How to manage the risks of value investing
As we’ve seen, Value Investors have the reputation for picking up cigar butts on the street which is hardly the most glamorous of occupations. But it’s especially unglamorous when you consider that the last puff is likely to taste horribly toxic.
While it’s certainly true that some bargain stocks do indeed end up broke or bankrupt, many investors see value investing as disproportionately risky - foolhardy even. But this is far from the case and illustrates just how much humans confuse uncertainty and risk. While the outcomes for individual stocks are far more uncertain, in aggregate the price behaviour of value stocks is actually less risky than growth stocks. After their many studies Professors Lakonishok, Vishny and Shleifer concluded:
“Overall, the value strategy appears to do somewhat better than the glamour strategy in all states and significantly better in some states. If anything, the superior performance of the value strategy is skewed toward negative return months rather than positive return months. The evidence thus shows that the value strategy does not expose investors to greater downside risk.”
In other words, in bear markets, value investing stocks actually decline less and outperform the market as a whole. The bargain state of low valuation stocks appears to act as a relative floor under their aggregate share prices.
In spite of this, the ‘hunter’ as we have seen is always going to be interested in picking individual stocks and needs a toolkit to avoid the worst of them. While we’ve already discussed some quantitative techniques of avoiding value traps, we’ll be covering a few more qualitative ways of filtering them before discussing the ins and outs of wise portfolio diversification as a hedge against individual stock disasters. And of course there still remains the seemingly un- answerable conundrum of ‘when to sell’.
How to avoid buying value traps
“The possibility of sustained decreases in business value is a dagger at the heart of value investing.” Seth Klarman
Buying undervalued stocks is a risky past time. That’s why Ben Graham introduced the margin of safety as the key principle in his investment philosophy. While efforts to lower the chance of failure in value investing have become more sophisticated the fact remains that the strategy is much more exposed to the risks of individual business failures than most other strategies. Recognising where those risks lie is the first step to understanding how to avoid the value hunter’s most dreaded foe – the ‘value trap’.
What is a value trap?
A value trap is a stock that masquerades as a value opportunity but which turns out to basically be a dying company. It looks like a bargain because it’s price has fallen so much – but unlike a true value stock it’s low for a reason, it’s experiencing a fundamental change in its business. Timothy Fidler of US fund manager Ariel Investments suggests that there are two main types of value traps:
Earnings-driven value trap: This is where the mirage of a low PE ratio vanishes as any earnings gradually evaporate over time – every time you think a stock looks ‘cheap’ again, earnings fall further. This process is usually persistent and can last for years.
Asset-based value trap: Also known as cigar-butts, these types of stocks look exceptionally cheap compared to the assets. In some cases, the trap is simply a hoped for reversion to a ‘normal’ level of high profitability which is actually unsustainable.
Top 10 signs that your stock may be a value trap
Of course, it’s easy to say with hindsight that a bad investment was a value trap but are there any ways to flag them in advance? Fundamentally, the key to avoiding value traps is doing your homework and exercising caution when approaching enticing investment prospects, but there are some patterns worth watching out for.
The following list is inspired by an excellent presentation given by James Chanos at the Value Investing Congress.
1. Is the sector in a long-term decline?
No matter how good the company, it will need a fair wind behind it eventually and if the sector itself is dying, it’s likely to be a huge battle to realise value.
2. Is there a high risk the technology may become obsolete?
Technological progress has hurt Value Investors more than anything in the past 20 years. It can radically reshape an industry and its product lines – this can have a major impact on the life cycle and profitability of a firm (e.g. the impact of the Internet on both newspapers and retailers).
3. Is the company’s business model fundamentally flawed?
Sometimes a company may simply be serving a market that no longer exists, or at a price that is no longer relevant, given competition or new substitutes for the product.
4. Is there excessive debt on the books?
More often than not, financial leverage magnifies the pain of a value trap. A company with no debt is unlikely to go under barring a major catastrophe, but on the other hand excessive leverage can destroy even a great company.
5. Is the accounting flawed or overly aggressive?
It’s always best to stay away from companies where aggressive or dubious accounting is employed. Chanos argues that you should be “triply careful” whenever management uses some unconventional accounting metric that they themselves define.
