Investing in Value Stocks? or Value Traps?

We have all done it as investors, even the great Warren Buffett has done it. In fact, Mr. Buffett bought the a whole airline sector a few years ago. What is the “it” I speak of? The it, is buying a stock based on valuation or on it being a “cheap” buy, only to be massively disappointed by its stock returns going forward. The subject of this week’s podcast? Is that a value stock? Or a value trap?

I am Chris Perras with Oak Harvest Financial Group here in Houston and welcome to our weekly stock talk podcast. Before we get into this week’s topic on value traps, please take a moment to click on the subscribe button and click on the notification bell so you will be alerted when our team uploads new content.

First off, almost everyone has a different definition of what a “value stock” is. Let’s come to an agreement for this video that it’s a stock that is cheaply priced versus its own history or versus the overall market on a price to earnings, or P/E basis, price to cash flow, or price to book value basis. Most of the time, “value stocks” trade at low multiples of earnings, cash flow, or book value because they have little promise of future growth; they have no ability to innovate, or they cannot control costs.

However, I argue that value traps can occur even in companies that appear healthy and are growing. Even if a company has been successful, having experienced rising revenue, profits, and share price for years, it can fall into a situation where it is a value trap in one’s portfolio. There are all sorts of criteria that one can look at to minimize the number of value traps stagnating or hurting your portfolio returns.

However, the number one factor that I have found is a company’s marginal ROIC. What’s ROIC stand for? It stands for return on invested capital. And what should an investor look for? They should see if the incremental cash return for the company is going up or down. In other words, is the cash a company is generating being invested in the business helping or hurting marginal and incremental growth and marginal returns. Is it adding to or subtracting from a company’s own historical investment returns. In almost every case I’ve looked at, it has turned out to be that simple. Whether I saw the dynamic before, during or after it was happening.

I’m not going to get into balance sheet, income statement, and cash flow analysis in this video. No, I’m going to try to keep this lesson as simple as possible. Is it almost as easy as asking your self are things getting better? Or worse? Or are they stable and consistent? I’m going to keep this big picture and qualitative. I’m going to reference 3 examples of time periods that produced a mass number of value traps. I want to keep it qualitative.

I know some people will argue that these stocks just got “overvalued” and the market took years to lower their valuation. Or the other way around, it took years for earnings to grow into its valuation. I would argue that the market was smarter than that during each of these periods and saw through whatever story the companies were telling.

Timeframe example one, the internet bubble and Y2K 1998 through 2000-time period. The poster child for the value trap that time created. Microsoft. I know, I know, you say Chris what are you talking about Microsoft is a behemoth and is now a $2 trillion market cap company. Well in the 1980’s through around 2010, Microsoft was one thing and one thing only. A desktop PC software company. And if you were around back in the go-go internet buildout years of the late 90’s and Y2K panic spending tsunami, you would remember this, if it was a computer or networking equipment, and you had it in stock on the shelves, you sold it. Salespeople did not have to sell. They were merely order takers, fielding a flood of inbound calls. Consultants had convinced the Fortune 500 and other businesses that unless they replaced all their computers, the world would stop. And Microsoft was a huge beneficiary of the Y2K fear and internet buildouts and their revenue accelerated to over 30% in both 1999 and 2000.

However, it turned out the world, and every old computer, did not stop and crash on January 1, 2000. In fact, companies had mostly pulled forward years of hardware and software purchases. From 2001 through 2010, Microsoft’s revenue growth dropped first into the high teens, then mid-teens and then into the mid-single digits in 2010. As their revenue growth slowed, what did Microsoft do? They did what most growth companies do and they took much of that additional revenue growth and its incremental cash, and they “invested” in a myriad of projects and sectors that were suppose to re-accelerate their overall business. Most of these programs were not successful enough to move the needle. And the ones that were successful, all were less profitable than Microsoft’s original software business model.

The market was smart enough to see this peak in marginal ROIC way back in 2000. It wasn’t until the new Microsoft cloud Azure suite business took off that a Microsoft shareholder was rewarded. For the 12 years in between peak bubble and the cloud computing wave, Microsoft investors were stuck in a value trap and better off indexing your money in the SP500, which is always the alternative for a long-term equity investor.

