If you ask many value investors, they would say that even the worst of stocks would be attractive at the right price. When one chooses a deeply discounted but very bad business, this is a term called cigar butt investing by Warren Buffet.
Warren Buffet explains that if you found a cigar butt on the street with only one puff in it, you may not find much value in it. However, if purchased at the right bargain price, it would make that puff all profit. (“The Essays of Warren Buffet, Lessons for corporate America” by Lawrence A. Cunningham)
What this post hopes to achieve This post hopes to encourage the reader to evaluate stocks by looking at the company first - that is you would first determine that you like the company and its business before further investigating its stock valuation. It attempts to dissuade against doing the opposite: finding deeply discounted stocks and then trying to justify the right price to compensate for a terrible business.
The problem of the cheap but bad business 1. Let’s say you find a stock selling at a price to book (p/b) of 0.5, or a p/e ratio of 3, or basically cheap on any other sort of financial measure. But then you look at the business and quite frankly aren’t a big fan. Perhaps it sells typewriters, or perhaps it makes flip phones. Whatever it is, the earnings are in consistent declines, and the industry itself is facing significant headwinds. The problem is, while it looks cheap at the present, as a part owner in the business we also care about future numbers too. So if earnings drop another 50% this year and the next, suddenly we’re looking at a p/e ratio of 12 2 years later. Suddenly we realize that the stock when viewed from a longer range perspective only appears to be cheap, but perhaps may not actually be.
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The problem is also well illustrated when we ask ourselves where the future stock returns are supposed to come from. Assuming this “cheap” stock pays no dividend, clearly we can only profit from our stock purchase if the stock price goes higher. We can hope all we want for the price to go higher, but the reality is that unless the business and/or industry begin to overcome the headwinds or even gain some tailwinds, the stock price is not predictably going to go up. The net result is that we are left holding a “cheap” stock a very bad business and may hold all the way till it hits 0 (and it’s so cheap it’s free). We don’t want to buy stocks “hoping” that it will go up. We wish to buy stocks confident in our analysis that it will go up.
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An example of mine: I too sometimes fall for the value trap of the cheap stock. About one year ago I purchased shares in Skullcandy because they were selling at a p/b of 0.7 and a low p/e as well. I had just read “The Intelligent Investor” by Benjamin Graham and thus was very drawn to buying stocks priced significantly below book value. However, what I had not considered was that headphones is an increasingly price competitive business (especially the ones Skullcandy was selling) and business was quickly deteriorating - inventories were quickly rising, it was clear they were selling headphones at increasingly slower rates. All that book value is meaningless if they could not sell it. What happened? The stock price stagnated for several months and I eventually sold for capital losses. While it is true that they ended up being bought out for significant premium later on, buyouts are not the sort of thing the individual investor can reliably count on.
Applications in stock investing (stock screeners, etc) 1. One of the most well known tools in this modern era for the stock picker is the stock screener. So one familiar with the stock screener might be wondering, does this mean that we should not use stock screeners at all, since they screen first on valuation? I ask the reader - if you have ever used a stock screener, have you ever found the task very frustrating - you’d find a cheap company but then when you look into the company you’d have absolutely no idea what they’re doing? And their website would look like a kindergartener made it? One possible solution to this is to first filter the companies in the screening pool to only be ones of quality (for example using your stock screener on the s&p500). But as this not always ideal, the way I have personally done is to run the stock screener, then for each of the results spend 3 minutes trying to understand what their company does. If I do not like the business or can not even explain what they do, I move on. There are so many companies to choose from, there is no reason to invest in something you do not understand.
- Watchlists - Something I’ve done is maintain watchlists of my favorite companies. I’d include companies which I view to have a wide MOAT and this would allow me to see which companies are selling at the greatest discounts with respect to the others, as one example. In my main watchlist I have included GOOG, PG, and AMZN among others, for example. I use Yahoo! Finance and there I’m able to sort companies based on certain metrics like “change from 52 week high” or “p/e” or “p/b”
Possible Exceptions 1. Liquidation is a big one. Sometimes one might buy a stock because they think that the company will soon file for bankruptcy and the resulting value is greater than the stock price. In this case, it would not really matter what the business is because a bankrupt business is a bankrupt business. If done well, this can be very profittable - however what I can say is that this is obviously by no means easy as you would have to accurately determine the liquidation value of the company, as well as accurately determine that the company does indeed want to file bankruptcy, and perhaps most excruciating you have to wait for the company to file bankruptcy (if they ever do). You might end up holding the stock for decades as oftentimes businesses can go through long periods of poor business and still remain afloat.
Conclusion It’s very common practice to “bottom feed” or purchase stocks solely due to low valuations. Purchasing cheap stocks of bad business is more often than not “falling for the trap” so to speak.
I hope this was helpful, feel free to leave questions and comments below.
Best of luck investing.
Submitted January 20, 2017 at 12:28AM by jjstock http://ift.tt/2jFlvIb
