Monday 27 April 2020

When is a bargain not a bargain?

Once you have assembled a list of likely bargain candidates, you have to determine

  • which to put your money into and 
  • which to avoid and move on.


Many of the companies in your initial list are cheap for a reason;; they have fundamental problems that make them decidedly not valuable.

On the list of value candidates whose stock price had fallen significantly in the past were Enron, Global Crossing, MCI, US Airlines and Pacific Gas and Electric.   These companies ended up filing for bankruptcy and shareholders lost a significant portion of their investment if not all their money.


To achieve your wealth-building goals, you have to determine 

  • why a company's shares are cheap and 
  • which ones have little chance of recovery.



1.  Too much debt

The first and most toxic reason that stocks become cheap is too much debt.  In good times, companies with decent cash flow may borrow large amounts of money on the theory that if they continue to grow, they can meet the interest and principal payments in the future.  UNFORTUNATELY, the future is unknowable, and companies with with too much debt have a much smaller chance of surviving an economic downturn.  

Ben Graham explained that he used a simple yardstick to measure health.  A company should own twice as much as it owes.  This philosophy can help you avoid companies that owe too much to survive.


2.  Company falls short of analysts' earnings estimates.

Analysts seem to be more focused on short-term earnings gains than future long-term success   These quarterly or yearly earnings estimates have been proven to be notoriously unreliable.  Routinely, large and good companies get pushed to new stock price lows because they missed the estimates of the thundering herd of Wall Street  Missing earnings is not fatal, and it tends to create opportunity for the value buyer; if the trend continues, however, the shares will likely continue to fall.


3.  Cyclical stocks

Some cyclical stocks may show up on your list of potential bargains.  They are highly dependent on how the economy is doing.  Industries like automobiles, large appliances, steel and construction will experience lean times and stock prices are likely to reflect this fact.   Although we have had recessions of varying lengths and depths, the economies of industrialised nations have always rebounded.  It is important to note that in the bad times, cyclical companies with heavy debt loads may well face insurmountable problems.  Adhering to a policy of avoiding overly leveraged companies will serve you well.


4.  Labour contracts

Stocks may also fall because of labour contracts.  During good times, some companies and industries cave into labour union demands that were affordable at the time.  Little did they realize that they were mortgaging their future.  As new competition unburdened by costly labour contracts enters their industries, their profits disappear.  In many cases, the unions have been unwilling to grant concessions.   It is never easy to give back something you have, even if not doing so threatens the very existence of the company you work for.  Although holding on to expensive contracts may or may not benefit management or the unions in the long run, the one person that most assuredly does not benefit is the stockholder.  

Many large corporations (old-line industrial companies) have pension liabilities - benefits promised to workers - that they simply will be unable to pay  Generally speaking, if a company has excessive pension liabilities or there exists a contentious labour environment, it may be best to put these companies' shares on the no-thank-you list.


5.  Increased competition

Highly profitable industries attract new competition.  The most serious form of this comes when an industry in one country has high-priced labour or expensive regulatory rules.  Other nations unburdened by such costs can often produce and export the same goods cheaper.  Think China.  Throughout the world, countries have seen foreign manufacturers of automobiles, appliances and other goods make significant inroads into their market.  If a company is facing strong competition from a more efficient competitor with lower costs, it is perhaps best to utter those comforting words "no, thank you" and move on to the next candidate.


6.  Obsolescence

Obsolescence is another potentially fatal cause for falling prices.

Although the last large scale manufacturer of buggy whips or hand-cranked automobile starters made a very fine product, there was simply no longer a need for its product.  There may be some small demand for these products, but a company that depended on them for most of its sales would soon be out of business

Consider the field of technology.  The rate of "creative destruction" has never been faster.  Newer and better products turn up every day making the older products obsolete  The new products are a boon to the consumer but the bane of the legacy company.  

Today, we can go online and order any movie from NetFlicks and never have to leave the comfort of your own home.  For this reason, you should avoid companies that are subject to technological obsolescence.  The world is simply changing too fast to depend on products and services that someone else can deliver better and for less cost.  Avoid these.


7.  Corporate or accounting frauds

These are perhaps one of the most dangerous reasons for share price drops is corporate or accounting fraud.

Although these crimes against investors are the exception and not the rule, and most CEOs are dedicated leaders who care about their companies and their shareholders, fraud does happen.  In recent years, the world has experienced some of the largest cases in history, Enron, Parmalat, Tyco, WorldCom and others.  Regulators have since done much to help prevent future occurrences but there will always be some form of shenanigans.

Criminals exist in every walk of life.  There is almost no way to uncover fraud before it becomes public.  By the time it is discovered, it is too late  The best the investor can do is to steer clear of financial reports that seem overly complicated.


8.  Companies you do not understand or are not comfortable with

If there is something you do not understand or are not comfortable with, put these in the no-thank-you pile.   If a company has too many problems - too much debt, union and pension problems, stiff foreign competition, they too go to the no-thank-you pile.  You have the luxury of filling your portfolio with stocks you are comfortable with and want to own for the long term wealth building it offers.



Summary

You should approach your list of investment candidates with a healthy dose of scepticism.

You should stick to businesses you understand and for which there is an ongoing need (products or services).

You should also like food, beverage, and consumer staples like detergents, toothpaste, pens, and pencils - the stuff you consume on a daily basis. Many of these products engender brand loyalty that keeps the same product day after day, week after week.  We are all creatures of habit, and we will usually repeat our consumer preference when we go shopping.

Your best friend in the whole investing world is your no-thank-you pile.  Knowing your no-thank-you pile gives you the value investing opportunities to build your wealth building portfolio.

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