6. Are there excessive earnings estimate revisions?
Analysts are quite lenient and usually allow companies to beat their estimates. Occasional missed earning estimates can provide an opportunity to buy on the dip, but a pattern of missing earning estimates may mean that management and thus analysts are struggling to forecast or understand the business properly.
7. Is competition escalating?
Be careful of companies facing increasingly stiff competition. Is there a tendency for the industry to compete on price to squeeze margins? If the profit margins have been decreasing over the last 10 years it may suggest the company is unable to pass increasing costs onto its customers due to increased price competition.
8. Is the product a consumer fad?
Another sign of a possible value trap is a product that is subject to consumer fashion or whims. Evolving consumer tastes and demand may mean that the market for the product is just a short-term phenomenon.
9. Are there any worrying governance noises?
Is there anything that suggests minority shareholders might be getting a raw deal? One flag is a very limited float of free shares or a tightly held company. While director share ownership can mean that their incentives are aligned with shareholders, it may also act as an impediment to institutional shareholders buying large quantities of stock. In general investors should also be wary of companies with a second class of stock with super-voting rights.
10. Has the business grown by acquisition?
Chanos argues that growth by acquisition is a major sign of a value trap. In particular, roll-ups of low growth, low P/E businesses with expensive share issuance should be seen as a red flag.
Among the potential pitfalls of a value investing strategy, the value trap is arguably the most significant risk facing an investor. While the qualitative checklist given above is an excellent help to avoiding these traps, we have previously discussed a few quantitative tests that investors can also use to help mitigate the risks. These include screening for positive financial trends using the Piotroski F-Score or for negative bankruptcy and earnings manipulation risks with the Altman Z-Score or Beneish M-Score.
Ultimately the best way to minimise the harmful impact of value traps is to pursue a strategy with wide diversification – the subject of the next chapter.
How diversification can lower your risk
“I mean if you put all of your eggs in one basket, boy, and that thing blows up you’ve got a real problem.” Jerry Bruckheimer
Diversification is the only free lunch in investment. The idea is so simple that even a child can understand the basics – “Don’t put all your eggs in one basket” – but in practice it seems to be almost impossible for individual investors to accomplish. Why? Primarily because of two reasons. Firstly, as we’ll see, they appear to put their eggs in too few baskets but secondly, even when they do choose enough baskets, they appear to choose baskets that all hit the ground at the same time!
Is just a few stocks enough?
In 1977 Elton and Gruber published a landmark research note that showed that most of the gains to be had from diversification come from adding just the first few stocks. Adding 4 more stocks to a 1 stock portfolio gives you 71% of the benefits of diversification of owning the whole market and the benefits of owning just 15 stocks brings about 87% of the benefits of a fully diversified portfolio.
As a result of these findings many of the greatest investors highly vouch for the idea of taking a ‘focused’ portfolio approach to investing. The stock- picking ‘hunter’ who has great confidence in his abilities is extremely comfortable at owning just a few stocks. Joel Greenblatt in The Little Book that Beats the Market waxed eloquently that if you know what you are doing you shouldn’t need a portfolio with more than about 5-8 stocks in it whereas others such as Bill O’Neil have been quoted as saying that “Diversification is a hedge for ignorance”. Intuitively also, the more stocks that an investors owns, the higher the transaction costs will weigh on portfolio returns.
“Behold, the fool saith, ‘Put not all thine eggs in the one basket’ which is but a manner of saying, ‘Scatter your money and your attention’; but the wise man saith, ‘Put all your eggs in the one basket and watch that basket!’” Mark Twain
William Bernstein, the renowned financial theorist, hit out at this ‘15 stock diversification myth’ with a smartly argued case that while investors who only own a few stocks may have reduced their portfolio volatility the real risk they face is of significantly underperforming the market by missing the winners.
Bernstein showed that much of the overall market return comes down to a few ‘super stocks’ like Dell Computer in the 1990s which grew by 550 times. “If you didn’t have one of the half-dozen or so of these in your portfolio, then you badly lagged the market”. As the odds of owning one of these super-stocks was only one in six Bernstein argued that you could only mitigate the risk of underperformance by owning the entire market!
