Market Outlook – Deja Vu?

“One Two Three Four/ If I had ever been here before/ I would probably know just what to do/ Don’t You?”-  Déjà Vu, Crosby Stills and Nash

Geopolitical events continued to dominate headlines and investors’ concerns through the end of 2014 and into the New Year.  In the Middle East, the rise of the Arab Spring continues to foster fears of contagion.  Worsening economic conditions in Egypt, Iran’s nuclear ambitions and Syria’s obstructionist leadership all served to increase tensions.  Despite sanctions, Russian leadership exhibits no intention to leave the Ukraine and may even be considering some interference in the Baltic region.  Chinese policy appears to be more inwardly focused as attempts are made to bring more order to the banking system while fighting corruption on a massive scale.  In the face of all these events, US policy appears to be weak and ineffective as they head towards another election year with an embattled political system in which agreement or consensus is unlikely.

As the Fourth Quarter progressed, economic concerns grew on a global scale.   European economies continued to exhibit signs of stagnation and fears of deflation.  Germany, the primary economic engine of Europe, reported slowing rates of production.  The slower rate of growth in the Chinese economy continued to weigh on many commodity prices.  Despite the apparent oversupply of oil, Saudi Arabia decided not to curtail production in order to support prices.  This event caused crude oil prices to fall precipitously from near $100 per barrel to nearer $60 and had a major negative impact on markets with larger oil exposure, such as Canada.  The US economy and market stood out as a refuge in this turmoil.
The collapse in oil prices has been particularly painful to the Russian economy where nearly 65% of their exports are related to oil and gas.  The Energy Sector in the Toronto Stock Exchange fell 17% in the quarter.  As we enter 2015, it is interesting to note:

  • There is a financial crisis in Russia
  • We are in a period of weak oil prices
  • Investors have fled into US securities and treasuries resulting in a strong US dollar…
  • While currencies in emerging markets are very weak
  • The Japanese and German economies are exhibiting signs of slowdown…
  • While the US economy stands out as the economy expands and employment improves
  • The strongest sector globally was Technology (Hardware) in 2014, and,
  • The democratic President of the United States is under siege from the Republican House and Senate


Market Outlook – Have we not seen this before?  This looks a lot like 1998!

If the analogy was perfect perhaps we would know just what to do, but some things are a lot different.  The emerging markets of the late 1990’s were the BRIC’s (Brazil, Russia, India and China) along with the Asian Tigers (Hong Kong, Singapore, South Korea and Taiwan).  Today, China is a much bigger and more dominant player on the world stage.  Also, many of the emerging economies of the late 1990’s had fixed exchange rates but are now facing the dilemma of having floating rates at a time when they are saddled with debt, much of it denominated in US dollars.  Eventually, it was the collapse in the Technology Sector that brought down the markets in the early 2000’s, including the US market.

Weak oil prices may yet have a damaging effect on the US economy.  Oil and gas production has soared over the last five years in the US as shale production has benefited from new techniques.  The strength in the US dollar will affect their ability to export into weaker economies with less purchasing power.  Many oil and gas companies have already announced cutbacks to dividends and capital expenditures in the face of uneconomic prices.  These cutbacks will reverberate throughout the economy as illustrated early in 2015 as US Steel laid off 800 employees involved in the manufacture of pipe for the oil industry.

On the positive side, lower prices will put more money in consumers’ pockets.  Lower prices should also spur demand while supply shrinks as companies cut back on programs.  In other words, the energy markets remain cyclical.  Where prices settle is anyone’s guess but we would surmise that ultimately prices have to reflect the marginal costs of production.  $100 per barrel may well be too high in today’s world but $40 is likely too low.  The strong, well-financed companies will survive and benefit from the opportunity to take advantage of acquisitions at low prices as the weaker companies fail.

As we enter 2015, a number of events will be on investors’ watch lists.  The United Nations Climate Change Conference will be taking place in Paris where nations will be outlining their national goals for moderating carbon emissions.  Two very important trade negotiations are also underway: the Trans-Atlantic Trade and Investor Partnership between the US and the European Union and the Trans-Pacific Partnership with the involvement of the US and China.  Freeing up trade will spur global economic expansion to everyone’s benefit.

