When Value Goes Wrong
At some point in just about everyone’s investing journey, the prospect of finding companies orphaned by the market becomes an interesting idea. The definition of orphaned can vary—it could represent a stock with an abnormally low price-to-earnings ratio, or a stock consistently making 52-week lows. Value investors find orphaned stocks particularly interesting because while the market has a habit of over-buying good news, it also tends to over-sell bad news, creating a situation where companies with otherwise fine business models are stuck in the doldrums.
Finding a company in the trough of its business cycle or that is looking to shed a plethora of bad news can be profitable—over time, the market is a weighing machine and good businesses will eventually rise to the surface. This process, of course, takes time. Here’s a bit from Joel Greenblatt’s course he taught at Columbia that illustrates the point perfectly:
If you do good valuation work and you are right, Mr. Market will pay you back. In the short term, one to two years, the market is inefficient. But in the long-term, the market has to get it right—it will pay you back in two to three years. Keep that in mind when you do your analysis. You don’t have to look at the next quarter, the next six months, if you do good valuation work.
Greenblatt, in my opinion, is spot on here. But, alas, sometimes we will inevitably get it wrong, and the company that we were hoping would pull out of its nosedive never quite seems to get it right. Despite this, investors hang on, hoping that management will come around and either develop a new plan or deliver on an old one. This is known as a value trap: a cheap company that, in all likelihood, deserves to be cheap, or which has re-rated lower for a good reason.
In this article, I’ll pick apart some of the things that lead investors to value traps and how they can be avoided. Let’s get to it!
1. Don’t Lean On Screens
The explosion of market data has been an enormous positive over the years. You can find just about anything you want on any public company at any time. And so, as much of a positive as this information can be, it is often a negative for investors who find themselves overwhelmed by the sheer volume of data available.
Running screens on stocks, then, is one of the most popular idea-generation tools out there. For value investors, however, it’s a lot less helpful than I think many imagine. This is because, even though the market sometimes gets things wrong, it very, very often gets things right. More often than not, screening for value stocks will yield a lot of fool’s gold.
True value situations will show up in screens, but it’s often a needle-in-a-haystack situation trying to find them. Why? Because there are a lot of bad companies out there, and only a few that possess actual value not indicated by the stock price.
Don’t get me wrong—screening for ideas is a valuable tool. It’s the overreliance on them that gets investors into trouble.
As an example, consider this scatterplot of stocks in the S&P 500 SPY 0.00%↑ with a market cap under $75 billion and a forward P/E under 10x.
If this were the screen of choice (not recommended), a novice investor might say, “Wow! Viatris VTRS 0.00%↑, NRG NRG 0.00%↑, United Airlines UAL 0.00%↑, and GM GM 0.00%↑ all look pretty cheap. I bet they can’t stay that way forever, this screen saved me a lot of work.”1
Meanwhile, a more seasoned investor might look at this screen and say, “Wow, my workload just increased exponentially” because a lot (a lot!) of work must be done to determine if any actual value situation exists in this screen.
And no, this isn’t exactly intuitive stuff. Growth stocks, for example, lend themselves to screening: the primary driver (growth!) is easily quantified. But value, on the other hand, often escapes the kind of quantification you can capture in a screen.
2. Find A Clear Catalyst
Left to their own devices, stocks don’t do much. They bounce a bit, sure, but every meaningful move in a stock—up or down—is typically the result of something. A catalyst.
To paraphrase Newton, a stock at rest stays at rest.
Cheapness alone will not generally move a stock.2 A fatal mistake often made by those who find themselves stuck in value traps is the fact that their idea lacks a clear catalyst. Even worse, however, is a value trap investment with a vague or imaginary catalyst (these often take the form of promises by management teams who habitually kick the can down the road or move the goalposts).
For some stocks, catalysts are clear—biopharmaceuticals and drug companies are some of the clearest examples of this. When a drug is approved or a key trial hurdle is passed, the stock typically reacts in a big way. But outside of that, most catalysts are not immediately apparent.
Let’s consider a high-profile example of a depressed stock and a catalyst that worked to re-rate it in short fashion.
Towards the end of 2021, Facebook META 0.00%↑ announced it would be deploying (read: incinerating) a lot of capital into something called the Metaverse. This new project was supposed to revolutionize everything about social media, so much so that the name of the company was changed to Meta.
The Metaverse was… not received well. Further hurting the company, Apple AAPL 0.00%↑ ratcheted up its efforts to give consumers a bit more control of the data they hand off to advertisers—a direct threat to the lodestar of Facebook’s (sorry, Meta’s) business.
On the back of these two problems (and CEO Mark Zuckerberg’s insistence on subsequent earnings calls that the Metaverse would continue being fed cash) Meta stock tumbled. Investors pleaded with Zuckerberg to abandon the costly venture, to no avail.
