“But I’m just a soul whose intentions are good, Oh Lord, please don’t let me be misunderstood” –Nina Simone
If you’re reading this, you’ve either already purchased the Value Trap Indicator or are thinking of purchasing it.
I want to clear things up about the tool, because in the 5+ years I’ve made it available to the public I’ve seen (well-intentioned) misconceptions about how to use it to make the most of it to find great investments in the stock market.
The two biggest pieces of feedback I’ve received include: (1) The VTI has helped me finally understand financial statements (2) Here’s stock A that has a great VTI, isn’t it an obvious buy…
As I’ve gained experience using the VTI with every stock I’ve purchased since 2014, and have learned what makes it great and when it’s not so great, I’ve come to the conclusion that some of the (2) type feedback has led people to companies that aren’t so great.
That’s not anyone else’s fault but my own, because I obviously haven’t simplified this process enough, yet.
Hopefully this post clears it up, and makes the VTI one of the best investments you ever make.
I want to cover these 3 main topics, and it’s critical you read all 3 before digging into the VTI. This should take only about 15 minutes of your time, which I believe is well worth unlocking the best potential you can from this unique stock analysis tool.
- What the Value Trap Indicator Is
- How I Would Apply the VTI if I Were You
- How to Input Data from a 10-k into the VTI Spreadsheet
The Mission of the VTI; What It Is
First and foremost, the mission of the Value Trap Indicator was to help investors protect their hard earned money from the worst investments in the stock market.
In other words, value traps.
There’s many reasons why avoiding losses is critical to great long term returns.
Among the biggest ones… the math. Take $100. Say you lose 20%; you’re down to $80. In order to get back to $100, you don’t have to make 20%, you have to make 25% ($80 * 1.25 = 100. Said another way: 25% of $80 = $20, $80 + $20 = $100).
This is because losses in the stock market (or “drawdowns”) are worse for return than gains are.
It all has to do with the math behind compounding and returns; there’s no way getting around that.
“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No.1”–Warren Buffett
In the quest to reduce investment losses, we have to flip the script and consider the worst possible case for a stock investment.
That is, the stock going bankrupt. Us losing 100% of our investment.
Charlie Munger elegantly describes this flipping the script as “inversion”, where you consider the opposite side of a problem (losses) instead of only the one side (gains).
Or as Charlie quips “All I want to know is where I’m going to die, so I’ll never go there.”
The VTI as a Bankrutpcy Indicator
This is where the Value Trap Indicator comes in.
When I first came up with the idea of the VTI, I decided to invert stock investments and heavily research as many big bankruptcies I could find.
This led to me researching the top 30 biggest bankruptcies of the 2000s and 2010s, and resulted in the first versions of the Value Trap Indicator.
Basically, the overwhelming common “red flag” of an impeding bankruptcy was negative earnings. And, companies with high debt to equity were also common among the list.
So in the first versions of the VTI, negative earnings and high debt to equity had a large influence on the final result, i.e. Strong Buy, Hold, or Strong Sell.
The VTI as a Valuation Tool
History has also shown that companies with high valuations—such as high P/E ratios, P/S ratios, and P/B ratios—have historically underperformed in many time periods, especially after a bull market turns into a bear market.
One of the best books which clearly showed this over a very long time period was James O’Shaughnessy’s book What Works on Wall Street.
Merrill Lynch also had a popular study going back to the early 1900s showing value stocks trumping growth stocks over the very long term.
Naturally then, these studies suggest that buying high price-ratio stocks can lead to big losses, as they have. So it makes sense to include them in a tool like the Value Trap Indicator which is trying to limit big losses, and ratios like these were a part of the VTI all through v6.0.
But there are some key details about these studies, and other similar ones, which determine whether an investor is likely to receive this outperformance or not—and it has to do with investor behavior. If that behavior doesn’t align with your long term strategy or values, you’re probably going to run into trouble.
Deep Value versus LT Margin of Safety
The key detail of those studies was the following:
- You had to buy and sell these value stocks in a one year period!
Buying low P/E, P/S, P/B, and other traditional value-type stocks can work so well because of the concept of mean reversion.
In other words, the stock market is extremely emotional and can severely undervalue and overvalue stocks at a whim. The legendary teacher from Columbia Business School Benjamin Graham affably referred to this phenomenon as “Mr. Market”.
So as an investor, if you can buy stocks where Wall Street is overly pessimistic on the company, you can gain great benefits from the stock eventually losing that pessimism and trading closer to what the company is really worth.
This is called mean reversion.