You can read our forth quarter fixed-income commentary here>>

You can view, read and download our forth quarter commentary here:

What is Successful Investing? Learn more here>>

Download Our Free Special Report – How to Hunt For Value Stocks. Michael Sprung will share with you 5 stocks set for long-term gains here>>

We believe that investment management is about managing risk, not chasing speculative returns.  

Like to learn more? Please contact us here>>

The opinions expressed here are ours alone. They are provided for information purposes only and are not tailored to the needs of any particular individual or company, are not an endorsement, recommendation, or sponsorship of any entity or security, and do not constitute investment advice. We strongly recommend that you seek advice from a qualified investment advisor before making any investment decision.


Is Your Stock Broker Acting in Your Best Interest?

The OSC is considering imposing a ‘best interest’ duty on stock brokers. Their industry body is resisting.

OSC considers imposing best interest duty on stock brokers. Their industry body is resisting.

Is Your Stock Broker Acting in Your Best Interest?

How do stock brokers choose investments for their clients? Most investors assume that stock brokers (who call themselves investment advisors,) assess their client’s risk tolerance and investment objectives and select investments that best match them. Indeed, stock brokers are legally required to select investments that are ‘suitable’ for their clients. Unfortunately, ‘suitable’ is a very broad term–learn more here>>

Have a look at your investment account statements. Ask yourself the following question: how did my broker choose the investments that I currently hold?

Mutual Funds

There are over 5,000 mutual funds are available in Canada. They’re classified into more than 30 categories: bond funds, equity funds, sector funds, specialty funds, regional funds, diversified funds, balanced funds, index funds, etc. Stock brokers like mutual funds because they are paid sales commissions and ongoing trailer fees that are invisible to their clients. Did your broker choose a fund that meets your risk tolerance and investment objectives, or the one that pays him the most? How many funds are enough? Learn more about why mutual funds are still popular despite high fees and poor performance here>>


There are thousands of stocks available on Canadian, US and international equity markets. One of the pitches that stock brokers make to prospective clients is, “as a client you will have access to our analysts’ propriety research.”  Brokerage businesses earn large fees by raising capital for publicly traded companies (known as IPO’s or initial public offerings,) and from mergers and acquisitions advice, (M&A’s). Studies show that the vast majority of analyst reports are buy recommendations, rather than hold or sell recommendations.

Exchange Traded Funds

Why have Exchange Traded Funds (ETFs) become so popular? Low cost diversification and low management fees are the main benefits touted by the industry. ETF fees are in the 0.5% range, compared with 2% to 3% for many large Canadian mutual funds. However, in many cases, investors are switching to ETF’s without fully understanding what they are buying. You can read more about the risks associated with ETFs here>>

While ETF’s may offer low fees, stock brokers often charge clients a management fee to select funds on their behalf.  Holding a large number of ETFs can lead to over-diversified and potentially inappropriate portfolio diversification in relation to clients’ risk tolerance.

Alternative Asset Classes

Over the past few years, there has been growing interest in ‘alternative assets’ such as hedge funds and private equity funds. These funds often promise higher returns than public equity markets and paradoxically, lower risk. Not surprisingly, many have failed to deliver either.

Hedge and Private Equity fund managers typically charge clients based on a ‘2 and 20’ fee structure: an annual management fee of 2% of assets, plus 20% of profits above a pre-set threshold. This means managers have a big incentive to take on more risk. They also share those fees with stock brokers who sell their funds.

How can you protect yourself from the many conflicts of interest inherent in the brokerage business?

In each of these cases, there is a potential conflict of interest between the clients’ best interest and stock brokers’ incentives to earn higher fees. The OSC is reviewing the potential benefits of imposing a fiduciary, or ‘best interest’ duty on stock brokers.  Not surprising, their self-regulating body, the Investment Industry Association of Canada (IIAC) is resisting this initiative. Learn more here>>

At Sprung Investment Management, we are discretionary investment managers, not stock brokers. We are independent of any bank or broker and our only source of revenue comes directly from our clients. We do not receive any kind of commissions or trailer fees from stock brokers or fund managers. We are committed to meeting a fiduciary duty. A fiduciary duty or best interest standard (already the norm for lawyers, accountants and some other professionals) is a legal requirement that we put the client’s interests first. Our investments are made in your best interest.

