A Framework For Spotting Value Traps
Ford, Verizon, Macy's, Old Dominion Freight, and Verisign
It seems that there are three main issues that can plague self-proclaimed value investors. No matter the skill level, everyone underperforms over certain periods, but for many investors that I highly respect and who have undergone lengthy or dramatic periods of underperformance, it seems it’s been due to either;
Taking Munger’s advice of buying good businesses to its logical extreme and grossly overpaying for rapidly growing companies in an effort to find the next megacap market darling;
Overreaching into short selling or using too much leverage, thereby making the portfolio “path dependent”, or reducing “staying power” as Seth Klarman would say; or
Getting suckered into buying “value traps” – optically cheap stocks whose underlying businesses are fundamentally challenged – that result in a cheap stock getting perpetually cheaper, meaning it was never really cheap in the first place.
Given the fact that so many people much smarter than me have succumbed to one or many of these issues (I have fallen victim to value traps, and will again in the future), I think almost as much about how to minimize these pitfalls as I do trying to find great investments. After all, avoiding mistakes is more important than seeking brilliance. We’ve written about the first two points a fair bit, so today let’s take a look at a framework we use to try to spot, and avoid, value traps.
Good Businesses vs. Value Traps
Every investor is basically on the lookout for “compounders”, or businesses that can become more valuable over lengthy periods of time. There are a few main ways to achieve this.
One way of generating durable compounding is buying a business that have a long runway to soak up its free cash flow and redeploy it into high-return opportunities. You’ll often see this in competitively advantaged retailers early on in their growth trajectory. Think of the Walmart’s or Costco’s in their early years; they can reinvest all the money they earn into building new stores that all have great unit economics and create tremendous value. Years ago John Huber popularized the term “reinvestment moat” for these types of businesses, and he wrote an article last week that touches on this concept (Floor and Décor appears likely to be a current reinvestment compounder).
Another way of consistently compounding value is to own a business that possesses a durable advantage but cannot reinvest all of its earnings into growing the business, so management returns a sizeable percentage of the market cap each year via dividends and buybacks. Lowe’s is a good example here. They can retain a decent amount of the cash the business generates (maybe 20-30%) at attractive incremental returns (of 30-40%) but have no use for the rest. This results in good but unspectacular absolute levels of growth, maybe high single digits. Then, because not all capital can be or needs to be reinvested, meaningful levels of cash can be returned to shareholders. Lowe’s pays a dividend and hammers their share count with excess cash. This is how 6-8% returns become 14-16% returns thanks to dividends and share repurchases (provided the company doesn’t trade at a demanding valuation multiple).
Finally, there are the capital-light compounders that can grow while retaining no capital and return essentially all profits to shareholders. Some tobacco companies fit the bill, along with many asset managers (like Brookfield Asset Management). Verisign is another great example I’ll expand upon below.
As for value traps, I like to think of them as somewhat of the anti-compounders. They display the opposite of the characteristics described above. Specifically, they demonstrate some combination of;
A need to retain a significant amount of the profits they generate just to maintain existing levels of profitability. In other words, they tread water or slowly drown.
They have very poor incremental, or even negative, returns on incremental invested capital. This results in the business retaining profits and standing still or shrinking.
They return too much capital to shareholders and do not reinvest in the business to an adequate degree or take on excessive leverage to fund unsustainable capital return programs.
I often use the example of an apartment building as an analogy for evaluating a stock. For a compounder, think of an apartment building that you buy for $1M, and it kicks off $100K in net operating income each year. Rents automatically escalate by 3% per year, and the building appreciates in value. Local ordinances mean supply growth of similar properties will be constrained going forward, lucky you! You reinvest a portion of rents annually into improvements that make the building more valuable still and allow you to charge higher rents to new tenants. Each year you pocket the cash that couldn’t be plowed back into the building. These are all great things, and this apartment building has the characteristics of some of the compounders described above.