Not only that but intuitively such low levels of diversification can be extremely dangerous in value stocks which often highlight troubled companies with teetering or questionable business models. Clearly in this situation the well diversified ‘basket’ approach to value investing can allow you to ‘harvest’ returns with less risk. This technique is vouched for by Benjamin Graham in almost all of his bargain stock strategies, as well as being used by such luminaries as Walter Schloss, Josef Lakonishok and others. If you fancy yourself as a quantitative farmer rather than a stock picking hunter this is certainly the route to follow. Joel Greenblatt followed up his above comments by stating that “Most individual investors have no business investing directly in stocks” encouraging most to invest broadly in 20 to 30 shares.
But the number of stocks you own isn’t the only number to watch
Modern Portfolio Theory has shown that there’s an ideal level of diversification between 2 stocks which both minimises risk and maximises return. You want to buy stocks that zig while others zag so your ‘baskets’ don’t all hit the ground at the same time. But while this may be easy in theory it seems to be way beyond the ken of most investors.
A 1990’s study of study of 60,000 private investor portfolios by Kumar and Goetzmann at one of the US’s biggest discount brokerages found that investors on average owned only 4 stocks.
Not only that but these stocks had price movements that were highly correlated – they all zigged together! As a result their portfolios were just as volatile as the assets held within them completely negating any benefits of diversification. Higher portfolio volatility puts far greater emotional pressure on investors which contributes to bad decision making and worse returns. The average portfolio in the study underperformed the market by up to 4% annually!
Figuring out whether or not stocks have correlated returns can actually be quite tricky and in practice is only evident in hindsight so it pays to think about them a bit more qualitatively. A simple starting point is to ensure that you are investing across different sectors and markets so that you aren’t exposing your stocks to similar macro risks.
But another idea is to ensure that you are investing in uncorrelated strategies rather than trying to find uncorrelated stocks. There is plenty of evidence to suggest that a strategy such as Piotroski’s ‘Bargains on the Mend’ has returns that are uncorrelated with other value strategies such as Benjamin Graham’s Net-Net strategy as they focus on very different risk factors – in a study by AAII they found that Piotroski’s strategy was the only one of their dozens of followed strategies that displayed net positive returns in the financial crisis.
In conclusion, take another look at your portfolio and see if you are deceiving yourself. Do you own just a handful of stocks? Are they all in the same sector? Are you indulging in a fantasy that you are incredibly smart and that the rest of the market is dumb and playing catch up? If so you are in serious danger of being caught out – there could be 60,000 other investors doing almost exactly the same thing who are all falling prey to the smart money that’s likely to be harvesting their self-deception as pure profit!
How to know when to sell
“I never buy at the bottom and I always sell too soon.” Nat Rothschild
Managing your portfolio and knowing when to sell stocks is one of the most difficult aspects of investing. While there is no shortage of buying advice by value investing thinkers, there is a lot less written by those in the know about how investors can apply some logic to their selling decisions.
Even Ben Graham was fairly quiet on the subject, other than a brief reference to selling after a price increase of 50% or after two calendar years, whichever comes first. As a result, many investors simply don’t have a plan in place to preserve capital and/or lock in profits. Instead, they are often swayed by fear of loss or regret, rather than by rational decisions designed to optimise their returns.
Cut your losses, run your winners
Studies show that, when making money on a trade, people often take profits early to lock in the gain but, when losing money on a trade, most people choose to take the ‘risky’ option by running losses and holding the stock. Unfortunately, the best investors usually do the exact opposite – they cut their losses and run their profits.
The explanation for this relates to a phenomenon know as ‘loss aversion’, or the fact that people actually value gains and losses differently. Behavioural studies have shown that losses have twice the emotional impact as gains and are thus much more heavily weighted in our decision-making.
To counteract this tendency, one option is to adopt a mechanical selling strategy based on strict rules (in other words, a system of stop-losses), as proposed by American fund manager William O’Neill of Investors’ Business Daily (IBD). However, as a growth & momentum-focused investor, O’Neill’s approach looks for rapid breakout, momentum stocks and obviously wants to bail out of non-performing turkeys as quickly as possible.
This approach is less clearly applicable in the case of value investing, where investors are deliberately targeting companies that are ignored or misunderstood, with a long-term view about the underlying intrinsic value and using a margin of safety.