At Sprung, our investment management approach is based on the value investing principles developed by Benjamin Graham.  Graham explained that “the essence of investment management is the management of risks, not the management of returns.” Learn more here>>

The management of risk begins when a new client joins us. You will meet directly with Michael Sprung and other members of our team. We take the time to get to know you in order to understand your investment objectives and risk tolerance.

Based on that understanding, we begin to build a portfolio that includes high quality stocks and investment grade bonds. Whereas mutual funds often hold a large number of stocks, our client portfolios typically hold 20 to 30. If you hold more, gains in any single stock will hardly affect the total value of your portfolio. If you hold fewer, losses in any single stock can have an adverse effect on your portfolio.

On the fixed-income side, we hold good quality investment grade bonds. We manage the duration of your holdings to reflect our view of the existing interest rate environment.

In summary, the benefits of portfolio management include:

  • A personal relationship with the person who is actually making investment decisions on your behalf;
  • Holding a well-diversified portfolio that properly reflects your risk tolerance and investment objectives;
  • Avoiding the conflicts of interest inherent in the broker/ fund manager relationship;
  • Transparency—no hidden fees or commissions;
  • Lower cost.

Does your portfolio properly match your risk tolerance and investment objectives? Sprung Investment Management Is Pleased To Offer Qualified Investors A Free Portfolio Review—Without Cost or Obligation. Learn more here>>

UPDATE March 27, 2014: Barry Critchley of the Financial Post interviewed Michael on the topic of a best interest standard. You can read the complete article here>>


Portfolio Management – The Concepts Behind Value Investing

Portfolio Management – The Concepts Behind Value Investing

The concept of value investing is not that complex: Identify securities that are priced below their true value.  However, to be a successful practitioner of value investing is far from simple.  Successful practitioners require knowledge of business and accounting principles, diligence and an analytical inquisitiveness, and, patience.

All value investors adhere to several basic concepts:

Portfolio Management – Value Investing Concept #1: A Company’s worth or value can be estimated

portfolio management value investing

Portfolio Management – the concept of value investing is not that complex: Identify securities that are priced below their true value.

The value of an enterprise is not static.  There are a myriad of exogenous factors affecting the value of a company at any point in time: the level of interest rates, the state of the economy domestically and internationally, the regulatory framework, the structure of the industry, tariffs, taxes, etc.  Then there are the endogenous factors that impact value: operating margins that can be effected by the costs of inputs such as materials and labour, operating efficiencies, taxes specific to the organization, financial leverage, the re-investment of earnings and the profitability available for shareholders.   Finally, the value of a company can be influenced by the requirements of the individual potential purchaser and their objectives.

Market participants are constantly monitoring these factors causing prices to change continuously.  Warren Buffet, perhaps the most famous value investor, has often stated the “in the short term, the market is a voting machine; in the long term it is a weighing machine”.  What he means is that a number of factors or sentiment can influence prices, but in the long run good strong companies will survive and prosper and their value will grow.

Most people would agree that whether you buy a new Samsung 50″ Smart TV when it’s on sale or when it’s at full price, you’re getting the same Samsung 50″ Smart TV with the same screen size and the same picture quality.  You can choose to buy I today at full price or you can hope that it goes on sale and that you get a bargain.  Stocks function in much the same way: prices are constantly changing and all levels various market participants are busy buying and selling. Stocks, like TVs, go through periods of higher and lower demand. These fluctuations change prices, and at some point, they may be priced at a level that you are comfortable paying.

However, unlike TVs, stocks will not be on sale at predictable times of year such as Boxing Day. If you are willing to do a little detective work to find stocks that are on sale, you can buy them at bargain prices that other investors have yet to appreciate.

Portfolio Management – Value Investing Concept #2: Always Incorporate a Margin of Safety

Another aspect to the discipline in value investing is estimating what your upside potential gain is relative to the downside or potential loss.  The analysis requires that various scenarios be examined in the case that things do not work out as planned.

