Laguna Niguel, CA

Sunday, June 03, 2012

Value trap or investment opportunity that is the question that investors must answer in order for them to be successful. Perry Como once sang to us about catching a falling star and putting it in our pocket. Wall Street has an adage that cautions against catching a falling knife. While most of us are not Warren Buffett who has made himself one of the world's richest people by seeing diamonds that others see as coal, there is hope for the rest of us mere mortals.

One of the common methods of identifying a value stock is to compare current valuations such as price to earnings, price to book, and price to free cash flow ratios as well as return on equity, dividend yield, return on assets etc. The key assumption upon which this approach is based upon is that past performance is somehow useful in predicting future results. Yet this is in direct conflict with Wall Street cautioning us, in small print, that past performance is not indicative of future results. So one must ask him/herself which is correct.  The answer is it all depends. Before answering this question, it would be instructive to examine a real example.  With this in mind, let us go back to those thrilling days of yesteryear before the collapse of Lehman Bros, Washington Mutual, Bear Stearns, et al. In 2008, all of these aforementioned banks as well as surviving banks such as J.P. Morgan Chase, Bank of America, Citigroup, etc. were selling at multi year low valuations. Yet those that perished, as well as those that did survive, saw their valuation ratios soar as their earnings disappeared and the price of their stock fell to historic lows. Even industry stalwarts such as Goldman Sachs were not immune to this phenomenon.  Clearly, at that time banking stocks represented a value trap, i.e., what appeared to represent values were truly not a bargain. They represented generational opportunities to lose money. In fact their shares still sell at levels far below the onset of the financial crisis.

During this time of turmoil in the financial markets, the price of Apple Computer's stock was less than $100. It recently closed at nearly $600 per share. By any measure an investment in Apple would have represented an opportunity of a lifetime. During this same timeframe, the price of Google's stock price doubled from $300 to $600 per share.

What differentiates the losers (banks) from the winners (technology companies) is their strategic positioning. Banks were adversely affected by their strategy of securitizing the mortgages that they had underwritten without regard to the credit worthiness of the borrower. The prevailing sentiment was that real estate prices only increased and the borrowers would ultimately be able to afford the payments or sell their houses at a profit. When home prices declined and the underlying mortgages exceeded the value of the properties, banks were forced to recognize losses on their mortgage portfolios.  While banks suffered, the aforementioned technology companies prospered. The reason being that they were able to introduce products that were enthusiastically embraced by their customers despite the recessionary environment.

So how does an investor separate the wheat from the chaff?  The answer depends on three issues:

1. Is the company strategically positioned to succeed given the macroeconomic, geopolitical, and competitive environment in which it operates? If the answer is not affirmative, then any investment would be questionable
2. Has the company demonstrated an ability to execute its strategy? If the company has not been able to operate profitably, one must understand what has changed that would allow it to succeed
3. What price is appropriate for a potential investment? The strategy may be right, the company may have demonstrated an ability to execute its strategy, but the price may not warrant an investment

 Fortunately, there is a methodology, Stratamentical Analysis which was first introduced in "A Common Sense Approach to Successful Investing," that provides the framework for determining whether a company's past performance is indicative of future results.

 

About the Author

Experienced as a registered representative, an individual investor and a management consultant to Fortune 500 companies, Doniger has developed his perspectives on the economy from a lifetime of smart investments. His other books are Common Sense Prescriptions for Financial Health, Improving Your Quaestrology which presents quaestrology, a unique perspective on managing one's finance and Common Sense Road Map to Uncommon Wealth which describes steps to take in managing your career and saving for retirement. He is also a regular guest on the Business Talk Radio Network and other radio shows. His articles have been published in media outlets such as Investor's Digest of Canada and Morningstar.

Marvin H. Doniger

Doniger & Associates

Laguna Niguel, CA

949-661-5456