To illustrate this contrast, Warren Buffett hardly ever sells – indeed, his philosophy is that a lower price makes a stock cheaper and a better buy, although admittedly he is mainly dealing with entire companies, rather than parcels of shares.
A view from Philip Fisher
Although himself more of a growth investor, Philip Fisher laid out a more useful set of selling guidelines for value folk in his acclaimed book, Common Stocks and Uncommon Profits[1]. He argued that there were three general conditions which suggest that a stock should be sold:
The investor has made an error in his/her assessment of the company.
The company has deteriorated in some way and no longer meets the purchase criteria.
The investor finds a better company which promises higher long term results after factoring in capital gains.
Gut feelings or worries about a potential market decline are not reasons to sell in Fisher’s eyes – and rightly so, given the inherent difficulties of market timing. He explains: “When a bear market has come, I have not seen one time in ten when the investor actually got back into the same shares before they had gone up above his selling price.”
A view from David Dreman
One thing that seems to be missing from this list is to sell when a company’s stock price reaches intrinsic value. David Dreman writes that when following a contrarian Low P/E strategy the investor should sell every stock as soon as it becomes valued equivalently to the market average – whatever the prospects for growth look like - and reinvest in another new contrarian play.
Should Value Investors use stop-losses?
Whether stop-losses should be employed is an interesting question for Value Investors. As value blogger TurnAround Contrarian notes, stop-losses are something of a taboo subject among Value Investors. Value Investors tend to take the (somewhat arrogant?) view that the hundreds of hours they spend researching a company means that they don’t need the protection of stop-losses – there is no need to worry what the market does because: i) they understand what they are buying, ii) they prefer companies with low leverage (lowering the risk of bankruptcy), and iii) they have bought with a ‘margin of safety’ which acts as their quantitative safety net.
While it is certainly true that the whole premise of value investing is that the market often drives the price of unloved stocks absurdly low before recovery begins, it may still be sensible to have some rules – or semi-automated procedure – for recognising losses because…
You won’t always be right
We all hope that the market will come to recognise what a bargain our latest investment was but there are two distinctly unpleasant alternatives. It may be that we may have bought in far too early and from a return perspective, any future realisation of value will be far too distant to justify tying up your capital that long. Alternatively, we may have got it wrong altogether and the stock may simply be a value trap.
Good examples here were both the banking and housebuilding sectors following the credit crisis. Some Value Investors jumped in once prices had fallen say 50% only to watch them far further by 80-90%.
Again from Turnaround Contrarian: “Having operated turnarounds, I know how quickly industry dynamics can change and how those changes can quickly impact pricing, cost structures and a company’s competitive position in the marketplace. An investor needs to realize cash flows can decline very fast.”
With that in mind, it’s worth considering implementing two selling- related rules in your value investing:
1. Always write down your investment thesis
It’s well worth writing down at the time of purchase the specific thesis that underlies the investment and any metrics for tracking this. This allow you to monitor how future events have impacted that thesis objectively, without getting caught up by hindsight bias or issues of loyalty/saving face.
One approach, advocated by Greg Woodhams at US investment management firm American Century Investments, is that, should the thesis be (materially) compromised, the holding should be sold immediately and one should avoid allowing new reasons to justify retaining the position.
2. Consider a stop-time
An alternative to selling merely because the price has dropped with a stop- loss is to consider a specific time-limit for loss-makers. Graham suggested selling either after a price rise of 50%, once the market capitalisation matched the net asset value, or at the end of two years. Sticking to a similar “stop-time” may be useful in automatically taking you out of dodgy investments.
The specific time-frame of two years is of course somewhat arbitrary but the idea is that too short a time period may not be enough time for management to turn a company around, whereas allowing more than, say, three years may cut your compound returns to unacceptably low levels.
Recognising failure is hard
Selling out at a loss is not easy, especially if you spent hours or days analysing and persuading yourself of intrinsic value – this is both due to the well-documented tendency/bias of loss aversion and because loyalty and a desire to save face can get in the way emotionally. Persistence is a virtue in value investing but equally, you may sometimes feel compelled to stick with the company you have come to know and love when the rational thing is just to walk away and invest the money in pastures anew.
For that reason, although a stop-loss may not suit a value-based investment style, it is still worth establishing some other clear guidelines / procedures for disposing of your worst investments before it’s too late.