The second period that one can look back on and see the creation of industry wide “value traps” was the end of the bull market for energy and commodities in 2008. Recall that commodities had a 7 or 8-year bull run as China built out infrastructure for its June 2008 Summer Olympics. On the back of that furious demand, from about 2005 on, almost every energy and commodity company announced massive, multi-year, capex spending programs.

These weren’t easy and fast “shovel ready” projects. These were not small, flip the switch, $1million corporate spends that would bring on more capacity in a month or two. These projects and expansions were billion dollar, multi-year, greenfield or expansion projects. The true final costs, timing, and cash returns on these “investments” would not be known for years. In investors and the markets mind, this is cash out the door with zero reliability, accuracy, or precision of estimating future cash investment returns. There are almost no, large, public investors that I know of that are willing or able to take on this unknown investment return. So, what do they do? They sell the stock and invest elsewhere until the return on those investments are closer or more clear. They do that, or they index that money.

Here is a chart of Chevron. Arguably the best run, of the larger integrated oil companies. One can see that once the large capital expenditures started, the stock peaked and started to underperform the S&P500. It didn’t matter that oil recovered back to $125 a barrel almost immediately post the great financial crises. Chevrons stock and almost every other energy and commodity name still underperformed the SP500 from 2010 through 2020 because they had all committed billions of shareholders dollars to projects with no cash flow visibility.
And look when Chevrons stock bottomed versus the overall markets, it was after oil traded at -$34 per barrel in 2020 and management teams laid off hundreds of employees and cancelled billions of dollars in expansion plans. That was the pivot in the entire industries marginal return on cash and investment.

Which brings me too today. Retrospectively, it is now clear to me and many others, that the Covid epidemic, pulled forward many areas of demand and growth not by quarters, but by years. This is problematic for many companies, future, marginal return on investment. I repeat the word “marginal” as these companies have passed peak revenue growth with now impossible comps. Think companies like Peloton or Teladoc.

Many Covid pandemic beneficiaries decided to take their covid windfall, and ramp hiring and or capital expenditures at much higher rates than pre-pan demic. All in the name of “investing for future growth. Of course, this aggressive spending strategy, creates the likelihood of creating a “value trap” even more quickly as the company is ramping expenses just as revenue growth is slowing. Recent areas and sectors that have seen this dynamic play out in the last 12 months include online gaming and media streaming.

Almost everyone who invests in single stocks at some point in their life will invest in a “value trap” or two. Even great investors like Warren Buffett have done it. Early recognition of a value traps potential comes from 1 – recognizing if a company is at or near peak incremental revenue growth, 2- at or near peak operating margins, or 3- at the beginning of a historically aggressive spending program for that company or the industry the company competes in. All three of these factors are indicators that a company’s peak return on invested capital may be behind them.

Remember that spending, as an investment by the company, can be in the form of either hiring bodies or ramping capital expenditures to “invest” for future growth opportunities and markets. The markets almost never care which spending excuse it is as cash is cash in its eyes. Of course, our goal as single stock investors is to minimize the number of traps that trip us up over time.
The Oak Harvest investment team is far from perfect, no investor is. Our Methods try to avoid “value traps” all together, but when we recognize them, our goal is to minimize their portfolio effect and move on to other investments with stable or accelerating marginal investment returns.

At Oak harvest, we think our clients are best served by us helping them plan for their future needs and risks, instead of focusing on the past. The future is always uncertain and that is why our advisors and retirement planning teams plan for your retirement needs first, and your greed’s second.

Give us a call to speak to an advisor and let us help you craft a financial plan that meets your retirement goals. Call us at (877) 896-0040, we are here to help you on your financial journey into and through your retirement years.
I’m Chris Perras and from Everyone here at Oak Harvest Financial Group, have a great weekend!

Investing in Value Stocks? or Value Traps?
Investing in Value Stocks? or Value Traps?

We have all done it as investors, even the great Warren Buffett. In fact, Mr. Buffett did it as recently buying the whole airline sector a few years ago. What is the “it” I speak of? The it is buying a stock based on valuation or it being “cheap” only to be massively disappointed by its stock returns going forward. The subject of this week’s podcast? Is that a value stock? Or a value trap?