how GE treated media or research analysts.

Perhaps, Alibaba could have been more open about the rising competition and challenges it has been facing in China earlier. 

So, in summary, I am not too worried about the communication signals at Alibaba. However, I cannot say there is absolutely nothing to worry about because of some of the above issues.

II. Culture and Incentives

There are tons of books on corporate culture. I think the most important traits of the culture of successful companies are: long-term thinking, obsession with customer focus, tolerance to mistakes if they were part of experimentation to improve the service or launch a new product, and little tolerance to big risks (high debt, significant losses), ‘skin in the game’.

Some ominous signs in corporate culture include the following ones:

Charismatic CEO

It isn’t good if the CEO is a celebrity more than a manager. Managers working under a charismatic CEO tend to follow the leader and not question his thinking. The quality of decision-making declines, and the company loses a sense of competition and customer needs.

The case of the rise and fall of SoftBank, led by its visionary CEO, Masayoshi Son, proves this point. The company managed to raise the largest VC fund in history, getting the backup from Saudi Arabia. According to various reports from its past employees, the most significant challenge its management faced for many years was how fast to spend the capital.

Big boards

Boards often lack critical capabilities, with members often agreeing with the management. As Buffett says, “You don't get invited to be on boards if you belch too often at the dinner table.” “I’ve been on 20 public company boards; I’ve seen a lot of corporate boards operate. The independent directors, in many cases, are the least independent.” As he explains, if directors get about $250,000 a year, and that’s an essential part of their income, “they’re not going to upset the apple cart.”

If the company focuses more on bringing big names to its board to attract attention in the media rather than adding talent and guiding/challenging management, it is a bad sign.

Growing board size is also not a good sign. GE had 18 board members, making meetings more formal ceremonies than working discussions.

GE Board of Directors in 2013

GE Board of Directors in 2013
Source: GE Annual Report 2014

Excessive spending on luxury

Few CEOs live frugally unless they are the founders of a startup. Warren Buffett may be the most prominent exception. In the book I have already quoted, Davis recalls his first casual chat with Jeff Immelt about his life as the recently appointed CEO of the company. 

Davis: “Do you wait in line at the hotel check-in?”

Immelt: “No, my forward team handles it and hands me a key when I walk in.”

Davis: “Do you use the hotel gym?”

“No, my forward team flies my fitness equipment down and sets it up in my room.”

Davis concludes: “I covered other large companies. None of their CEOs at that time had a security detail, advance teams, or gym equipment set up for them in their hotel suite.”

Boring is good

Collins also discusses the’20-mile march’ concept - a disciplined approach to solving significant challenges by focusing on regular and consistent steps rather than extraordinary leaps forward. This approach also helped Roald Amundsen come first to the South Pole ahead of Robert Scott.

This does not mean that such companies avoid looking at potentially breakthrough technologies and only focus on making predictable products. Rather, such companies have a consistent ‘boring’ approach, like allocating 10% of the budget on experiments or allowing engineers to spend 20% on ‘new projects’ like Google.

Instead, it becomes a red flag if a company changes its pace by chasing big winners involving great financial and human resources.

Rising personnel turnover, falling talent density

If more employees start leaving the company and new managers are brought in, it signals some underlying changes. Often this could be a bad sign as old executives may be dissatisfied with how the company is run or its strategy. Moreover, getting the right people can be even more complicated. So the risk is that the fresh members of the team are not as good, and they dilute the talent density of the company. This can trigger a more significant exodus as employees who have stayed with the company longer may feel underappreciated and leave.

The departure of the founder also increases the risks of more personnel leaving.

WSJ recently ran a story about an Amazon veteran who spent 15 years helping it build its Cloud business. He recently decided to leave Amazon and join Microsoft to work on a new challenge. The turning point for him was the retirement of Jeff Bezos in 2021. “Jeff said he was retiring and it was like, ‘Okay, what is this world going to look like?” Bell said.