Buying stocks at bargain prices will likely give you a better chance to make a profit when you sell them. The corollary is that it should also make you less likely to lose s great deal of money if the stock doesn’t perform as you hoped. This principle, called the margin of safety, is one of the keys to successful value investing. However, value investors do not pretend to be smart enough to tell when a particular security is at its lowest point or highest.  That is why value investors attempt to purchase securities when they estimate the upside price appreciation is considerably larger that the potential price decline.

If you determine a stock has an intrinsic value of $100 and you buy it for $66, you can potentially make a profit of $34 simply by waiting for the stock’s price to rise to the $100 it’s really worth. Also, a well-managed company should grow over time and become more valuable, giving you a chance to make even more money. If the stock’s price were to rise to $110, you would make $44 since you bought the stock on sale. If you had purchased it at its full price of $100, you would only make a $10 profit. Benjamin Graham, the father of value investing, only bought stocks when he perceived they were priced at two-thirds or less of their intrinsic value. This was the margin of safety that Graham felt was necessary to earn the best returns, while minimizing downside risk.

Portfolio Management – Value Investing Concept #3: Diversify because The Market can be Wrong Longer than you can be Solvent

The hunt for under-priced securities often leads value investors to look at companies that are not currently in favour. This is often called “contrarian” investing.  As in Concept #2, a value investor may but a stock only to see it either not move, or decline in value. While you are waiting for the rest of the market participants to recognize the value that you perceive to exist, a long time period can elapse.  Of course, when a security declines in price, particularly if it declines below the level that you determined to be the downside limit, you must constantly be monitoring and testing your assumptions.

For this reason, value investors diversify their investments in order that some of their holdings may be performing well while others are currently languishing.  The degree to which you diversify is highly dependent on your own particular risk tolerance.  While some investors may feel comfortable holding only a handful of stocks, others prefer to have twenty or more stocks in their portfolios.  You want to hold enough securities representing business cycles that are less correlated with one another that no one security will cause catastrophic deterioration in your portfolio while not holding too many securities that together will just mimic the overall market environment.

Portfolio Management – Value Investing Concept #4: Investing Requires Diligence and Patience

Value investing is a long-term strategy; it does not provide instant gratification. Value investors spend their time studying the fundamentals of the companies in which they invest and little time concerning themselves with the macro-economic environment.  It is your valuation discipline that leads you to find companies that meet your criteria.  Do not expect to buy a stock for $17 on Tuesday and sell it for $30 on Thursday, although this may occasionally happen.  In fact, you may have to wait years before your stock investments pay off.  Value investors typically invest with a three to five year time horizon in mind: long enough to persevere though a business cycle.

Value investing also requires good judgement:  you cannot simply use a value-investing formula to pick stocks that fit desired criteria. Some valuation techniques and criteria are more suited to some, but not all, companies.  You must have the patience and diligence to stick with your investment philosophy even as your picks go through the inevitable market downturns.  Resist the temptation to switch styles mid-stream, as this is where many investors get whipsawed.


Portfolio Management – What is Value Investing? Why Does it Work?

Portfolio Management – We Explain How Our Value Investing Approach Works

Many investors have some idea of the principles underlying value investing. Beginning today, we are pleased to launch a new column, entitled  Portfolio Management, where we will explain in detail the steps involved in our approach. We will also compare value investing with other investing styles.

portfolio management value investing

Portfolio Management – in this new column, we will explain how our value investing approach works.

Before we begin, let’s talk about the difference between investing and speculating. When I appear on business and financial news channels, such as BNN, I am often asked what I think the price of a particular stock will be a year from now.  As a value investor, I can calculate the future value of a business with some degree of accuracy. Relating that business value to the future price of a stock is much more difficult.

When you see experts suggest a specific future value for a stock, market index, or commodity, it might be helpful to think of them as baseball players. The top major league players have batting averages between .300 and .400. That means that when they step up to bat there is only at 30% to 40% chance they will hit the ball.  Similarly, when market experts forecast a future outcome, there is a chance that they may be proved correct, but this is also a good chance that time will prove them wrong. If you choose to follow their advice you are in our view, not investing, you are speculating. This is also known as gambling or betting.

