Bad Companies & Value Traps
Rule #1: Don't lose money.
Major losses come from investments made with good intentions but unsupported by good fundamentals.
Avoid bad companies and value traps — but how can you recognise them in the first place?
Signs of Bad Companies
On a high-level: a company is good if it creates value and bad when it destroys it.
Focus on the following to draw your conclusions (there are of course overlaps)
More of an option (or a trade), than an actual business.
Business model quality shifts and pivots.
Changes in the competitive environment.
Terminal decline.
Management quality and alignment of incentives.
I elaborate on all the above categories below… 👇
RANGE OF OUTCOMES — options, trades and actual businesses
Investing in companies that are actually options (or bets) as opposed to investing in actual businesses. The difference between the two can be found in their expected range of outcomes.
Ultimately, an option-type investment can crash and burn or increase in price by many multiples — while an actual business will only perish in extreme events, and probably won’t appreciate violently in a short amount of time.
A business has redundancies — it is not fragile.
A business has time.
A business can adjust.
A business can generate cash.
A business doesn’t need external funding sources constantly.
A business doesn’t rely on cyclicality to make a buck.
To further illustrate the point on options, read this essay on the business of shipping as it relates to options trading.
BUSINESS MODELS - shifts, changes and broken ones
When something fundamental has changed for the worse, the future will unfold very different from the past. But it may take time to show, and that’s the hard part.
Excerpt from the Berkshire Hathaway 1981 Letter to Shareholders:
That day is gone. But the lessons learned during its existence are difficult to discard. While investors and managers must place their feet in the future, their memories and nervous systems often remain plugged into the past. It is much easier for investors to utilise historic P/E ratios or for managers to utilise historic business valuation yardsticks than it is for either group to rethink their premises daily. When change is slow, constant rethinking is actually undesirable; it achieves
little and slows response time. But when change is great, yesterday’s assumptions can be retained only at great cost. And the pace of economic change has become breathtaking.When your business is in the midst of fast change — chances are you will make a mistake. Why? The variables used to make an assessment of the company’s intrinsic value will probably be wrong — making your task impossible.
“Games are won by players focusing on the playing field — not by those who are glued to the scoreboard.”
—Warren Buffet
Don’t become obsessed with historical data and expect the future to unfold as it did in the past. There may be completely new realities brewing rendering your investment a write off.
Remember: small changes in one variable can bring total changes in another. This is especially true when you are fragile.
Investors looking for “cheap” stocks to buy usually fall in this trap, as they focus too much on the past. Cash flow generation and ok-ish balance sheets on companies that have “good” brands are usually the best candidates to become value traps. Capital-intensive cyclicals also have the same power to fool investors and lure them in.
To read more about the traps that investors fall into when valuing companies, see the below.
COMPETITION - death by disruption
Many a company has gone broke by disruption. The story is common: technological development, something newer and better comes along, something cheaper, something better marketed or even just a more-recognised brand of a similar product. There are many ways to kill a company. And many times the slow death of a company is readily apparent.
The problem is investors have a hard time seeing it and stick to their guns in a stubborn-irrational way. In fact, they don’t care much about the quality of the business because they obsess about the valuation it is selling for — missing the forest for the trees.
“But look at it — it’s so cheap!” …. 🤦🏻♂️
Well, look at the shifts in value in media since the proliferation of Netflix and streaming. How much value was destroyed in Legacy Media? How much value was created for Netflix and others?
Do you think this massive shift could have been captured by conventional valuation metrics and multiples? I don’t think so.
I talk more about the media space in other Philoinvestor articles, you can start with the one on Netflix below.
TERMINAL DECLINE - a slow and painful death
Depending on how one defines terminal decline, you could give many examples of businesses suffering from steady negative growth and/or negative prospects going forward.
Physical retail and the ecosystem surrounding it? The City of London as a financial centre? Office Space? Hula Hoops? Printers? Video clubs and Movie theatres?
Being strict on the definition isn’t the point — what matter is getting the business right! These big picture trends are usually longer and deeper than one expects, making them very risky for those who dabble in the sector with their eyes on the rear-view mirror.
It’s important to never rest on your laurels and track your investments very closely to protect yourself from big changes. When in doubt — stay out.
MANAGEMENT - the make or break
This is the variable that can destroy even the most high-quality business.
Make sure that management is aligned with shareholders, that they are making the right decisions and that they aren’t great liars and crooks.
Business is hard, this isn’t a walk in the park — and the tougher the business the more true this statement is.
If you are investing in a business that needs a lot of skill and constant vigilance, verify that management is competent and that they can navigate all the ups and downs in their respective markets.
For example, a business in a capital-intensive cyclical industry needs management that knows to keep a pristine balance sheet and that doesn’t overextend itself at the wrong time.
If the company over-expands at peak cycle, they will soon be bankrupt when the cycle turns and squeezes them.
Lastly, to make a good return, management should know how to play the cycle and have enough staying power to make it through the turns. There are too many bankrupt companies lying in the graveyard of all-in gamblers looking for thrills and fast riches.
Further Reading
