The Value Trap

"In the short-term, the markets are like voting machines, but over the long-term they are like weighing machines."
Benjamin Graham

As readers of this blog know, I am trying to learn how to practice what is generally called value investing. I try to buy stocks the same way I buy anything else, the best quality and the lowest cost. Sometimes my schemes work, sometimes they don’t. Today I would like to discuss one of the traps that is a danger to value investors. I have stepped into this particular trap on two occasions.

As is recommended on the Motley Fool website and many other places, I like to see three attributes in a company

1)Sustainable competitive advantage – Some story line that makes this company special. Coca Cola’s brand name, Chevron’s size and global reach, Hong Kong and Shanghai Bank’s penetration of China without the corruption common in that country.

2)Free cash flow – Almost all of my stocks pay dividends. I like it when companies pay me to own their stock. I don’t quite trust companies that want to keep everything for their own greedy managers. I know. I know. Start up technology stocks need to reinvest profits into new products, but when does it end? Apple has been around for about 30 years and they are still not paying a dividend, unacceptable.

3)Great management – A visionary leader and competent employees is the ideal but I would accept a high level of competence and energy in the workforce, anything but a bored bureaucratic management and a hostile workforce, GM comes to mind.

Then, of course, I look at the stock. My eyes are immediately drawn to three numbers on the financial Web page for that stock. These are somewhat related to the first list.

1)Price Earnings Ratio – Generally, I want this number to be 20 or lower. It is the price of a share of stock divided by the earnings for a share of stock. Historically, the PE ratio for the New York Stock Exchange averages around 16. A high PE number could indicate a stock that is overvalued. Again, this is not true for new companies, particularly in the pharmaceutical or technology areas. In such a case people are paying a premium for future earnings. Sometimes a company is losing money. Then it has no PE ratio. That is not a good thing.

2)Dividend and Yield – The dividend is simply how much the company gives you in a year for owning their stock. Let’s say the dividend or a particular company is $1.00per share. Now divide that number by the cost of a share, let’s say $25.00. The yield on this imaginary stock is 4%, a pretty good return. I tend to believe that a sustainable dividend kind of puts a floor under the value of a stock. This generally but not always true.

3)Free Cash Flow – Basically, FCF is the net profits minus the capital expenses, something like your take home salary minus the mortgage payment. I really like FCF because it pays dividends. It is nice to get 3% or more for my money without too much risk. These days I am barely paid anything for leaving money in the Credit Union. Another nice thing that companies do with FCF is stock buybacks. When the company is buying shares in its own stock that generally indicates the mangers think it is a bargain. When they are buying millions of shares this makes the price go up. Be careful, sometimes managers do this to hide some weaknesses that will ultimate doom the share price. (Note the quote at the beginning of this article.)

The knowledgeable reader will notice a glaring weakness in the last list, one that bites me from time to time. I tend to ignore growth. There is another ratio that should be in any quick look at a stock.

Price Earnings Growth – The PEG ratio is the PE ratio divided by the company’s growth percentage. Let’s say a company has a PE ratio of 20 and it has been growing at 10% per year and you expect it to continue to grow at that rate. The company has a PEG of 2. The lower the PEG ratio the more likely the stock is a bargain. As an engineer and an embittered old cynic, I have a problem with this number. I am very comfortable with interpolation, the art of taking two know points on a graph and estimating the value of an unknown point between the two known points. I am not so happy with extrapolation. A trend is a trend until it is no longer a trend. The line on a graph may be linear up to some point and then take a wicked curve in the opposite direction. When I plug a number into the denominator of the PEG ratio, do I use history and extrapolate, or do I just make a guess after looking into my crystal ball? Neither option appeals to me.

Back when I started learning how to invest, I bought a small amount or Merck, the drug company, at a little over $70 a share. Merck had a competitive advantage (valuable drug patents), plenty of free cash, and at the time it was considered the best managed company in the country if not the world. Merck had a low PE ratio and paid a righteous dividend. The knock on Merck at the time was growth was expected to be flat, as they did not have any new potential blockbuster drugs in their pipeline. I thought great management and scientists would take care of that problem. I was wrong. Merck continued to drop and I continued to hold. I thought it would come back but then the Vioxx class action lawsuits started and Merck fell from the sky like a wounded duck. Finally in disgust, I sold at a little over $30 a share. Merck paid a dividend every year I owned it. Just guessing, something like $1,000 or more over those years. During the time I owned the stock, Merck sold one of its divisions and I made something over $500 on that sale. So in reality I only lost a little over $2,000 and I got something like $500 back from Uncle Sam in the form of lower taxes, so my actual loss was something like $1,500 (plus the taxes I paid on the dividends).

The morals of this story? Dividends are like an umbrella. When the rains come they will help keep you dry but when Hurricane Katrina (the Vioxx lawsuits) hits a company, your little umbrella is going to be blown away. If you ignore growth and what the collective wisdom of the market believes about growth you better be very good or very lucky.

Lord Maynard Keynes once gave some advice to people like me who tend to be buy and hold investors. “In the long run, we are all dead.”

Hey! Let’s be careful out there.