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Limiting Downside Risk by Learning How to Identify Value Traps

As value investors, our main goal is to find a company trading at a discount to its intrinsic value. Out-performance and a sufficient margin of safety can only be established through this search of value. It’s basic buy low, sell high.

However, looking for an opportunity such as this tends to attract stocks that are trading at a discount for a good reason. The presence of a value trap can ensnare investors, and lead otherwise profitable strategies into turbulent waters.

limiting downside risk

Downside risk management is an often overlooked aspect of the investing world, and it entails more than just a simple diversification solution. Every investor must face the same simple fact. An individual position that records a loss must often gain a much higher percentage return in order to break even.

For example, a 10% loss on a stock requires a subsequent 11% gain in order to break even. The discrepancy raises as the losses become bigger. A much larger 50% loss requires a full 100% gain to break even, and a 75% loss requires 300% returns to break even.

As we can see, the presence of substantial losses, or drawdowns, in our portfolio greatly hinders our ability to create an outperforming portfolio. The simple principles of mathematics thus make losses more substantial than gains, and force an investor to focus more on limiting losses than maximizing gains. At least an intelligent investor would do such a thing. It turns out, this reverse focus mindset fares very well in other competitive fields.

One of the great chess masters recently shared that his secret to success lies in a reverse focus mindset. While most other chess players focus their energy on the opening strategy, this chess master studied the end game instead.

He soon discovered that no matter which ending scenario the game turned to, he was able to adapt and dominate his opponent through his sheer mastery of the end game. He went on to become one of the greatest chess players of his time.

Investors can also study the “end game” of an investment, as it pertains to a value trap or value opportunity. At the end of the day, a stock has two possibilities. One is that it continues to be traded on the exchange and life goes on.

The second possibility is that a stock goes bankrupt. It is this second possibility that disturbs me the most, and is most detrimental to a successful value investing strategy. The gain required on a 100% loss is infinite. That’s money that is lost forever. As you might already know, some of the best looking opportunities are actually value traps, and it’s a value trap that turns into a bankruptcy that causes the most damage.

Looking back at some of the most shocking bankruptcies of the past, I was able to quickly comprehend just how deceiving a value trap can be. In late 2008, Lehman Brothers seemed to be a fine value play through many income statement valuations, with a P/E below 15 and a P/B below 2. In the same token, a company like Borders looked like a strong value play to some narrow minded investors, who saw the consecutive dividend increases and low price to book valuations as signs of a strong opportunity for profits.

Instead, both companies went bankrupt. An investor who faced these losses also had to face the prospect that this kind of a scenario could happen again, without warning or insight.

Yet a prudent investor would look at these situations as opportunity for learning. While these companies looked attractive on the basis of a few select valuations, a bigger picture analysis would uncover that Lehman Brothers also carried a debt to equity of 29, and Borders had recorded negative earnings for over four years.

If we were to look at other value trap bankruptcies, we’d hope to find predictable symptoms that show that these deceitful traps are actually easily avoidable if you know where to look. 

Value Trap Research Results

Turns out, this is exactly what I’ve found. Knowing that the value investor’s greatest threat is a value trap, I took a backwards approach and tried to study the worst case scenario of any investment: the bankruptcy. By examining the 30 biggest bankruptcies of the 21st century, I was able to discover that not only are value traps quite predictable, but many of the bankruptcies had the same symptoms. If we know the symptoms of bankruptcy, we can greatly reduce exposure to them.

With this valuable information, I took the most common symptoms and formulated a number based indicator to decipher value situations. By looking at all three financial statements, the income statement, balance sheet, and cash flow statement, I pulled the most important valuations from each and incorporated them into the indicator. This had the net effect of flagging any company that had even one poor valuation metric. This might seem like a strict condition, but consider how just one valuation tipped investors off to Lehman Brothers’ perilous situation.

With a solid foundation of seven categories, and a wide coverage of the most important and bankruptcy predictive valuations, the Value Trap Indicator would’ve avoided 29 of the 30 bankruptcies examined, a full 96% accuracy rate.

The information from the bankruptcy research clearly identified the two biggest possibilities of a value trap turning insolvent. These were the presence of negative earnings (annual), and a high debt to equity relative to the average.

The average debt to equity of any stock on the major exchanges is usually around 1. Any company with a much higher debt to equity ratio was increasingly at risk to bankruptcy, as was a company with a combination of negative earnings and higher debt to equity.

So by avoiding these situations, a value investor can greatly increase overall return and limit major drawdowns. This has the double effect of keeping an investor in the companies that are profitable and successful, thus increasing probability for out-performance by principle as well.