Betting involves predicting the results of some activity—either in sports or investing–and placing a wager on the outcome. The potential gain can be great, but so is the potential for a total loss of your initial ‘investment.’

For value investors, investing in not about trying to guess future values of stocks. It’s about finding ones that are currently miss-priced or undervalued. What does it mean to say a stock is undervalued?

If you’re an avid sale shopper, you already have one of the key skills a value investor needs. As a value conscious shopper, you know that the best time to buy a 12 pack of your favourite mandarin soda is not at its regular price of, say $6. Mandarin soda might be worth $6, but you know that if you wait for the right opportunity you can get it for less. The right time to buy mandarin soda may not even be when it is on sale for $4. The deep value shopper know that if he or she waits until the soda sales cycle hits a low and they can purchase a 12 pack for just $2. Then, you buy enough soda to last you several months, or maybe even longer. You’ll be getting a $6 value for just $2.

Apply this idea to stocks and you have the essence of value investing. Before buying a stock, you want its market price to be lower that its intrinsic value. If you buy undervalued stocks in businesses that you believe will grow over time, experience has shown that you will be rewarded with incremental dividend growth and modest capital appreciation. It’s not exiting or flashy, but it does work.

In subsequent posts, we will explain the steps in the value investing process.

Blackberry and Value Investing

Blackberry’s Decline is an Instructive Story about the Difference Between Investing and Speculating

Blackberry 6210 Time All Time 100 Gadgets list

Remember the Blackberry 6000? – launched in 2003 with 6210 entering the influential Time All Time 100 Gadgets list.

Since 2008, Blackberry’s stock declined from $140 to less than $8 as the company repeatedly delayed the release of its new handsets. During that time, we were often asked if we thought the stock was a good buy. Our response to that question is a good way to explain the principles behind value investing, as well as the difference between investing and speculating.

Based on decades of experience, we have found that our three-part value investing strategy is the best way to reduce risk and volatility and earn consistent returns over time:

  1. Appraise the intrinsic value of each company over a business cycle;
  2. Seek long-term growth of capital by investing in companies that are undervalued;
  3. Utilize a margin of safety to promote return of capital…not just return on capital.

In order to do that, we do look a range of financial ratios including price/earnings ratio, price to book value and debt coverage. Over a 5 to 10 year period, we want to see growth in revenues, earnings and dividends. As well as financial data, we look at the skills of the management team, the products the company makes and the markets it serves.

When we looked at Blackberry (or Research in Motion as it was then known,) we saw a business with significant revenues, a large cash reserve and a strong customer base. However, when we looked at the company’s products, it was clear that its current offerings were out of date and that the launch date of its new devices was receding into the future. Most significantly, we were observing an industry undergoing rapid transformational change. New paradigms were emerging as the industry structure evolved to serve different markets with newer technology. This shift made reasonable predictions of future direction futile. In that environment, we could not make future projections for revenue or earnings with any degree of confidence and therefore did not recommend the stock as a buy.

So, here is the difference between investing and speculating: in our view, investing is about buying shares in businesses that you believe will grow over time and reward patient investors with incremental dividend growth and modest capital appreciation. Buying Blackberry was in our view, pure speculation: a bet as to whether consumers would embrace their new handsets when the eventually came to market. Unfortunately, that bet has not turned out well for Blackberry investors.

Another nail in the Blackberry coffin: Rogers won’t stock new Z30 phone when it’s released later this month


Does your portfolio contain investments or speculative bets? We are pleased to offer qualified* investors our free portfolio review. It will help you to understand if your portfolio matches your personal risk tolerance. Ask us how>>

*Canadian residents with a minimum $500,000 portfolio.


Interest Rates are up and Markets Volatile. Are Market Benchmarks a Good Way to Judge the Performance of Your Investments?

Investors expect their investments to outperform the market. With interest rates rising, that expectation may mean they are taking on more risk than they should.