Incentive structure

A lot has been said about the incentive structure and how it impacts companies’ decision-making. Ideally, you want management to be focused on creating shareholder value which means investing in projects with high returns and higher than the company’s cost of capital. 

Many family-run companies focus long-term and encourage decisions that build wealth over time rather than boost earnings in the next quarter. Of course, there are exceptions to this rule, especially if the controlling family is represented by the third generation or later.

Spending time learning the details of the incentive structure is also quite important. If the company targets simple growth in sales or earnings, this may lead to bad outcomes later on. Management will be encouraged to look for more deals, play with accounts and not care too much about the cost of doing this (cost of capital, leverage).

On the other hand, if the company targets ROIC or Book Value Per Share growth, shareholders’ wealth is much better aligned with the company’s strategy.

Just think how it can be easy to manipulate EBITDA for management. One out of dozens of examples is this. Instead of hiring more personnel to its department to work on some problem, management may bring a consultant. When calculating EBITDA, this assignment could be classified as a one-off expense and excluded from costs. In the end, the company may spend more on consultants but report higher EBITDA.

Removing share-based compensation from adjusted earnings is a well-known trick that management is encouraged to play if it has the wrong incentives.

How relevant is this for Alibaba?

Apart from last year’s reports on a sexual assault of a female worker at Alibaba by her colleague and a client, I think Alibaba’s culture is generally strong with not too many red flags.

Jack Ma has been a charismatic leader, but he has stepped down from management roles at Alibaba already. Besides, the company has been promoting strong teamwork culture. There have been a few top management changes in the past 12 months, but most new managers were internal promotions. The company does not look for big-name CEO or emphasise status (like GE’s Board).

Most top managers have a high share of compensation in the form of share options. I have not found specific KPIs (e.g. EPS vs ROIC) that determine the allocation of such options yet. 

III. Strategy and Capital Allocation

According to Collins, one wrong signal is Undisciplined pursuit of more - more scale, more growth, more acclaim, more of whatever those in power see as “success.” Poor signs could include undisciplined attempts to enter entirely new areas of business or geographies for which management has little expertise and is not related to the core product.

Big ‘transformational’ deals based on a vision and at high prices are almost always a red flag too. Often, such deals are undertaken at a later stage of corporate decline (Stage 4 using Collins’ classification). Collins writes:

“The critical question is, How does its leadership respond? By lurching for a quick salvation or getting back to the disciplines that brought about greatness in the first place? Those who grasp for salvation have fallen into Stage 4. Common “saviours” include a charismatic visionary leader, a bold but untested strategy, a radical transformation, a dramatic cultural revolution, a hoped-for blockbuster product, a “game-changing” acquisition, or any number of other silver-bullet solutions. Initial results from taking dramatic action may appear positive, but they do not last.”

A bad sign is also when the company loses its focus and starts targeting too ambitious goals that are not very well defined. For example, under the previous CEO, Jeff Immelt, GE decided to become “the backbone to the entire industrial internet of the US”, looking to expand its solutions for digitalisation. The goal was too broad and encouraged poor capital allocation by management (many unrelated deals with little attention to prices).

How relevant is this for Alibaba?

This third group of signals is more mixed, in my view. While Alibaba has avoided large value-destructive deals and does not look desperate to grasp any opportunity to turn the situation around, it has expanded quite considerably in the past several years. 

The jury is still out on Alibaba’s pivot from a pure online marketplace to building a complete logistical infrastructure, and entering Tier 3/4 towns in China has been the right move. The company has been actively launching new retail formats emphasising offline presence.

Alibaba has had different strategic priorities recently and lacked some consistency. I am not too worried yet, although if management pivots again, it would be a wrong signal.

An unfavourable regulatory environment can partially explain such inconsistency.

On the positive side, the launch of the share repurchase programme last year and its upscaling this year are worth noting.

