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As a value investor I have always been concerned about a value trap. A Value trap is a company, which remains cheap forever, and you are not able to make any money out of it.

Now a company can be a value trap for a variety of reasons, which can be

1.The company performance keeps deteriorating and as a result the intrinsic value keeps going down
2.The market just ignores the company and the sector because there is nothing exciting happening in that sector and most of the companies are hardly glamorous
3.Management action can result in a value trap too. The management keeps blowing away the excess cash into unprofitable diversification instead of returning it to the shareholders

So how does one avoid a value trap. I think this is a very important consideration of value investors especially if one is investing in ‘graham’ style bargains. A ‘Catalyst’ is something which one should look out for to avoid a value trap.

A catalyst can be any of the following

1.Likely management action such as buyback, bonus etc
2.Likely asset conversion opportunities such as LBO, de-merger, accquisitions (think L&T for an example of de-merger)
3.Likely shift in demand supply in favor of the company due to changes in the business cycle – steel and commodity companies in the last few years come to mind.
4.Regulatory changes – Banking comes to mind
5.Unexpected earnings increase
6.Finally time – However one should have a defined time horizon in which one would expect the investment to work out.

So when I look at value or deep value stock, I tend to look beyond the numbers. Is there a likely catalyst, which would unlock the value, or am I getting into a value trap? and how long will it take for the catalyst to be play out. That would define my expected returns too.

Ofcourse this concept of catalyst is not some original concept of mine. It is referred to frequently by Mario gabelli and Marty whitman.

I work in the tech industry and have always been fascinated by technology and the role it is playing in improving our lives (definitely mine – cannot think of life without broadband, internet, e-mail, google etc).

Back in 2000, during the tech bubble, like others I got swept by the internet and technology mania and went ahead in invested in technology stocks. The basic logic of my analysis was correct, but I got the valuation wrong (overpaid for the optimism). After promptly losing money and later reading munger and buffett’s thoughts on technology, I have changed my approach to technology.

I am by no means a techno-phobe. I spend time reading tech blogs, looking and trying to understand changes happening in technology and how it seems to be impacting various businesses such as newspapers, media, advertising etc. But it is diffcult to realistically forecast a technology business out for several years. It is more so for technology businesses as valuations of most of these companies is high and to make any money, one has to be able to forecast the cash flows for 5 years or more.

Over time based on what I read and based on my experience, I now prefer companies which are predictable than which will have the highest growth. My own experience has been that markets tend to pay more for growth than predictability ( FMCG v/s IT services stock ?)

At the same time the decision to invest in tech stocks also boils down to one’s investing philosophy. I have tend to have a focussed portfolio with a few names and want to hold for 3-5 years with low maintenance (quarter or annual followup). As a result it is difficult for me to hold technology stocks as it requires too much effort to follow them.

As an aside I work in IT services. So my professional career is tied to the Tech industry. The last thing I want to do is put all my eggs in the same basket. That is not the typical way of looking at diversification. But for me the income stream through my career and my stock portfolio need to diversified sufficiently. Who wants to be lose a job and also see the stock portfolio crash at the same time, because the industry hit a roadblock !!

I keeping reading this debate on whether long term buy and hold is a smart strategy or is it a fad followed by buffett followers.

It would seem to me that such a discussion clearly shows that the person debating it really does not get the core idea of the approach. Long term buy and hold is not long term buy and forget. There is no such business which one can buy and forget. When there is such intense competition, one has to follow or track the company in which one is invested.

My typical approach to understand the industry and then the company in detail. If I am comfortable with the company and the industry and if the valuation is compelling, I tend to slot the company into one of the three buckets

Type 3 companies are value stocks (graham style) where the intrinsic value of the business is flat or at best increasing very slowly. I hold such companies till they come within 90% of my estimate of intrinsic value and then I sell them. I do not see a benefit of holding such companies too long if the company is selling close to the intrinsic value which is turn is flat or worse, shrinking

The other end of the spectrum are my type 1 kind of companies. These are dominant companies with strong competitive advantages and their intrinsic value is increasing at decent pace. Such companies are more of the buy and hold ‘longer’ type of companies for me. I typically read the quaterly updates for these companies and try to check if their competitive strenghts are intact and they would continue to increase their moats as time passes. I have found that selling such companies when they touch their intrinsic value (atleast my conservative estimates) has not been a good idea. Most of these companies do well over time and their intrinsic value keeps increasing. So even if the company is moderately overvalued, then I would tend to hold on. Ofcourse if the company is wildly overvalued, then I would sell the stock.

The type 2 companies are between 1 and 3. This is grey area where majority of my picks lie. Most of these companies have decent comptetive advantages and their intrinsic value increases erratically. So these kind of companies require more attention and at the end of each year, I go over my thesis and try to re-think whether I should hold onto the stock or sell it , especially if it is selling close to the intrinsic value.

All of the above is a decent amount of work. Which is why I don’t hold more than 10-12 stocks in my portfolio. But finally I think there is no buy and forget kind of stock. Ofcourse I don’t follow the stock on daily or weekly basis. My follow up is more quaterly or annual.

Found this Q&A buffett had with University of Kansas Business School Students. As usual the Q&A was a learning experience for me. In particular I found the following reply interesting

Q: What sources of investment ideas are available today?
WEB: First, you need two piles. You have to segregate businesses you can understand and reasonably predict from those you don’t understand and can’t reasonable predict. An example is chewing gum versus software. You also have to recognize what you can and can not know. Put everything you can’t understand or that is difficult to predict in one pile. That is the too hard pile. Once you know the other pile, then its important to read a lot, learn about the industries, get background information, etc. on the companies in those piles. Read a lot of 10Ks and Qs, etc. Read about the competitors. I don’t want to know the price of the stock prior to my analysis. I want to do the work and estimate a value for the stock and then compare that to the current offering price. If I know the price in advance it may influence my analysis (emphasis mine). We’re getting ready to make a $5 billion investment and this was the process I used.
I used to handicap horse racing. The odds had to add to 100%. Sometimes there would be what in horse racing is referred to as an “overlay”. We’re looking for overlays in the stock market. It’s like a treasure hunt.
You can increase your sources of investment ideas by widening your circle of competence. I’ve widened my circle over the years. I only needed to understand insurance in 1951. There were enough opportunities in that sector alone.

The above answer had me thinking. I have been making an effort in trying to learn about various industries and deepen and wide my circle of competence. The process I am following is

– pick up an industry and identify the major players in the industry
– If available, read a sector analysis report from any major brokerage firm: These reports give me good starting point and allow me to develop an initial understanding of the industry
– Use the initial understanding to build my ‘industry analysis’ worksheet
– Come up with additional questions (in terms of the competitive dynamics of the industry)
– Read the AR for the major companies (initially for the current year and then for the previous)
– Update the ‘industry analysis’
– Do valuation analysis for some of the companies which may be cheap

At the end of the above process I may find some companies worth investing. A lot of times I draw a blank. But I guess it is fine because as long as I keep doing this and improving my circle of competence, opportunities will come up.