When the US Federal Reserve signalled earlier this summer that it may begin to pull back on its quantitative easing programmes, interest rates jumped and equities swooned. As the dog days of summer draw to a close, investors may wonder how to evaluate their investments. When investors are evaluating an investment product, they often ask, “How does its performance compare with the market benchmark?”

interest rates rising investors risk

With interest rates rising, investors may be taking more risk than they should.

This seems like an entirely reasonable question. Investors are willing to pay a manager for improving investment returns and comparing returns with market indices is a good way to judge the performance of various investment products.

The Oxford Dictionary defines a benchmark as “a standard or point of reference against which things may be compared.” For example, Octane rating is a standard measure of the performance of gasoline. It compares the quality of the fuel you buy at the pump with an ideal fuel. Regular gasoline with an Octane rating of 87 provides 87% of the performance of pure Octane.

While pure Octane is an ideal fuel for the engine in your car, market benchmarks are not designed as ideal investment vehicles. Consider the S&P/TSX Composite Index, an index of the stock prices of the largest companies on the Toronto Stock Exchange (TSX) as measured by market capitalization. The Toronto Stock Exchange listed companies in the index comprise about 70% of market capitalization for all Canadian-based companies listed on the TSX.

The challenge with using the S&P/TSX Composite Index is that, far from being a benchmark or investment ideal, it simply reflects the nature of business in Canada. And what business is Canada in? You have likely heard the expression that we are ‘hewers of wood and drawers of water.’ In fact, resource companies (combining the energy and materials sectors,) comprise about 50% for the market capitalization of the TSX Composite Index.

That concentration in the resource sector means that the S&P/TSX Composite Index is highly volatile. For example, as commodity prices rose in 2009, the TSX moved up sharply. With commodity prices falling this year, the TSX has exhibited higher volatility and poorer performance compared with US markets.

Investors expect and even demand that fund managers earn their keep by out-performing market indices. In order to do that, managers must take on more risk. However, if a fund out-performs in a rising market, it will likely under-perform in a declining market. That’s exactly what many Canadian investors experienced in 2008: while the TSX Composite Index declined by 33%, many supposedly conservative large-cap equity funds declined by 40% or more.

Many investors will claim that they are aggressive investors when markets are rising. But when markets fall, they find they are in fact risk adverse.  Daniel Kahneman and Amos Tversky founded the field of behavioral physiology. They studied how people manage risk and uncertainty and concluded that investors are not so much risk adverse as they are loss adverse. They summarized their research by saying that “losses loom larger that gains,” in investors’ minds.

A robust portfolio should include high-quality dividend stocks diversified across the various sectors of the economy. On the fixed-income side, investors should hold bonds with short durations to limit the effect of interest rate hikes. We believe that over the next business cycle, equities will be the preferred asset class as the recovery gathers momentum and interest rates continue their assent.

Read more about interest rates and markets in our Second Quarter Commentary

You can read a good discussion of this topic at The Passive Income Earner

Investment Management – Risk vs. Return

Investment Management – Risk vs. Return

investment management risk return

“The essence of investment management is the management of risks, not the management of returns.” – Ben Graham

Investment management is generally defined as the professional management of various classes of securities—typically equities and bonds—in order to meet each individual client’s specific investment goals. At Sprung, our investment management approach is based on the value investing principles developed by Ben Graham.  Graham explained that “the essence of investment management is the management of risks, not the management of returns.”

That approach may seem counter-intuitive to many investors—and their advisors. They assume that investment management is all about managing returns. Many expect and even demand that their advisor out-perform market indices. What they fail to understand is that by doing that, they are in fact taking on more risk. If a fund out-performs in a rising market, it will likely under-perform in a declining market. This is exactly what many Canadian investors experienced in 2008: while the TSX Composite Index declined by 33%, many supposedly ‘conservative’ large-cap equity funds declined by 40% or more.

Seared by this experience, many investors pulled out of equities. However, with interest rates at historic lows, they are hungry for income. In response, many advisors have placed their clients into so-called ‘high-income’ funds. Many investors see the word ‘income’ and assume that these are safe, conservative investments. In fact, many of these funds expose investors to significant risk due to a large exposure to below investment grade corporate bonds, otherwise known as junk bonds.