Do not underestimate the destructive power of downside risk and the value trap. Learn how to avoid exposure to them. Research and personal experience help, but a reverse focus mindset and an outside-of-the-box approach fares much better.

Downside Risk from “Hot Stocks”

In 2014, Twitter violently lost -17.90% in a single after hours trading session. What caused this? According to mainstream media, the decline was due to weak user growth and lower than expected timeline views.

If you are wondering how you are supposed to know why these numbers were relevant, don’t worry as you aren’t alone.

There’s a problem with the hottest stocks of today, and it’s the same problem that has hurt hot stocks in the past. When a stock earns itself a trendy and shareable story, it tends to invent measuring techniques along with it.

While this may seem favorable at first, in reality these innovative measurements contribute to the downfall of the company.

Think for a second about what would happen if we did this in other fields. What if we were constantly inventing how to measure sports players?

Like for the game of football. We know that the 40 yard dash is a very reliable tool to understand if a player is quick. But what if we just invented new speed measurements?

You can’t compare one player to another unless you are using the same measurements. As soon as you start getting creative– like instead measuring an 80 yard dash for a player, or how fast he can run home and back, or even how many feet the sun falls as a player runs 300 steps– you lose the ability to understand if the player is quick or not.

Yet it is the exact same in the stock market, but no one understands how silly these vain metrics are.

The Hot Stock from Two Decades Ago

If you don’t believe me, I want to introduce you to a stock that was very similar to the popular Twitter stock. It was called Pets.com, and it was revolutionary in its time (during the late 90s and early 2000s). You see, Amazon was just starting to gain traction, and all other internet based stocks were gaining vast attention.

It became clear to the world that internet was a groundbreaking innovation, but not just because it made communication easier. No, it also made commerce easier, and it opened up a whole new world of possibilities and profits.

You might remember this period as the dot com boom. Any stock that had a .com at the end of its name was instantly popular, and instantly rose in share price.

internet bubble stocks

If you don’t remember, you can’t truly understand what was going on at that time. People were making fortunes on Wall Street. It was as easy as buying some internet stocks.

And Pets.com was the one of the leaders of its time. The mainstream media was calling this period the “new economy”, and bidding up internet stocks to absurd valuations.

Nobody cared how expensive these stocks got, or that these stocks didn’t have real earnings. It didn’t matter because the speculators were profiting, and the party just kept on rolling.

But of course as we know now, the party eventually stopped. What did Pets.com investors learn? At the time, nobody thought that it was strange that people were basing their stock buying decisions on invented metrics such as “clicks and views.”

Remember this was the “new economy”, and so traditional valuations such as price to earnings (P/E) or earnings growth didn’t “matter”. Instead, “experts” were speculating based on the amount of page views the website was getting.

They were doing this with all different kinds of internet stocks. In their minds, they saw the exponential growth of Moore’s Law and thought it would apply to the earnings, even when they weren’t there. It was widely accepted that page views would eventually mean higher profitability– even if this didn’t happen, someone else would buy the stock from you at a higher price, because it was “always going up.”

Pets.com learned the hard way what happens when you invent metrics. The business world is ruthless in that it doesn’t care what the stories are, a company with poor cash-flow will go bankrupt. Sure enough, Pets.com went bankrupt.

Hot Stock Metrics are Useless

The thing you should learn is that user growth shouldn’t mean anything to investors. Timeline views are a joke metric. Do you think we should examine the user growth of an oil company, or the website views of a bakery?

Of course that is ridiculous, but still TWTR analysts use these. When you are considering investing in a business, you must use business metrics.

All businesses have the following in common: profit, assets, and liabilities.

All of the other metrics used to measure businesses evolve from these standard 3. Profit is the single most important metric, it’s why they call it the bottom line.

Until a company can prove itself profitable, then you are essentially gambling on its success. When you invest in companies, you want part of the profits returned to you and in a way that is sustainable for the future. Many debt fueled growth stories fizzle out quickly.

What did hot stock Twitter look like according to business metrics?
Well, -$142 million in earnings, -0.38 in book value.

The negative book value means that the company currently has more liabilities than assets on its balance sheet. I hope you don’t need a business course to understand that isn’t sustainable.

The company is losing money also, so how is that picture going to get any better? Earnings could improve eventually, but does that make you an investor or a gambler?

There is a difference between chasing a hot stock and wisely investing your money. Big difference. Just ask all the previous shareholders of Pets.com.

Remember: A stock can be struggling or its popularity could be through the roof… but only by reviewing all aspects of the annual reports will you limit the downside risk of the investment. Whether you use a tool like the Value Trap Indicator or learn how comb the annual reports yourself, you owe it to your future to master this skill.