But then, a subtle pivot came in the form of a remark made by Zuckerberg (and on the heels of leaked employee gossip and emails that Meta would be trimming its workforce and getting leaner)—in the Q4 2022 conference call held on February 1st, 2023, Zuckerberg relegated the Metaverse to the backseat of Meta’s priorities.
In the year between the announcement of the first large Reality Labs (the business segment housing the Metaverse) operating loss and Zuckerberg’s shift away, Meta’s stock languished. The stock’s price to earnings fell substantially, from roughly 25x earnings at the end of 2021 to nearly 12x by November 2022.
And yes, I understand that Facebook may not be a model value stock—but it is a stock with at least one clear catalyst and one that was visible for investors paying attention (I’m not just saying that you can read the article I wrote on Meta in March 2023 on Seeking Alpha here).
Once again, a stock at rest stays at rest. A few catalysts investors can be on the lookout for include:
Comments from management around forward guidance. Management will sometimes stomp their feet on conference calls about upcoming tailwinds, but because these aren’t numbers that can be crunched and screened for by a computer they are often overlooked except for by those willing to read the transcripts.
Mean reversion on margins. Very often stocks are beaten down by headwinds that compress the company’s various profit margins. These headwinds are often temporary. Diving into what could cause margins to revert could uncover powerful catalysts.
Subtle accounting changes. I hesitate to put this one here since it’s a bit of a head fake management teams can play with the numbers, but small accounting changes can impact profits down the line. Taking these in the context of the larger business picture and not relying on them solely is key. An example of this kind of change would be Google’s GOOG 0.00%↑ GOOGL 0.00%↑ extension of the useful life of its servers and other equipment (page 40 of the company’s 2022 10K) resulted in an estimated $3.4 billion tailwind to the bottom line for 2023.
3. Don’t Buy The Story
When you write about stocks, you get a lot of… unsolicited feedback. In my experience, none of the clanging voices have been so vociferous as those who have clung to a value trap, fully confident in the hope that things will turn around. Why? More often than not, it’s because management said so!
Take Hanesbrands HBI 0.00%↑, for example. In March 2023 I wrote an article on Seeking Alpha (which you can read here) in which I was pessimistic about the outlook of the company due to a burdensome debt load and what I perceived as a bit of goalpost-shifting from management.
In 2021, Hanesbrands announced an initiative called the Full Potential plan, which was a roadmap to re-invigorate the child brands of the company. Fast forward to 2023, and the company pushed its revenue target of $8 billion from 2024 to 2026. On top of that, the company entered into amended covenants with creditors for its Senior Secured Debt Facility as the capital ratios required by the original covenants soured.
The pushback was steady from those who were long the stock, mostly on the basis that amending the covenants was a shrewd move by management.3 One commenter even said I was implying the company was set for bankruptcy (I wasn’t). Whatever the pushback, the fact remained that multiple folks (presumably with money in the stock) reviewed at least some of the information I had reviewed (again, presumably) and came to very different conclusions.
So how does this happen? The answer, in my opinion, is that many times investors become married to the story of a stock. More to the point, investors get married to the story told by management and lose the bit of adversarial edge that investors need to maintain to hold some degree of objectivity.
Consider, for example, if you were to give your shifty, layabout uncle $1,000 for equity in his new business venture.4 As an investor, and somebody intimately familiar with his past shenanigans, you are likely to treat his claims that things are going GREAT! with a healthy degree of skepticism.
Now consider the fact that you’ve invested in a company with a management team you don’t know from Adam—how likely could it be that the folks overseeing your equity investment aren’t cut from the same cloth as your uncle, who are just looking to make a buck for themselves and move on?
I have written before about how investors should view management teams generally (I’ll link below). It never ceases to amaze me that folks can be willing to invest in a company on a whim with a management team they know nothing about, and accept their pronouncements more or less blindly, while at the same time the equity investment with their uncle would raise the hair on the backs of their necks. Here’s the thing: you might as well invest with your uncle if you aren’t willing to interrogate management’s statements for accuracy and consistency. At least you’ll be able to follow up with him directly!
Anyway, the moral of the story is: don’t buy the story. Investigate the story. Poke holes in the story. See if you can falsify the story. Only when you do that will you have a hope of remaining objective.
Further Reading…
Dislcaimer: Nothing in this post is investment advice or should be construed as such. Please do your own due diligence and consult with a financial advisor before making any financial or investment decisions. This is purely a work of opinion and entertainment.
Hopefully no one, even novice investors, takes an approach this simplistic to analyzing investment options.
To be fair, in some outlier situations, it sometimes can. But that’s for another time.
And, sure, management deserves credit for attempting to work out the situation, but do we applaud an arsonist for extinguishing a fire? (I am not calling management arsonists. I digress.)
I don’t know why you would do this, but hey, let’s go with it.