Value Trap Investments
During the pandemic, some companies mobilized quickly to modify their service or business models to match the changing environment. Investors need to be mindful of which companies are going upwards and which are going backwards (or stagnant, which will eventually result in backwards momentum as their smart competition takes root in gobbling their market share). 2 scenarios really present themselves during an economic crisis. Heavy cash hoarders will open up the coffers and take ground by acquisition, investing in new technology, and otherwise expanding their footprint. The second scenario is much more recessed, conservative approach while preserving cash and taking small but calculated steps as they weather through the rough water. Neither is wrong. As an investor, it is to proceed with extreme caution when on the hunt for bargain buy stock deals. Some are there, some are not.
Cash is king. Cash, like any other working asset in a business, operates just like a piece of equipment, land, human capital, etc. It is a tool. Cash buys a company time and provides clarity as a safe haven mentality for companies to continue working towards viable product solutions. Without the right tools, you cannot build a grand spectacular. A great business idea without a ceded infusion of cash is no different from a perfectly functioning Boeing 747–8 sitting on an empty runway with no fuel. Neither will take off. Big companies know this and their smart and savvy CFO’s and accountants are constantly looking to expand their cash balance and make strategic investments. Well…and to mention, their boards have no grace for retracting of any kind. As a CEO, if you don't produce year over year growth, you are eliminated. Period. Preserving cash does more than raise the value of the company. It acts as a buffer against major downturns or market changes. Cash is then deployed to amend business strategy, invest in new markets, keep the company afloat, etc. Operating on lean cash with high expense can lead to short sighted decisions that can lead a company’s demise. Vision and tone typically cannot sustain in cash strapped companies. Panic and short sighted thinking can lead to bad decision making. Imagine making a personal decision when you are under extreme stress or worry. It can create a scarcity mentality . We’ll eat bad food if there is no alternative.
During the pandemic, companies saw significant reductions to quarterly revenue. This downturn moved in lockstep with their stock price. Many investors saw this as a buying opportunity to pick up companies at bargain prices. What’s next is to determine whether this is a value investment or value trap. The quintessential definition of value in a stock price is nothing more than the present discounted value of future after tax earnings of a company. This means, from a value perspective, buying the stock today is discounted against its future earnings. Stocks that have swung to a heavy reduction in price our first thought is how do we quantify its value against the price and is it discounted appropriately. The reason for this is if, again, we stick to the price today is determined by the value tomorrow. Current price vs future value. The reason the price dropped. Is it weighted down by overall bearish sentiment? Or is it taking a reduction due to loss of revenue and assets that will be impacted for a prolonged period of time or permanently. The latter is what is know as the Value Trap. Investopedia defines a value trap as: Value traps are investments that are trading at such low levels and present as buying opportunities for investors but are actually misleading.
Stocks that fall into a value trap category appear to be priced cheap because it has been trading at lower valuation metrics. Investors think they are getting a bargain on the front end. Remember, there is a reason the stock is down. We have to identify what reason or reasons is keeping the price lower. In this case, historical context is weighted differently in analysis. Meaning that if we placed a net present valuation on annual sales at $100m a year ago while juxtaposing it against an expected growth rate and return, we’ll see the stock might appear as a bargain buy. However, if the company divested, lost a major customer, and/or other material change that negativity impact the company, the value today will completely shift. What it is worth tomorrow is not the same as yesterday. When investors search for trade ideas and companies to invest in, many can get allured by a low P/E Ratio ( the ratio for valuing a company that measures its current share price relative to its per-share earnings) and a high dividend yield. This can be very misleading on the front end and should immediately raise suspicion to a smart investor. High dividend yields are often a sign that investors doubt payments are safe (reflected in the stock price). Companies that carry high yields also will come with bloated debt or deteriorating business conditions. When searching for bargains, use a guilty until proven otherwise approach. Don’t rely heavily on simple measures of financial strength. A dividend may only be 70% of free cash flow but that’s little help if the free cash flow is at risk of collapsing. The yield is always represented relative to the stock price. Because it is based on an annual rate of return. If the stock crumbles, the yield goes up. But you have to remember, that dividend may evaporate subsequent to stock price tumbling as liquidity vanishes or is re allocated to help bolster operations. Take a look at the company’s payout ratio in regards to their dividend yield. Anything over 100% is assuring.
What To Do
Read. The answer to everything is read. However, read the filings. Don’t read analyst opinions online through platforms like MarketWatch, Zacks, etc. Stay away from analyst opinions. More often than not, they function like paid PR to boost or drop a stock price for the purposes of positioning for their clients like Morgan Stanley, Sachs, etc. Proper due diligence is necessary to gain valuable insight into a direction and best positions you into a predictive analysis. Changes such as earnings, contracts, acquisitions, etc is all denoted in the disclosure documents required by the SEC. Read the 8ks, the 10qs, the important news that is useful and resourceful that can have impact to the company. We must first understand why the company’s stock price is down. If the evidence presented in your research suggests this company is facing major headwinds, don't do it. If they are in a sustaining or growing industry and the drop in stock price is due to outside factors that the company can weather long term, that maybe a value buy and something to consider adding to your portfolio.