And most mean reversion tends to happen in a very short time period, within 6-12 months, which is why to capture the gains from mean reversion you must sell within this short time period and move on to the next value opportunities.
On average, the math bears out that this has worked more often than not for many time periods.
The essence of this strategy and investor behavior is called “deep value” investing.
Long Term Value Investing
The flip side of deep value is the “margin of safety” concept.
For a long term investor looking to let a company compound their capital and grow over time, this means having a “margin of safety” on how you think that company will grow.
If you buy a stock and there’s no mean reversion, its P/E stays constant over the time you hold it, then your gains from this stock will equal the growth rate for the company.
In other words, if you buy a stock at a P/E of 35 and it grows at 15% per year, you will earn 15% per year on your investment if the P/E stays at 35.
That’s also simple math.
But the problem that growth investors get into is that a company’s P/E doesn’t tend to stay high forever. In fact, the longer a company sticks around, the closer to the (stock market) average P/E the company will tend to fall to.
When a stock’s P/E falls, investors will see losses if earnings stay flat. If the company doesn’t grow earnings enough to outpace this contraction in P/E, then the investment will lose money by this amount.
A falling P/E which started high tends to happen with stocks where the market is too overly optimistic—this is the double edged sword of mean reversion.
Mean reversion says that eventually, the emotions, positive or negative, tend to fade away.
That’s why margin of safety helps an investor limit losses.
If you can limit the losses which come from mean reversion when stocks are priced too overly optimistically, then you can limit the probability of lots of losses.
To be an effective value investor, you have to choose:
- Am I going to implement a deep value approach?
- Am I going to take a more buy and hold approach?
The answer to that question determines how you should probably use the VTI; let’s cover that next.
How I Would Apply the VTI if I Were You: Pick Your Side
Remember the key differences between deep value and long term margin of safety.
Deep value relies on buying low P/E, P/B, or P/S stocks, buying lots of them, and capturing that short term gain that they will, on average, return.
Because another key part of deep value is heavy diversification.
Even Benjamin Graham used 50+ stocks in his portfolio when he implemented his deep value approach. And the reason you diversify so heavily is because many of these deep value stocks can end up being poor investments because they are usually bad companies, so you need lots of stocks to mitigate that risk.
All of the academic studies on deep value investing shows that low price-based stocks preform well on average, but there’s huge swings within those averages.
So you have to tread carefully.
If you’re going to take a long term, buy and hold approach, you don’t need as much diversification if you’re selecting great companies which will continue to grow over time.
The problem is that great companies tend to be more expensive in the market, of course, so it’s much harder to find these at cheap prices.
But when you do find these companies trading at decent prices, it’s a good idea to make more significant investments with them, and then let them do their thing over the long term.
The problem there is that selecting great companies isn’t as easy as it sounds.
That’s why you need a margin of safety, so if you pick just a good or decent company instead of a great one you can still get decent returns.
In the world of stock picking, that means buying growing companies at reasonable prices instead of overly expensive ones.
VTI version 6 (deep value) vs VTI version 7 (margin of safety)
It turns out that earlier versions of the VTI, all the way up to v6.0, are great for investors looking to take a deep value approach because the formula will filter out many of the more expensive stocks.
A stock has to be cheap, pretty much dirt cheap, in order to come out as a VTI v6.0 Strong Buy.
That’s great for investors looking to buy dirt cheap, but will put you into lots of companies that either aren’t growing much or probably won’t grow much.
If you’re playing the mean reversion game, that whole growth thing doesn’t matter too much because you are flipping these stocks and are on to the next one every year.
With the VTI v7.0 update, I realized that this price-based filtering isn’t always the best for finding great long term investments, because it’s rare for great companies to also be dirt cheap.
So that’s why I removed price-based ratios in the v7.0 update.
This was based on an extensive backtest I ran (over 4,000 stocks over 15 years). Turns out that the price-based strategy wasn’t the greatest for this time period.
Granted this backtest takes place when growth stocks have trumped value stocks, but I’d rather have a strategy that aligns with my values regardless of whether growth or value happens to be outperforming.
For my own investing, I had to decide whether the deep value approach resonated more with what I was trying to do, or whether the long term margin of safety approach was better for that. I chose the long term margin of safety, and that meant removing some of the filters which only work to help you find dirt cheap stocks.
After running backtest after backtest, I finally found a revision to the formula which would still keep me from stocks that were statistically likely to underperform, while not excluding some of the great growth companies which could’ve traded at decent valuations at one time or the other (read more about the results of the backtest here).