Today, corporate junk bonds provide significantly higher yields than governments bonds, but they contain a hidden risk. As value investors, we tend to avoid date specific forecasts. However, a growing number of market watchers think that Obama may replace Fed Chairman Ben Bernake in August and end his easy money QE policy – read more here. This could lead to a jump in interest rates, causing longer-term bond prices to drop. As rates rise, the ‘spread’ or difference between government and corporate bond rates will widen.

If you own a fund with the words ‘high income’ in its name, you could be at risk.

Our investment management approach shifts focus away from chasing returns. Instead, we seek to reduce risk by focusing on company and market fundamentals by following our three-part value investing strategy:

  1. Appraise the intrinsic value of each company over a business cycle;
  2. Seek long-term growth of capital by investing in companies that we perceive to be mis-priced;
  3. Utilize a margin of safety to promote return of capital…not just return on capital.

We believe that investors are better served by following a value-based risk management approach, rather than chasing the latest ‘hot’ money products touted by many advisors.

Value Investing – How to Avoid Value Traps

In this National Post article, I explain how value investing principles can help investors avoid value traps when selecting stocks. The key is to assess whether management can execute strategy over the business cycle. The biggest mistake many value investors make is not being proactive enough in pulling the trigger on a stock that shows signs of deterioration. To view the article click here

Value Investing: What is a Value Trap?

Value investors can find a stock that appears to be a good value because it is trading at low multiples of earnings, cash flow or book value for some period of time. The stock attracts value investors who are looking for a bargain because it appears to be trading below its intrinsic value. The value trap occurs when investors buy a stock at a low price, but over time the price fails to rise. If a stock continues to trade at low multiples of earnings, cash flow or book value for long periods of time may indicate that the company or perhaps the entire sector is in trouble, and that stock’s price may not move higher.

To avoid value traps, value investors should consider the following:

  1. Avoid stocks that have dropped in price due to to exposed corporate fraud. Remember that when fraud is involved, the figures in the financial statements that are used to determine value are meaningless, and the company simply cannot be valued appropriately.
  2. Beware of overly optimistic guidance from the company’s management. A company that promises double digit earnings growth is likely being unrealistic. When management can’t deliver, they may be tempted to fabricate data.
  3. Avoid companies with high debt or leverage. Debt can be a double edged sword. When the economy is growing companies can increase earnings using leverage; in bad times, they can lose money much faster.
  4. Avoid companies that have fallen because they offer outdated products and services. Remember Blockbuster? Who needs to goes to store to get DVDs when we can download them at home with the click of mouse? Outdated products and services often signify that the lost revenues are probably lost forever, and that a rebound in the stock price is unlikely.
  5. Be careful of companies facing increasingly stiff competition. The obvious example of this is RIM. Value investors look at the profit margins over a period of 5 to 10 years, and also compare profit margins of competitors in the industry. If profit margins are decreasing through the years, the company may be unable to pass increasing costs onto its customers due to price competition.
  6. Avoid companies in highly regulated industries. High regulatory costs in Canada, the US and Europe have forced many companies to relocate their business to other countries like China.
  7. Be cautious with stocks that have dropped due to a dividend cut. Dividend cuts usually means the company has little or no earnings to pay out. The price correction following a dividend cut can be prolonged.
  8. Pay attention when companies miss earnings estimates. Analysts are generally quite lenient in their estimates and tend to revise their estimates downward before earnings releases to allow companies to beat their estimates and look good. A pattern of earning misses is foreboding.
  9. Invest in profitable businesses only. Look at the company’s income statements dating back at least five to ten years. Look for upward trend in revenue, earning and dividends. A company with consistent negative earnings every year may be too expensive at any price.
  10. Look for a healthy balance sheet. The company should have current assets greater than current liabilities, to ensure that it can pay its bills in the short term. Calculate the quick current ratio by dividing (total current assets – inventory) by total current liabilities, and make sure the ratio is greater than one. Another good measure of financial vigour is the debt to equity ratio, obtained by dividing total liabilities by total equity plus capital surplus. Debt to equity ratio should preferably be less than 1; the lower, the better.