One of the basic tenets of successful investing is the search for stocks that trade at low multiples of earnings, cash flow, or book value. These so-called value stocks can frequently bring outsized profits with very little risk to one's capital.
Unfortunately, too many investors fail to look beyond basic financial metrics before making an investment decision on a potential value play. This frequently results in stock purchases that appear to be a no brainer, but are, in reality, nothing more than a poser on the road to nowhere.
Still worse, it can take years for the assumed investment thesis to play out - if ever. In the meantime, the investor is left holding a stock that slowly drags a portfolio down.
An example of a stock that appears to be a good candidate as a value stock is Navient Corporation (NASDAQ: NAVI). Navient trades at a miniscule price to earnings ratio of 4.75 and yields an impressive 4.86% based on Thursday's closing price of $12.42.
The stock trades with a forward P/E of 6.4, and a price-to-book ratio (P/B) of 1.1. On the surface, NAVI appears to be a potential value play.
But looks can be deceiving…
Navient faces significant long-term headwinds that will prevent the company from gaining any momentum to move higher.
The company's problems started a few years ago before Sallie Mae spun Navient off as a separate company. As part of the Health Care and Education Reconciliation Act of 2010, Congress established that the only entity able to issue government-backed student loans would be the U.S. government.
That meant Sallie Mae could no longer originate loans backed by the U.S. government. Its gravy train had ended. Now, in order to offset the void left by originating government-backed loans, Sallie Mae turned to an alternative revenue stream - servicing loans held by others. You see, Uncle Sam can't be bothered to actually collect payments, so Sallie Mae offered to do that for a fee.
Sallie Mae learned rather quickly that collecting payments on active accounts was a low-margin business. They needed another way to grow their revenues.
It's here they learned that collecting on delinquent student loans offered the biggest bang for the buck. In fact, Sallie Mae found that their cut of delinquent loan collection could be roughly 20 times higher than the revenues generated by collecting payments on current accounts.
And like most government programs, this created a moral hazard.
You see, Sallie Mae had no incentive to keep loans current. So it treated borrowers unfairly according to current and settled lawsuits. The plaintiffs alleged that Sallie Mae employees intentionally sent confusing or misleading correspondence to debtors, all the while neglecting to tell them about various programs available to find relief from their loans.
And as you might expect, the tactics infuriated borrowers, often making them less likely to make their payments. Of course, this played right into Sallie Mae's hands by effectively transferring an account from the low-fee current accounts bucket to the higher-fee delinquency bucket.
As a result of these actions, Sallie Mae regularly generated $300 million - $500 million a year in "contingency revenue."
Unfortunately, the revenue stream was about to dry up…
Sallie Mae's tactics garnered unwanted attention, especially after the company targeted 78,000 military members with its unfair practices. This put the company squarely in the crosshairs of regulators.
As the government turned up the heat on Sallie Mae, the company split into two pieces. A brand new company, SLM Corp., would act as a consumer bank - offering traditional banking products, including private (non-government backed) student loans.
On the other hand, the old Sallie Mae now trades as Navient Corporation.
But the new company currently faces headwinds that the old Sallie Mae never anticipated, such as the $210 million in settlements charges related to various Sallie Mae offenses. Unfortunately, the settlements are only just beginning.
The company's CEO, John Remondi, indicated the company faces significant regulatory headwinds from, "the likes of the Credit Financial Protection Bureau, States Attorneys General, and the New York Department of Financial Services."
Unfortunately, this list isn't exhaustive since it doesn't even mention the Department of Justice's investigation about intentionally cheating active-duty troops.
But this isn't even the worst news for Navient…
You see, asset-backed securities (ABSs) are one of Navient's key sources of liquidity. The company funds almost 75% of its business with pooled assets backed by student loans yielding roughly 2.5%. It then uses these loans as collateral for a new "security" that will pay a rate of 1.25% to investors who are happy to get more than 1% in a zero rate world.
Now, as long as the student loans are being paid on time, Navient can generate the revenue required to keep its ABS investors happy. But if the student loans fall into delinquency, Navient is stuck paying its investors with an unstable income stream.
This is already starting to happen…
You see, ratings agencies, Fitch and Moody's, have placed tens of billions of dollars of Navient asset backed securities on "credit watch" due to rising delinquencies in the student loan market.
As Navient's ability to pay its 1.25% coupons becomes impaired, the asset-backed securities quickly lose value. This snowballs into investors losing money and future investors requiring a much higher risk premium to fund future deals. This would completely wreck the company's business model and effectively freeze Navient out of the credit markets.
And without access to the ABS market, Navient will be unable to grow its business. In fact, Navient's primary business model is a slowly dying shell of its former self - competing in an obsolete market that is virtually unfixable.
At the end of the day, Navient remains a perfect example of a stock that appears to be a classic value stock. But truth be told, the best case scenario is that Navient should be valued at $10-$12 per share - right about where it trades today.
Over time, their fortunes will get bleaker as Navient has no real way to grow its business. This means investors should stay clear of Navient - unless the idea is to short the stock. Simply put, sometimes a company deserves to be beaten down.
And in this case, Navient is the poster-child for a value trap.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.