Characteristics of Value Stocks & Value Traps

November 7, 2012 | Comments (5)

Written by

Jae Jun

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Can we Boil Down Value Traps Into a Number of Characteristics?

Vitaliy Katsenelson, author of Active Value Investing, and creator of the Katsenelson Absolute PE valuation model, hosts a conference called VALUEx.

In June, Jim Chanos, legendary short seller, gave a presentation on the topic of value stocks and value traps which I wanted to highlight.

Value Stocks: Definitive Traits

  • Predictable, consistent cash flow
  • Defensive and/or defensible business
  • Not dependent on superior management
  • Low/reasonable valuation
  • Margin of safety using many metrics
  • Reliable, transparent financial statements

Do these 6 points remind you of somebody who said similar things?

For me, Buffett came first to mind.

Buffett has preached about cash generating companies, companies with a wide moat, a business where any dummy can run it, cheap or fair price for a great company, seek margin of safety and clean accounting.

These six points succinctly define great companies at cheap to fair prices.

Companies like IBM, Waste Management (WM), Wal-Mart (WMT), Microsoft (MSFT) fit the description.

Value Traps: Some Common Characteristics

  • Cyclical and/or overly dependent on one product
  • Hindsight drives expectations
  • Marquis management and/or famous investor(s)
  • Appears cheap using management’s metric
  • Accounting issues

Note that these are just some common characteristics and not everything can be boiled down to five characteristics.

But if you read some books and case studies on short selling such as The Art of Short Selling, you will realize that some of the five themes do come up often.

Of particular interest to me is the third point about famous investors which is not something I had considered.

It reminds me this particular bias and how easily we can get fooled by following smart money too.

Skill bias
When education and training causes confidence to increase faster than ability.

The best example is the hedge fund Long Term Capital Management. Staffed thick with PhDs and two Nobel laureates, the fund exploded in 1998 under an incomprehensible amount of leverage. Behind the failure was raging overconfidence. “The young geniuses from academe felt they could do no wrong,” Roger Lowenstein wrote in the book When Genius Failed.

Warren Buffett said this about the firm’s sixteen-person management team:

They probably have as high an average IQ as any sixteen people working together in one business in the country … just an incredible amount of intellect in that group. Now you combine that with the fact that those sixteen had extensive experience in the field they were operating in … in aggregate, the sixteen probably had 350 or 400 years of experience doing exactly what they were doing. And then you throw in the third factor: that most of them had virtually all of their very substantial net worths in the business …And essentially they went broke. That to me is absolutely fascinating.

Coinstar (CSTR) Being Shorted by Chanos

The reason why I’m writing this post in the first place, is because I was looking at Coinstar (CSTR) and Chanos’s short position was what caught my eye.

As I was briefly glancing through the numbers, Coinstar is at very attractive valuation levels.

Check out some of the numbers below taken from the stock valuation and analysis spreadsheets.

value traps

Values traps in the numbers?

Numbers look great, but I’m not convinced about the business model.

Majority of the revenue comes from Redbox kiosks, but how long will DVD distribution last in a world where everything is going digital and devices make it easier to consume digital content?

I won’t get into a full stock analysis, but the short seller’s analytical method of trying to find how and why an investment will break sure is interesting and brings a completely different perspective to your analysis. Could this be one of the value traps?

I’ll let you enjoy the details of Chanos’ shorting positions and reasons from his presentation.

Disclosure

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