2 Value Traps And A Lesson In Contrarian Investing

Includes: CAT, NOK
by: David Urban

Over the past year, contrarian investing has come back with all the problems in the global economy. But most people do not understand what it means to be a contrarian investor.

A contrarian investor is defined in the investment world as someone who takes a position that is contrary to the market. Simple enough. But for someone to truly be a contrarian, it means much, much more than that.

First, you have to know what you are a contrarian against. This is where 90% of the contrarians fail the test. Think about it for a moment and it makes total sense. Why are you going against the market in the first place? What information do you have that leads you to believe that the market has mispriced a particular security? Unless you first know why you are in opposition to the market, you should not be opposite to the market. This principle is the key and core of any contrarian investing strategy.

For small investors, this means that just because you get a feeling about a stock, it does not mean you should act on it in a contrarian manner.

The key to being a successful contrarian at an individual stock level is to be able to recognize the difference between a value stock and a value trap. The distinction between the two is very subtle and often lost on investors.

A value stock is a stock whose price has fallen below the fundamental value of the company. A value trap is a security whose price has fallen below its fundamentals for a very good reason and is headed lower.

Here are two examples of value traps:

Nokia Corporation (NYSE:NOK) is a well-known stock and a global brand. Before the release of the iPhone, Nokia's phones were used around the world and the company was known for being the global leader in clamshell phones. But the iPhone changed all that, and over the course of a few years, Nokia went from being a world leader to an also-ran.

The stock has fallen precipitously over the past five years from a high of close to $31 per share to less than $2 today. Along the way, there have been moments where Nokia looked like a buy to investors. After all, they have a deal with Microsoft on the Windows phone that may yet prove attractive. They also have a powerful global distribution network and a well-regarded phone in the Lumia 900.

In the past nine months, Nokia's P/E has fallen to unbelievably low levels, while the dividend yield has spiked. Yet, this is precisely why Nokia is a value trap rather than a value stock. The low P/E and high dividend yield reflected the market's belief that Nokia would not be able to stem the loss of market share.

To date, Nokia has not been able to gain significant traction in the smartphone market where their most recent market share, according to Nielsen, came in at 1.7%. The lack of a strong application ecosystem hurts as well, causing consumers to choose iPhones from Apple Inc. (NASDAQ:AAPL) and Android-based phones over Nokia's offerings. Earnings warnings are becoming more the norm than the trend as sales continue to slow.

While the smartphone market is one of the hot areas in technology right now, Nokia is falling behind the curve with respect to its competition. Until the Lumia begins to gain marketshare in the smartphone market, it appears as though Nokia's stock price will languish, as many investors see their value stock turned into a value trap.

A second example is Caterpillar Inc. (NYSE:CAT). Everyone knows that Caterpillar is one of the largest suppliers of tractors, construction equipment and power generators in the world, yet the stock sells for an inexpensive 10.3 P/E, sports a 2.54% dividend yield, and is down more than 10% year-to-date after being up more than 30% earlier in the year.

So what gives? Caterpillar appears to be a great value play, especially for those investors looking for exposure to the mining sector, as Caterpillar products are popular at all stages from drilling to production.

Weak commodity prices are pushing down the attractiveness for projects. When commodity prices fall and economic growth begins to slow, a $500 million project becomes less attractive and juniors have a difficult time obtaining financing.

The weak financing market for junior mining stocks has hit Caterpillar hard. As financing for projects dried up, many juniors are muddling along, hoping to make it until the next cycle turns up. Weak financing markets provide juniors with four options regarding their projects: Continue to drill and prove up the deposit to the Proven and Probable from Measured and Indicated; put the mine on care and maintenance; heavily dilute shareholders including management; or sell out to a major at a depressed price.

When looking at Caterpillar's stock price, it is not enough to take the fundamentals at face value. The market is telling us that the weak financing market for junior miners will impact Caterpillar as orders slow for mining equipment and power generators. While it may look like a value stock, the reality is the market is waiting to see how a slowing global economy and weak financing market impacts Caterpillar's order book. Cummins Inc. (NYSE:CMI) has already warned, and the market may be looking for a warning from Caterpillar as well.

Being a contrarian investor is much more than just going against the market. It is first and foremost being able to separate value stocks from value traps, which means looking beyond the financial statements into the sector environment and how it reflects back to the stock in question.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.