Turns out, you see trouble in the balance sheet more often than not.
Basically, when stocks either had positive earnings which turned to negative earnings, or when stocks had a Debt to Equity that significantly increased (15% or more), then stocks tended to underperform the average stock market for periods up to the next 1-5 years.
That key finding is what makes the Value Trap Indicator v7 so special.
What’s difficult about the reality of the update is that now we can’t rely solely on simple price-based metrics to find value; we have to find a margin of safety outside of just a low P/E.
Using VTI v7: Estimate a Growth Rate, Keep a Margin of Safety
Since I’m blessed to be researching stocks as my full-time occupation for subscribers of The Sather Research eLetter, I can dive really deep into lots of different companies to understand their business model, and more intelligently filter between the good companies and the great companies.
At the end of the day, finding that margin of safety means identifying those companies with the strongest competitive advantages, or “moats”, and buying them at reasonable prices.
Growth is an unavoidable component of value investing, even Warren Buffett said it himself:
“In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.“
But I understand that many VTI spreadsheet clients don’t have the same luxury as I do; trust me, I was there myself.
The key to using the VTI v7 and finding success is to incorporate growth into your valuation, and keep a margin of safety into that growth estimate.
One brilliant way to do this is with the PEG ratio, popularized by Peter Lynch.
I want to take that one step further. Call it, the Safety 1st PEG. This ratio forces you to estimate your own growth rate rather than simply taking a past growth rate and projecting it into the future, I wrote some thoughts about this sort of a modified PEG ratio here.
VTI v7.2 and the Safety 1st PEG
I also included a version of the PEG ratio to be automatically calculated when you fill out the VTI spreadsheet as another way to track a company’s potential value compared to its growth, but you don’t have to force yourself to use it.
That’s the beauty of VTI v7; the formula no longer considers deep value metrics and also doesn’t give you any Strong Buy signals.
Instead, it tells you what to avoid, a Value Trap Indicator instead of a “What to Buy” Indicator.
The question of what to buy shouldn’t come down to only the numbers if you’re taking a long term margin of safety approach like I am, unless you’re churning lots of stocks with deep value.
There’s more to a long term investing process that I recommend you learn over time, especially starting with these four resources:
Why the Focus on P/E and PEG rather than P/B or P/S
- IFB171: Why Price to Book Died; VTI 7.0 Update
- Price to Sales is NOT Relevant When Margins Are High – 20Y [S&P 500 Data]
Ideas for Implementing a Margin of safety with Your Growth Estimates
- The Top Down Investing Strategy – Key Statistics to Follow in Your Analysis
- How to Estimate Future Free Cash Flow Growth for a Mature Cash Cow
For the purposes of the VTI v7, I’d say dive-in and worry about the details as you get better, with time.
Nobody learned how to shoot a basketball, or perfect a golf swing, or shred down a ski slope, in their very first day.
But as you practiced and got better and better, you started to notice and master the details, and the using the VTI Spreadsheet (rather than reading about it) is the only way to practice and start to decode the industry jargon.
How to Input Data from a 10-k into the VTI Spreadsheet
Which brings us to the last part of this guide, the nuts and bolts to inputting financials into the VTI spreadsheet.
Rather than drone on about it, let me do one and record my screen as I go along. You can watch that video here:
I’d also warn you that going through sec.gov and the 10-k’s is daunting at first, and there’s a few common hiccups which clients have struggled with. I’ve addressed the biggest ones here:
- Inconsistency with Shares Outstanding in Company 10-K Annual Reports
- “I Can’t Find the 10-k Financials!” Check Exhibit 13
Get Connected, and Get Started!
I also recommend reaching out to our growing and inspiring community of very smart people working through the VTI spreadsheet to find great companies.
It is the place to upload your filled out VTI spreadsheets for feedback and to check errors, and is fantastic for bouncing around ideas and relating to other investors in the trenches in real-time. It’s a secret Facebook group, and you should’ve received an email with instructions for joining when you purchased the VTI spreadsheet.
If I still haven’t answered your concerns you can email me at [email protected], I’m happy to help you when I have time, if the above solutions haven’t helped you.
As you gain experience with the stock market, you’ll find that mastering it is very similar to learning a new language.
At first it’s difficult, and then you gain momentum, and one day you’re fluent.
But people are always adding new words to the vocab, and that makes it fun, and there’s always something new to learn. If that doesn’t explain investing I don’t know what does.
Hopefully the VTI spreadsheet is your best translator, coach, teacher, personal trainer even—and that you find incredible ROI from the investments you make over your lifetime.