How to avoid Value Traps?

 

Yesterday afternoon I had a really great chat with many financial planners and fund managers, the topic of discussion was volatility and value picking in market. People behave in different ways in regards to both of these subjects. I was happy to see that financial planners were pretty OK with volatility and had understanding that in long run this volatility smoothens. Even the fund managers agreed with that opinion.

Then the discussion went on to how good quality stocks are trading cheap to their valuations (P/E ratios etc.) but then when they are confident that it won’t go further down but they still do! In same way they also felt that few stocks they felt that they are still over priced and should correct but they move further up and challenge their analysis.

Correct term for the above situation is value traps. To come out of this value trap the very first thing people should do is switch off their analysis totally based on price and also switch off the markets. It is important that they separate price with business attribute.

It is very easy to value any business and there are many ways and many successful investors have their own theory on how to evaluate them. But analysis doesn’t stops at valuations. It is also important that your research is done on right variables of business rather then just on available value tools (PE ratio, Price to book value etc.).

To avoid these value traps it is important that you do your research on their fundamentals and find the variables that are deteriorating. Now we think that if any business is trading at discount to its intrinsic value then check their margins.

If the margins are intact and revenues are growing then the business is fundamentally sound. I thought to do research on what we believe with the help of A1 service (can’t wait to reveal more information and share with you all in regards to that).

Infosys just released its second quarter results and Bharti Shipyard that many of you know that I am shouting so hard to avoid, I thought to put them both on test. 

 

Infosys

 

We have noticed a lot of volatility within this business from last one year. We have noticed price falling down from 3000 levels to down 2200 levels.

I want to share few facts with you all before going further with my analysis. Last year company paid almost 62% of their earnings as dividend to its shareholder and retained 38% within the business.

 

Normally we have noticed that by average Infosys pays an average of 30% of its earnings as dividends. The variation in these payouts impacts valuations of company.

 

The above chart is of Infosys with actual intrinsic values in red line. After almost 15 months it was trading at discount to its value. If you would have followed our model and would have invested in 2008 and 2009 year when it was trading at discounts your compounded returns (not everyone use them) would be around 18% per anum.

Lets get back to the margin analysis. Throughout the financial crisis till date I have noticed that their margins were all intact.

Infosys

Year 2011

Year 2010

Year 2009

Year 2008

Year 2007

Operating Profits margins

32%

33%

33%

30%

31%

Net Profit Margins

24%

26%

28%

27%

28%

We can notice that operating profit margins are all unharmed from last 5 years. The net profit margins have dropped but the variable to its fall to blame is Tax.

Infosys

1st Quarter of 2012

2nd Quarter of 2012

Operating Profit margins

28%

30%

Net Profit margins

23%

23%

Quarterly operating profit margins look scary but if they manage to keep above 30% I don’t see any reason to panic.

Bharti Shipyard

If we look at the margins table of Bharti Shipyard, I am pretty sure you would understand what I mean by value trap.

Bharti Shipyard

Year 2011

Year 2010

Year 2009

Year 2008

Year 2007

Operating Profits margins

29%

26%

29%

29%

32%

Net Profit Margins

7%

10%

13%

15%

17%

The operating profit margins are not damaged but look at the net profit margins. The variable that is impacting its margin is the Interest expense. Over here it is debatable that soon interest rates when start falling down then everything looks like green pasture for company. But my view is bit different. I am worried of its huge debt on balance sheet. If interest rates start falling down then management would also like to bring its debt down. So they have two options, both they will raise more equity and dilute the current holding of shareholders or else will implement strict budget and try to pay it off from its profits.

In both the scenarios it is uneconomical for shareholder to invest in Bharti Shipyard.

Bharti Shipyard

1st Quarter of 2012

Operating Profit margin

32%

Net Profit margin

4%

Look for the companies with stability and predictability of its revenue and earnings in this market condition as I mentioned in my previous post.

Now a job for you is to search for such value traps and feel free to share over here. I would also love to see if you could also look for those characteristics that I mentioned in my previous blog.

Finally don’t go out and buy Infosys if I am stating. Do your own independent research and buy them when they are trading at huge discounts.

Happy Holidays!!