Wednesday, October 22, 2008

Beware the Value Trap

It's happened to everyone. A stock on your watchlist just took off on good news but you recently chose to buy something else. Now you have no cash and would have to sell that something else to buy it. It's hard to justify buying a stock for $55, when you did all your research on it at $40. So you wait. "Maybe I'll get it on a pullback," you tell yourself. But it doesn't come back. It just keeps going. $80. $100. $150. You take it off your watchlist. It's too damn painful to watch anymore!

You did everything you should have in researching the company, saw the value but failed to capitalize. You have a certain emotional attachment to the stock. It was "the one that got away."

But now, lo and behold, the stock is all the way back to the price you wanted to pay for it 2 years ago! It has fallen 70% from it's highs. The selling is quite apparently overdone and you want to buy that precious gem everyone seems to be throwing out with the bathwater.

But is this a rational decision or an emotional one? It's hard to argue that a 70% decline can be just an aberration. There's obviously some reasonable cause for concern.

Yes, I'm talking about the big commodity producers. EnCana, Potash, Freeport McMoran, Teck, Goldcorp, and BHP have all been taken behind the woodshed. I'm also talking about financials, retailers, and big techs like RIMM, Apple and Google. They've all fallen victim to the credit crisis, the perception of slowing global growth and the decreasing desirability of debt. In other words, they've fallen victim to deflation.

So if I think this selling is overdone (I don't, but that's not the point of this article) why shouldn't I try and pick up some of these great companies at bargain prices compared to just a few months ago? After all, they are trading with P/E valuations below 10 and some of them pay out dividends of 10-15%!

Well, here are a few good reasons:
1) Lower profits are implied and will drive that P/E ratio higher
2) The dividend could come under pressure if profits start falling. This could drive the stock price even lower.
3) Profit taking will be rampant on any bounce in the stock price

This is what is commonly referred to as a 'value trap.' And anyone trying to pick up bargains should be aware of the potential pitfalls in value investing. For the long-term investor, these companies may not produce the steady income desired and to the momentum investing community their 'stories' are old, so capital appreciation is not guaranteed.

On the other hand, finding an intermediate term bottom could be quite rewarding for someone with a shorter time horizon. The commodity producers especially, could double from their bottoming prices. But capturing that would require catching the bottom, the subsequent top and withstanding all the volatility in between. Not easy.

But instead of looking for companies that have been beaten mercilessly, I find it far more constructive to look for sectors that haven't been sold nearly as much and have the potential to be market leaders if and when we have a mid-cycle recovery.

Chief among those candidates are some of the high-flying biotechnology stocks. These companies have just started making money in the last few years and have the demographic tailwinds in their favour (aging populations). They don't care about no stinkin' credit crisis. And their share prices prove it. Some are still in distinct uptrends. Others still are making new highs (remember what that feels like?) On my watch list are GENZ, GILD, IMCL, ILMN and EBS.

These companies generally have desirable characteristics like low debt levels, consistent profit growth and diverse product lines. They may be off 20 or 30% from their highs a few months ago, but their uptrends are still in place. Why don't investors looking for capital appreciation look here first?

Simple. It's not nearly as satisfying to catch a stock half-way through it's uptrend as it is to catch a stock at it's bottom price.

I'm also looking at some others in the technical instrument space like WAT and ABI. And if we are to have a productivity revolution of sorts, where better to look than companies like FLS and CIR?

My intention in this article is not to give stock recommendations. And to be clear, I do not own any of the stocks I've mentioned. I still think I can buy them cheaper. My intention is to try and pry you away from the common trap of buying old ideas. Everyone knows the China story. Yes, they'll keep consuming copper. But that doesn't mean copper miners are a good buy. When the crash happened, the internet didn't disappear - but the best of the internet stocks took 5 years to recover. Most are still way below their highs.

Try to look beyond today's ideas and think about what we need over the next decade. My answer to that is higher efficiency, more sustainability and an answer to many of the diseases plaguing mankind. Others have different answers. But the key is that they are new ideas.

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