On the flip side, imagine a different apartment building that you also buy for $1M. You think it’s a steal because it was appraised for $1.75M a few years ago. It appears “cheap”. However, you find out after owning it that the building every year needs more maintenance projects than the $100K in net operating profits, so you need to invest more equity, or take on more debt, to fund these projects. Furthermore, when you try to raise rents, tenants leave and your vacancy rate goes up. The part of town is deteriorating and you realize five years down the line, and after reinvesting more than all of your “profits” over that period, that the building is only worth $750K. This was a value trap.
Instead of a theoretical apartment, here is how we look for value traps and a few real world stock examples.
Cash-in, Cash-out Framework
An initial test/filter Matt and I use to spot a potential value trap, or identify a potentially good business, is what we call the cash-in, cash-out framework. It’s simple yet very powerful.
We are trying to answer a simple two-part question: how much cash does the business reinvest and what are the returns on the reinvested cash? We prefer to work from cash flow statements, as normally cash doesn’t lie and it is much more difficult to manipulate than GAAP earnings or balance sheet figures. Just don’t forget to consider stock compensation, which is a very real expense.
I like to look at ten year increments and add up how much cash came into a business from all sources - operating cash flow, debt issuance, and share issuance - versus how much cash left the business via debt repayments, share repurchases, and dividends. Add the two together and you get the dollar amount of cash retained (from all sources) over that time period.
Next, we look at the cumulative profits over the same time period to get an idea what the reinvestment rate is as a percentage of total operating profits. Finally, by looking at the change in operating profits (often this requires some normalization) over the time period and dividing by total retained profits we can assess incremental returns on retained capital (incremental ROIC or I-ROIC). If profits grew by $1B and it took $5B of retained capital to generate that extra $1B, I-ROIC is 20% ($1B/$5B). Reinvestment rate and I-ROIC, in conjunction with shareholder yield, tell me roughly how the business has compounded in value on a per share basis.
Examples
Below are a handful of examples up and down the spectrum of compounders and value traps.
I’ve included three value traps and two compounders above, and it’s not hard to spot the difference.
Ford has the pleasure of operating in a brutally competitive and commoditized industry subject to constant technological change and heavy capex requirements. The business is thrown curveball after curveball. Over the past decade the business has reinvested more than all of its profits at a modestly negative return. This is the definition of treading water. Thanks to the use of debt the stock has generated a 4% yield meaning the business (not shareholders, though) eked out a small annual return.
Verizon is puzzling to me as I would expect it to be a better business given it operates in a lightly regulated oligopoly with hard to replicate assets. Alas. The company soaked up 90% of earnings over the last ten years and barely grew for a measly 1% compounding rate. A generous debt-fueled dividend payout took business returns to an underwhelming 6%. While the yield seems attractive, a high dividend payout cannot go on forever if it’s driven by increasing levels of debt.
Macy’s has been a disaster. Left behind by better positioned specialty retailers and ecommerce businesses, Macy’s reinvested a third of profits at highly negative rates and has become far less valuable over the past decade, as you can see.
Old Dominion, on the other hand, is a beast. The company competes in a tough industry (trucking) but has out maneuvered the competition, invested in hard to replicate trucking terminals, and executed exceptionally well. Overall the business has reinvested almost 60% of earnings at around 30% incremental returns for an exceptional ~17% annual compounding rate, which becomes close to 20% with shareholder yield included.
Verisign is the definition of capital-light. It’s also a little known but interesting company. As Matt wrote a few years ago:
“Verisign maintains the authoritative address book for the internet. Like houses have street addresses, websites have IP addresses. And like the post office needs a street address, internet browsers need an IP address. Verisign maintains a directory that stores domain names and their corresponding IP addresses. When you type Amazon.com into an internet browser, the browser has to look up the IP address in Verisign's directory before it knows where to take you. Verisign's domain name system (DNS) is a simple but mission-critical part of the internet, and by extension global commerce and communication.”
Verisign is basically a monopoly that owns the directory of the internet, an operation that requires essentially no incremental capital to maintain. Verisign naturally grows via new website domains coming online each year and exercises regular price increases. Because this growth comes with no commensurate investment, all profits are returned to shareholders via repurchases. Strikingly, Verisign earns about 50% more money today than ten years ago while net taking capital out of the business.
