INVESTING

Avoiding Value Traps

Companies and their stocks fall on hard times for any number of reasons. Sometimes hard times spell buying opportunities, other times you're better off keeping your distance. The hard part is telling the difference. Whitney Tilson shares some tricks of the trade.

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By Whitney Tilson
October 3, 2003

A legendary company with one of the world's best-known brands falls on hard times. Earnings decline and debt rises. Analysts and the media fall over themselves to heap scorn upon the company. The stock hits lows not seen in a decade or more.

Am I talking about Kodak (NYSE: EK)? Indeed. But the description fits McDonald's (NYSE: MCD) in March, when the stock hit a 10-year low of $12.12. Back then, I made McDonald's one of my largest positions and it's paid off with a quick double. So might Kodak be a similar opportunity today? Managed properly, it could be. But until management abandons a recently announced, completely hare-brained strategy, I wouldn't buy it anywhere near today's price.

Value investments come in all shapes and sizes, but today I'd like to focus on four (ranked from most to least attractive): 1) growth companies suffering a period of slow or no growth that turns out to be temporary; 2) growth companies reaching saturation and must adjust to slower growth in the future; 3) companies in decline, but management is aware and adopts an appropriate strategy; and 4) companies that are declining, but management is in denial and engages in value-destroying actions.

While these might appear to be very distinctive categories, it can be extremely difficult to categorize a particular situation. Yet, few things are as important for CEOs and investors to get right.

High-growth companies that hit a speed bump
These are the most mouth-watering (and least common) opportunities. Here, the stock of a great, high-growth company takes a beating due to short-term factors, and then the company resumes its winning ways. While I hate to dredge up painful memories, the worst sale I ever made was one of these situations. In March 2000, I dumped my shares of Apollo Group (Nasdaq: APOL) at $9.54 and have since watched it rise steadily to nearly $70. Ouch! (In my defense, I sold in order to buy more Berkshire Hathaway (NYSE: BRK.A), which has nearly doubled.)

Apollo, which provides higher education programs to working adults, has always been a fabulous business, with high barriers to entry, fat margins, rapid growth and exceptional returns on capital. But the stock's valuation may have gotten a little ahead of itself when it peaked at nearly $20 in 1998. When investors began shunning everything but tech stocks, Apollo fell below $10 even though the business continued to perform. This is key: The very best situations are when stocks get clobbered, but nothing whatsoever has happened to the company. The best one analyst could come up with in January 2000 when I bought was vague "concerns re: Q2:00's earnings estimates as well as the lack of any catalyst."

Again, such situations are rare, however. Usually, when the stock of a high-growth company tumbles it's because something bad has happened to the business. So how can one distinguish between a temporary hiccup and more serious problems? There are no easy answers, so a careful analysis of a company as well as its markets and competitive situation are required.

Let's look briefly at teenage fashion accessories seller Claire's Stores (NYSE: CLE), which has nearly tripled in the past two years, and Sun Microsystems (Nasdaq: SUNW), which has lured value-seeking investors to their doom for three years, tumbling from more than $60 to around $3 today. What explains the vastly different outcomes? Two years ago, Claire's was reporting weak results due to slow mall traffic post-9/11, but nothing else was wrong with this excellent business. Sun's end markets, meanwhile, have collapsed and the competitive environment has worsened dramatically. Betting on Claire's turnaround was a much simpler, safer bet than trying to determine at any point over the past three years what might happen to Sun's business.

Fast growers become slow growers
Even the best, fastest growing companies eventually run out of lucrative new markets to tap and must adjust to slower growth. Precisely when a company has reached this point is far from clear, however, especially to management and investors who often become so accustomed to high growth that they begin to behave as if it's a company's birthright (for a classic example of this, see my column on Cisco's Hubris). Some of the biggest train wrecks have been caused by management teams that failed to recognize a changing environment and continued to pursue high growth -- or at least the appearance of such via accounting shenanigans (see my series on Lucent (NYSE: LU), for example).

Two stocks I own, Office Depot (NYSE: ODP) and McDonald's, followed a typical path. Both grew rapidly for many years, but eventually began to saturate their core markets. Yet neither scaled back their expansions, so new units performed poorly, margins and returns on capital fell, and the stocks followed. In both cases, new CEOs came on board, announced sensible strategies to scale back growth and milk the businesses for cash, and the stocks eventually soared.

As an investor in such situations, the key is to wait until the new strategy is announced and then carefully evaluate the situation. If you believe that the strategy is sound, the management team can execute on it, and the company's competitive position remains strong, you want to buy the stock before the company starts reporting improved numbers. If you wait until it's obvious that things are back on track, then you will likely miss a profitable doubling of the stock.

Well-managed declining businesses
A declining business can still be an excellent investment, but it must be managed properly. For a classic case study, look no further than Deluxe (NYSE: DLX), the country's largest check printer. With the increasing use of alternate methods of payment, the number of checks written is declining 3%-4% annually (and the rate of decline is accelerating). Initially, Deluxe attempted to compete in new arenas by launching a division called eFunds, but soon realized that it had little competitive advantage in this space and spun-off eFunds at the end of 2000 (Kodak, take note!).

In its core business, Deluxe has countered lower unit volumes by increasing prices and cutting costs, such that earnings grew a robust 32% from 2000-2002, despite revenue growth of only 2%. In addition, Deluxe also cut cap ex, freeing up cash to not only pay a hefty dividend (currently 3.6%), but also to buy back a mountain of stock -- reducing the share count by 20% in the past two and a half years -- so that earnings per share have grown even faster than net income.

Badly managed declining businesses
Kodak at one point sensibly followed the same strategy as Deluxe, milking its core business for cash to pay a fat dividend and buy back stock. The company limited its expenditures in new areas such as digital cameras and printers by entering into joint ventures and licensing agreements. Yet Kodak is now abandoning this strategy and announced last week that it would slash its dividend by 72%, invest heavily in new technology areas, and look to make acquisitions (for more on Kodak's announcement, see Tom Jacobs's column). According to a Kodak spokesperson, "We are going to be a bigger, bolder, more diversified Kodak, going for bigger hits, and bigger wins."

If this strategy succeeds, Kodak's CEO will rightly be hailed a visionary genius, but I think the odds are very poor. Ask yourself: What are the chances that Kodak builds a profitable business making digital cameras, competing against Nikon, Olympus, Minolta and the like? And what are the chances that Kodak builds a profitable printer business, competing against Hewlett-Packard (NYSE: HPQ), Lexmark (NYSE: LXK), Epson, Canon, etc.? Finally, having made public its eagerness to make acquisitions, what are the odds that Kodak will make good acquisitions at attractive prices?

Conclusion
Investing successfully requires making correct distinctions among many different types of companies and business situations. There are no shortcuts to making these difficult judgments, but this I know: You should not look to CEOs, Wall Street analysts or other investors for guidance. As always, think independently and only invest when you're certain that the consensus view is wrong.

Separating the wheat from the chaff takes time and experience. If you like the idea of spotting turnarounds, David and Tom Gardner mine those fields in Motley Fool Stock Advisor (where toymaker Hasbro (NYSE: HAS) is a top pick), and Tom Gardner selected comeback kid Talk America (NYSE: TALK) in his Motley Fool Hidden Gems.

Whitney Tilson is a longtime guest columnist for The Motley Fool. He owned shares of Berkshire Hathaway, McDonald's and Office Depot at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. The Motley Fool is investors writing for investors.