Moneyball Series Part 3 — Impressions

Moneyball is somewhat similar to value investing where we buy assets with high earnings power or value for the least amount of money possible. I decided to start this series to look at some of the timeless lessons from Moneyball that are applicable to investing. I hope that you would have as much fun reading this series as much as I had writing them.

Impressions

In baseball, scouts traditionally find talent by going out to games and subjectively surveying the players’ athletic abilities. Billy Beane, the Oakland A’s GM, was (wrongly) discovered in this manner and was a first-round draft pick right out of high school; his subsequent failure in pro baseball made him realized that the accepted ways of appraising players were deeply faulted. That such means of allocating millions of dollars dominated drafting decisions in the business of baseball speaks to just how wired we are to draw instant conclusions from impressions.

Similarly, as value investors hunt for the hidden gems, majority of the time will be spent on trying to differentiate between true value or value traps. This is one of the most important and difficult aspect of stock selection.

What is a Value Trap?

A value trap is a relatively cheap stock whose price simply doesn’t rise no matter how long you hold it. Sometimes the reality is that a cheap stock can remain expensive when the company’s true value remains even lower than the stock price. The stock price is likely to continue dropping and the investor would be “trapped” holding it. This is often the case because of one or more specific, permanent factors that are dragging the company into a sustained, long-term decline.

One of the goals of every value investor is to avoid value traps. None of us want to buy a cheap stock and have it get cheaper. But even the best value investors sometimes get stuck.

Fortunately, we can take steps to maximize the probability of purchasing a real value investment:

Factors to Consider Whether Your Investment is a Value Trap

1 — Free Cash Flow

I feel that free cash flow is one of the most important aspects to consider when investing in a company. If a company’s free cash flow is poor, or non-existent, it might mean that the company is not growing and is burning cash (esp those stocks that have a large cash hoard). These companies will probably not grow enough to escape value-trap status.

2 — Management

Poor management can sink almost any company. If management is selling stock, giving guidance that is untrustworthy. You can look these information up by reading their conference transcripts or annual reports. These would be signs of a possible value trap.

Look for management that owns their company’s stock; insider buying is a positive sign. Quality management will give trustworthy guidance and demonstrate they have the knowledge to successfully guide the company. For starters, you can look up Micro Mechanics’s Annual Report. The CEO managed to present his company very well and I was very impressed.

3 — Lack of Catalyst

A cheap stock (low P/B, high NAV, NTA etc etc) will remain cheap until there is a catalyst that changed its outlook or fundamentals. Look for potential catalyst (eg takeover target, revenue and profit growth, etc, etc) to see if there is a reason for the market to get excited about. If there are no such catalyst happening soon, you could be holding onto this stock for a very very long time.

A stock may look cheap when compared to its past earnings. But the market values companies on future earnings and growth of those earnings. What a company has earned in the past will have little to do with its value today. Conversely, if a company is expected to do badly in the next few quarters, the share price would look cheap compared to past earnings.

4 — Avoid Companies Issuing More Shares

Equity financing is far more expensive than debt financing, and a company that is issuing more shares rather than buying them back may be desperate for cash, leveraged to the hilt, or simply poorly managed.

Furthermore, issuing more shares would dilute your holdings, hence making your stock less valuable.

5 — Accounting

Producing complicated or fraudulent company accounting reports often means there is additional hidden problems. This is very hard to detect but any hint of fraud should eliminate an investment from consideration for purchase. This usually results in further declines in the stock or bond price.

Real value investments will have transparent financial reports and credibility with investors. Quality companies with sound management will demonstrate openness and honesty with their successes and failures.

There are also instances where stocks with low P/B ratios due to inflated asset prices. I would also look out for biological assets as I feel that they are riskier assets ( eg. as a pig farmer, african swine flu might just wipe out all your pigs). For more reading on why I avoid biological assets, you can refer here: https://www.asiaone.com/sgx-treading-cautiously-over-biological-assets

Conclusion

It is difficult to determine the difference between a real value gem and a value trap. Even the best value investors would buy value traps sometimes. Making mistakes is a part and parcel of investing.

The goal is to maximize your probability of purchasing a real value investment, and minimize buying value traps. Use these factors to weed out potential value traps; then focus on the hidden gems you might want to add to your portfolio.

Cheers

Originally published at http://themosspiglets.com on January 18, 2020.