The table above is only half the story. Stock returns can differ materially from business returns thanks to a change in multiple. Here’s how these five stocks have fared.
As you can see, the businesses with subpar returns on capital either destroyed tremendous value for shareholders over the last decade or grossly underperformed the broader stock market.
The main point related to why three of these businesses were value traps is the optically inexpensive starting valuations. Ford, Verizon, and Macy’s all averaged a PE ratio of 12x or less during the starting year. The problem is, despite a seemingly “cheap” beginning multiple, all businesses failed to create value over time and, as shareholders realized what was occurring, the stocks became even cheaper. On the flip side, Old Dominion was a value investment - investors got far more in value than what they paid for - which resulted in outsized returns.
We can now classify each of these businesses into its proper category (at least over the last decade).
To be clear, these stocks are cherry picked and meant to illustrate a point. I’m sure you can find a plethora of stocks that had cheap starting valuations, poor returns on capital, and still re-rated to a higher stock price for some reason over a ten year period. While those stocks undoubtedly exist, and probably in great quantity, I seriously doubt most people’s ability to reliably predict those situations for any extended period of time. I certainly couldn’t do it, it would be akin to throwing darts.
The point I’m making is, by assessing the economic fundamentals of a business whose stock may look cheap, you can implement guard rails as to whether or not you may be looking at a value trap. I’m skeptical of any stock that looks cheap but has flunked the cash-in, cash-out test over a many-year period. This filter at least gives us some hope of not fooling ourselves when we are enamored only by a cheap purchase price. Cheap businesses can be fine investments, but cheap and good businesses can be spectacular, and more importantly, limit your downside. To us, it’s also a far more replicable process, and a lot easier to stick with over the long run.
There are a few more critical other points to this discussion, as what I’ve described above is the easy part of the analysis (anyone can plug numbers into a spreadsheet).
The historical numbers are the result of what happened over the past ten years, and what matters is what happens over the next ten years.
Understanding what happened is easy, understanding why it happened and, more importantly, if it will continue to happen is where superior qualitative judgement and experience are required.
For example, perhaps over the next ten years Verizon will not need to reinvest so much capital into the business, and can return a significant amount of capital to shareholders at today’s very attractive prices. I don’t know if this will be true, but if it is, anyone who spots it early enough will be handsomely rewarded.
Maybe, now selling at 5x earnings, Macy’s is finally cheap enough to generate outsized returns going forward given just how low expectations are. Or, maybe they’ll go bankrupt.
Or, maybe Old Dominion’s competitive advantages will deteriorate and capital needs will increase even further while incremental returns decline. Unlikely, but possible. You get the idea.
To realize the excellent returns of Old Dominion and Verisign investors needed to hold onto the stocks at optically expensive multiples. This is not easy for many value investors, including myself, to do. But, when you’ve found a good business for a good price, and the business keeps executing - as measured by superior returns on retained capital and/or attractive yield resulting from an identifiable and ongoing business advantage - the valuation to sell is usually higher than you might think.
Finally, using this I-ROIC framework will cause you to miss opportunities when businesses are at key inflection points and the future looks dramatically rosier than the past. That’s fine with us, because I think it causes us to “miss” more losers by keeping us out of trouble. It also means we will almost surely not find the next Amazon, but that’s not the game we are trying, or equipped, to play.
It’s ok to make exceptions to this rule. Sometimes we may spot a business that we believe we understand well enough to determine the future will be brighter than the past. I just wouldn’t want to fill a portfolio with these situations.
Yesterday’s value traps can become tomorrow’s compounders; investors just better be sure they can answer the question, from first principles, why the future is likely to be different than the past. Otherwise, they’re likely to be suckered into buying stocks with justifiably cheap multiples and regretting it years later.
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Dan, I know this is an old post so not sure you'll see it. What is causing the difference between actual return and calculated? ODFL for example: You calculate an annual business return of ~19% + a rerate in the multiple of ~8%. That gets to ~27%. What is the 4% difference between that and the 31% actual stock CAGR?
This is great, thank you for this insight into your investing assessment shorthand