IV. Insiders’ actions, not words

Finally, a well-known signal worth paying attention to is what corporate insiders are doing. Given the amount of information they hold about the business, it is a worrying signal if the stock drops considerably and they are not buying it. Of course, the CEO may already have 99% of his net worth in the company’s shares and earn a modest $200k salary. In such a scenario, he may still decide to sell shares even after the correction due to his personal circumstances.

But other than that, lack of insider buying or, worse, active selling by executives after the drop in share price - should be viewed as a red flag.

How relevant is this for Alibaba?

Jack Ma has been selling his shares in Alibaba over time, although not recently (in the past 18 months).

The use of various offshore funds and share-backed bank loans complicates the picture.

But if any of the insides made any tangible purchases of Alibaba stock, we would have learnt this.

In general, the lack of buying by insiders is negative. However, since most top management continues to hold large amounts of Alibaba stock and options, I am generally not too worried about this issue.

Conclusion on Alibaba

In conclusion, it would be naive to confidently state that Alibaba is free from any red flags discussed above. At the same time, there is no significant clear negative signal to suggest that the company is going through a continuous decline and is facing more downside risks in the future. No large stock purchases by management, complex group structure with many inter-related transactions and rapid expansion into offline and auxiliary services look a little worrying. 

It may also be that I simply lack sufficient information to make better observations.

Because of that, I am not planning to buy more shares on weakness at this stage, but also I do not want to sell right now. The company is valued quite cheaply by the market (9x LTM P/E excluding $54bn net cash) and remains focused on delivering faster growth and higher margins. Macro challenges and regulatory headwinds are mainly temporary, which should help the company achieve better results once the external challenges subside.

I admit that my conclusion may lack a clear message (BUY or SELL). This can be frustrating to a reader. But the primary goal of this post was to record my thinking process and later review it to see if I made any mistakes and what I could improve in the future. Moreover, I don’t have enough insights into Alibaba and by trying to present a more coherent view of the company, I would be fooling myself. In the autumn of last year, my original thesis was based on the assumption that the market had overreacted to regulatory news. I have not found sufficient evidence to suggest Alibaba is a value trap facing permanent decline. 

Summary Checklist for identifying early signs of corporate decline

I. Communication
  • Does the company have a general explanation for its success? Does it know why it does the specific things and under what conditions they would no longer work?
  • Does management appreciate the role of luck in corporate success?
  • Does it tend to blame external factors like market conditions?
  • Are financial statements easy to understand, or are they often restated and hard to reconcile?
  • Does it put too much pressure on the analyst community and media to filter all criticism and create an impeccable image of the company and its management?

II. Culture and Incentives
  • Charismatic CEO
  • Big boards
  • Excessive spending on luxury
  • Boring is good: consistency over big moonshots
  • Rising personnel turnover, falling talent density
  • Incentive structure: EBITDA/EPS vs ROIC / BVPS, Long term vs Short term

III. Strategy and Capital Allocation
  • Are there signs of ‘undisciplined pursuit of more’: more scale, more growth, more acclaim, more of whatever those in power see as “success”
  • When faced with challenges, does management become more focused and disciplined or try to grasp any opportunity?
  • Is the company venturing into entirely new market segments and geographies unrelated to its core products?
  • Big ‘transformational’ deals based on a vision and at high prices are a red flag
  • Any signs of the following: charismatic visionary leader, a bold but untested strategy, a radical transformation, a dramatic cultural revolution, a hoped-for blockbuster product?
  • Does management set too ambitious, general targets (e.g. “We want to become the backbone to the entire industrial internet of the US”)

IV. Insiders’ actions, not words
  • Are insiders buying shares?
  • Are insiders selling shares after disappointing results, weak share price performance?
  • What proportion of their net worth is in the company’s shares?
  • Are there any questionable related-party transactions?

DISCLAIMER: This publication is not investment advice. The main purpose of this publication is to keep track of my thought process to better assess future information and improve my decision-making process. Readers should do their own research before making decisions. Information provided here may have become outdated by the time you read it. All content in this document is subject to the copyright of Hidden Value Gems. Please read the full version of the Disclaimer here.