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Articles tagged as

value stock

  • Signal from Noise
Nov 27, 2019

– Value Stocks Have Underperformed for Years; the Dream of Mean Reversion – Value Traps Camouflaged to Look Just Like Value Stocks but Get Cheaper and Cheaper – History Littered with Failed Turnarounds; Seven Simple Rules to Distinguish the Two The holiday season kicks off this week as consumers get ready to stampede for Black Friday shopping deals. Everyone wants bargains. Investors, too. Who doesn’t like a cheap stock? Diligent value discrimination is imperative this year, with the Standard & Poor’s 500 index up some 25% so far. The natural inclination is to go bargain hunting for cheap stocks, shares that have underperformed the rally. Some investors will find the siren’s song of “cheap” stocks irresistible, only to crash upon the “value trap” rocks. Second, value stocks have been outperformed by growth stocks for half a decade. (See nearby chart.) Since 2009, for example, the Russell 1000 Growth index (RLG) is up almost 80%, trouncing both the Russell 1000 Value index, up 28%, and the Standard& Poor’s index (SPX), up 53%. The dream of mean reversion says that after so many years, value stocks have to go up, right?  Some value stocks do, but some are value traps and just get cheaper and cheaper. Let’s define both. A value stock looks cheap on various historical valuation measures, such as a single-digit price/earnings ratio or a relatively low EV/Ebitda, or price to sales or book. Sometimes, it’s inexpensive because it belongs to an out of fashion sector (or region). Value stocks work when there is change: either the market decides the sector is more attractive, think crude stocks when oil prices rise, or there is some intrinsic and lasting earnings improvement in the company’s fundamentals. That’s a turnaround stock, and what investors hope for when they buy a value stock. The value trap can also be found in the value patch but it’s a camouflaged asset that looks cheap but whose price never returns to fair value. How does an investor distinguish the two? The following are rough and ready guidelines I use. They are not hard and fast, but the more boxes your value stock checks, the more likely it is a value trap. 1)  Value trap business models are structurally impaired long term and don’t look fixable.  Horse and buggies were disrupted by the combustion engine. Railroads by airlines, etc. The Internet has permanently damaged the traditional models in several sectors, newspapers, advertising, publishing, and retailing. Some, like Target (TGT) and Wal Mart Stores (WMT) are managing the challenge but others, like JC Penney (JCP), are floundering. 2)  Revenues and operating profits are flat or down three to five years or more. Operating margins drop consistently along with market share.  To the extent there is EPS growth, it’s increasingly supported by cost reductions and share buybacks. Think IBM (IBM), whose stock has been declining slowly for years, with EPS rising mainly on buybacks.    3) Promised changes don’t arrive and the company consistently misses goals.  Management is unwilling or unable to take the risk, due to weak resources or high leverage, of changing the model to meet the new paradigm.  Change costs money and big change costs lots of money. 4) High debt relative to cash flow or Ebitda. The company is unable to lower debt ratios and increase investment simultaneously. 5) No catalyst, whether for want of new products or services or a lack of activists who see enough value in the stock to effect change. But even activists don’t guarantee change. See Sears (S). 6) Value traps have trouble attracting CEOs. 7) One-trick pony. Over reliance on one or two products for the great majority of sales.  How crucial is the company’s product? If it magically disappeared tomorrow, would the world be able to exist without it? Jonathan Boyar, a principal at Boyar Value Group, says, “If you can’t point to something specific (in the way of a catalyst), it’s more likely you’re looking at a value trap than a solid investment opportunity.” Currently, he thinks CVS (CVS) is a value stock, not a value trap. The stock had dropped from $110 to $51 over the past four years, when Boyar identified it as a fallen angel, and since then it has recovered to $75.  It’s the dominant pharmacy chain in the industry (80% of the U.S. population lives within 10 miles of a CVS) with a 26% market share, and now also one of the largest health insurers and pharmacy benefit managers. It trades at a lower P/E multiple compared to its peers, a function of investor uncertainty regarding the impact of the merger, where CVS took on debt and made a large-scale strategy shift. Still it generates a healthy amount of free cash flow and expects to delever to around 3x net debt to Ebitda by 2020 (from around 5x end of 2018), Boyar points out. The Aetna acquisition provides a potential catalyst for CVS to join its peers in adopting a “captive pharmacy benefit manager” business. History is littered with turnarounds that were value traps: Eastman Kodak, Polaroid, Sears, Staples, etc.  These days there are questions as to whether Macy’s (M), Kraft (K) or Kohls (KSS) are value traps. Even Warren Buffett succumbed to a value trap: Tesco. Value traps are cheap stocks that stay cheap. Sometimes, it’s the expensive stocks that offer value. Prior “Signals” Date Topic Subject / Ticker The Signal 11/20/19 Stock Aaron’s (AAN) Roughed Up Aaron’s (AAN) Stock Looks Undervalued 11/13/19 Stock Bed Bath & Beyond (BBBY) Bed Bath & Beyond Fixable; More Best Buy Than Blockbuster 10/30/19 Stock GH Pharmaceuticals (GWPH) Undeservedly Caught Up in the Volatile Marijuana Stock Fad 10/23/19 Stock Sherwin Williams (SHW) Sherwin Williams Paints a Pretty Profile 10/16/19 Stock Eyepoint (EYPT), Sonova (SONVY) Both cater to the increasing vision, hearing needs of seniors 10/9/19 Stock Skechers U.S.A (SKX) Volatile Skechers stock could be ready to roll higher 10/2/19 Stock Arcos Dorados (ARCO) Arcos Dorados Shares Undervalued; Turnaround In Sight 9/25/19 Stock Peloton (PTON) Peloton IPO Offers Growth, Scarcity Value—For Now 9/18/19 Stock Oshkosh (OSK) For investors with a long term horizon, OSK looks cheap. 9/5/19 Market BBB bond mkt implosion overdone Don’t sweat the BBB market so long as market chugs along 8/29/19 Industry Soybean/Tariff Impact on Trump 2020 If tariff wars continue, auto – not farm – states could hurt Trump 8/21/19 Stock We Co. (WE) Fast growing company but poor governance 8/14/19 Market M&A to Accelerate? Ultra-low rates could spur accelerated M&A 8/7/19 Stock Caterpillar (CAT) Cyclical stock could benefit from recovering growth 7/24/19 Stock Mowi (MHGVY) Salmon fish farmer could benefit from BYND trends 7/17/19 Market Earnings Recession Look Through the EPS Recession to 2020 EPS

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