Value Traps and Market Bottoms

Here is a graphic depicting the performance of the three major U.S. stock indices over the past quarter. As you can see, Q1 wasn’t a particularly good month for the markets.

Graphic courtesy of the WSJ

Whenever the markets enter a “down-period”, there is a temptation to try and predict a market bottom, claim that stocks are cheap and value investments abound, etc, etc. However, this is not the best approach to take as one hand it ignores some very real problems the markets are facing and is a fool’s errand on the other. When looking at the graphic above/considering the market’s performance last quarter, it would be smart to avoid the following type of thinking:

Don’t try to forecast a market bottom. 99.99% of the people trying to call a market bottom are going to be wrong and the other 0.01% will just be very, very, very lucky. People have been calling “market bottoms” in stocks and housing for the past year and have been wrong every time, so why bother joining them? The only thing you should be considering is whether or not a particular stock is “cheap” relative to its earnings, earnings growth potential and the health of its balance sheet. In short: a smart investor doesn’t care when the market bottoms out, as they always have quality stocks in their portfolios regardless.

Don’t misunderstand cheap/avoid the value trap. A low price on an absolute dollar basis doesn’t make a stock cheap; instead a stock is cheap when it trades at a discount in relation to its earnings, growth potential and financial health. $5, $7, $10/share isn’t cheap if the company is heavily in debt, leaking money like a sieve, and management’s plans to rectify the situation are falling short. I.e. there is probably a good reason for a stock being mathematically cheap, and it probably isn’t undervalued. I wouldn’t purchase a beaten down stock based on the assumption that the company will recover, unless I see that management has a viable plan in place to do so and the financial health to get it done.

I.e. a realistic turnaround strategy that takes into account the capabilities of the competition, the resources the company has its disposal and a realistic assessment of the market the company operates in/sells to.

Avoid the Brand Based Value Trap. I see this in the business media all the time a commentator presents the idea that a well known brand will keep a struggling company from failing, so you should snap up the shares while they’re mathematically cheap. Designating a company as a value investment due to a mathematically cheap stock and well known brand may sound like a good idea on paper, but there are some rather serious problems with that argument:

1. Companies with well known brands fail all the time, often after having struggled to generate growth (or even profits) for an extended time period.
2. Being well known does not a strong brand make, rather a strong brand is one that (at the very least) generates profits and more specifically is one that consumers prefer over the competition. Outside of situations where a poorly managed company is squandering profits through mismanagement a struggling company does not have a strong brand, because while people are aware of the brand, they aren’t willing to spend their money on it.

This is not to say that brand shouldn’t be a factor in your value stock calculations, but you should be looking for true brand strength as opposed to mere awareness. In the case of struggling companies you should be looking for evidence of management taking steps to rehabilitate the brand, not simply trying to leverage awareness of a brand the consumer is effectively voting against. Finally the stock should be truly cheap on a value stock basis: relative to earnings, financial health and future growth prospects.

The key with this type of volatile market that could calm down in six months or six years is to ignore the broader market performance, focus on quality stocks and not let the market’s performance influence your decisions too much. If you’re always in quality stocks you’ll always make money, no matter what the broader market does.

Comments

[dectra]

Good post, nice to see some straight point by point rebuttals to the talking heads who constantly say how 'cheap' stocks are right now...

[leh]

Talk to Bill Miller about buying so-called value traps--he's been the absolute pro at this strategy over the past year or two, and was most recently pounding the table for BSC--all the way up to the day it went under! This incident remains for me the ultimate example of reckless and premature bottompicking, and I am amazed Miller remains unabashed and is still lauded by other investment professionals (not, however, by his actual investors at Legg Mason, who have fled his fund in droves). If he were a pro baseball player, he'd have been sent to the minors by now. But this is big business, where incompetence is rewarded, and I doubt Miller has taken a pay cut or forfeited his bonuses while his investors take the brunt of the beating his bad picks have doled out. The man ought to be ashamed.

[fabien hug]

Good article. Thanks. Stocks are cheap relative to their past earnings and still... Lots of not so good news may still come.

[Rebeldog]

Good article. Great advice for the new investor and an excellent reminder for old heads.

Rebeldogs

[wisdomseeker]

Bullshit. You can't figure out a company's value without estimating the forward earnings (for multiple years). You can't do that without making assumptions and forecasts about the future of the economy in general.

Your prediction about the earnings of XYZ will look a lot different if your macro forecast anticipates a recession with 5% less GDP than if you anticipate a growth period of 5% more GDP. Remember, net earnings are a derivative quantity - revenue minus expenses - and we can have a lot of GDP with zero net corporate earnings.

And don't forget the black swans that you can't anticipate at all!

That forward earnings analysis is the same analysis, with the same sorts of assumptions/forecasts, currently being used by those trying to call a bottom in the market. The only difference is the size of the business being analyzed. There are some things that get more complex at the macro level but also many that get simpler.

But either way, picking "good stocks at a cheap price" or picking "the index at a cheap price", you are bottom-picking. The only difference I see is that with individual companies you might get some benefits from simplicity (especially if you're Warren Buffett, but not if you're Bill Miller right now) and you also get the benefit of averaging over a lot of picks.

You might counter that you don't have to be exactly right, you just have to make some money over the long term. To which I'll counter that the bottom-pickers don't need to be right either, they just have to be in for the eventual recovery, to make moeny over the long term.

[bruin532]

value trap vs value: Were told dividends are a must, international exposure a must, growth in emerging tecnologies/markets and best of breed a must. Since we dont know if/when the market bottoms and a MM is going to give you 2% with no upside being exposed to the market is a necessary evil. GE @32 with a .38% dividend fits the bill. JPM @ 43 and a .35% div and continues to look for buying oportunities shoud be the #1 bank when the dust settles these two will be poised for upsede potential in a good market yet still weather a down market with relative safety. Financials dangerous yes but the backing of the Fed is a wonderful thing.