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How to Spot a Value Trap: Research in Motion

Question: When looking at cheaply-priced stocks, how do you know which ones are solid value stocks and which ones are dreaded value traps?

Answer: The value stocks eventually recover, whereas the value traps do not.

I realize that my answer is no more useful than Will Rogers’ advice to “Buy stocks that go up; if they don’t go up, don’t buy them,” and that is precisely my point. There is no systematic way to recognize a value trap.

Some sectors are more prone to value traps than others, and this is something I’ll elaborate on later in the article. But first I’ll give an example of a value trap that ensnared yours truly—BlackBerry maker Research in Motion ($RIMM).

When I first started considering RIMM last July, it was one of the cheapest companies in the world. At one point in time it traded for just 3 times earnings and barely half its book value.

My thinking when I bought RIMM was straightforward enough. While the company was losing the smart phone war to Apple ($AAPL) and Google ($GOOG), it had a strong and growing services business with sticky revenues, a strong and growing presence in emerging markets, and a rock-solid balance sheet. Yes, the company was losing market share, but its sales were still growing and a decent clip. At the price at which it traded, RIMM didn’t have to win the smart phone war in order to be a good investment; it merely had to survive.

In most industries, this would have been sound thinking and the makings of a great contrarian investment. But in technology, where platforms are everything, it doesn’t hold. Much like the Game of Thrones, with technology platforms you win or you die

Shrinking market share for your platform begets further shrinking market share. Retailers don’t want to take up shelf space better used for more popular products. Carriers don’t want to offer incentives. Programmers don’t want to write applications for a shrinking platform. Rather than a gentle decline, you get a sudden collapse.

Case in point RIMM. With the BlackBerry, RIMM invented the smartphone as we think of it today and quickly rose to dominance. After conquering the corporate and government markets, the success of the BlackBerry spilled over into the consumer market. BlackBerries became known as “CrackBerries” for their addictiveness. As recently as 2010, RIMM held nearly half of the smartphone market, only to see that market share shrink to single digits today.

Believe it or not, I do believe that RIMM has a future. But its future lies as a software and services company, providing enterprise e-mail, messaging and security, and not as a hardware maker. A slimmed down services-only RIMM would be worth owning at the right price. But before that happens, management will likely destroy quite a bit more value attempting to salvage their hardware and operating system.

Not all cheap tech companies are value traps, of course. Microsoft ($MSFT) and Intel ($INTC) have both been cheap for years, though both have strong underlying businesses nearly impervious to competition and both have been rewarding shareholders with a high and growing dividend.

As much as we would like for it to be, this is not an exact science, and you’re not going to get it right every time. In the end, the best defense against a value trap is emotional discipline. Look at your investments critically and don’t make excuses when they fail to perform. Use stop losses when appropriate. And be honest with yourself when you ask the question, “If I didn’t already own this stock, is this something I would want to buy today, knowing what I know?”

Oh, and follow Will Rogers advice about avoiding stocks that don’t go up.

Disclosures: Sizemore Capital is long INTC and MSFT. Alas, we were formerly long RIMM.

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When in Doubt, Follow the Greats

Stocks fell sharply as we started trading this week on fears that Europe’s sovereign debt crisis was again spiraling out of control.  Of course, I could have used that same opening sentence at almost any point in the last 10 months and it would have been equally true.  The remarkable thing about 2011 is that it has been largely devoid of any real news.  The macro concerns driving the market haven’t changed much in two years—and yet we continue to see some of the most volatile daily price swings since the Great Depression.

The art of investing is an exercise in making decisions under conditions of uncertainty.  But today, it seems that the cloud of uncertainty is a little thicker than usual.  Despite having two years to discount the likelihood and consequences of default by one or multiple “PIIGS,” the market’s persistent volatility shows that investors are as uncertain as ever.

I’ve been consistently bullish for most of the past year, arguing that the low prices on offer more than compensated investors for the risk of meltdown.  But I’m also the first to admit that the volatility of recent months has thoroughly frayed my nerves.

During times like these, I like to do what your college professor might have called “cheating.”  I like to look over the shoulders of other investors and see what they are doing.

As I wrote last week in an article on Warren Buffett’s recent acquisitions, you should never mindlessly ape the trading moves of another investor.  But studying the moves of successful investors can be an effective way to step back and get a little perspective on your own trades.

With all of this said, today I’m going to take a look at the portfolios of three of my favorite institutional investors: Mohnish Pabrai, Joel Greenblatt, and Prem Watsa.

Mohnish Pabrai

We’ll start with Pabrai, the author of the must-read The Dhandho Investor and a well-respected value investing guru.  Based on his SEC filing for the 3rd quarter, Pabrai went on a buying spree in the financial sector.  After initiating a massive position in Bank of America ($BAC) and adding to his already-large positions in Wells Fargo ($WFC) and Goldman Sachs ($GS), Pabrai’s weighting to the financial sector jumped from 39 percent of his portfolio to a whopping 58 percent with a fair bit of the reduction coming from basic materials. Materials dropped from 46 percent to 33 percent of the portfolio (see Pabrai’s portfolio here).

Though his returns are not reported, we can assume that Pabrai’s high allocation to financials has hurt his returns this year.  He wouldn’t be the first.  John Paulson’s flagship fund was at one point down by nearly half this year due to his high allocation to financials and his use of leverage (see Don’t Mess Up Like Paulson).  Still, Pabrai has proven to have a sharp eye for value over the years, even if he—like many other high-profile value investors—tends to be a little early.

Joel Greenblatt

Moving on, let’s now take a look at what Joel Greenblatt is buying these days.  Greenblatt runs Gotham Capital and is the author of the eminently readable The Little Book that Beats the Market.  Unlike Pabrai, Greenblatt tends to have a relatively high portfolio turnover.  He made few major moves in the third quarter, though he was a net buyer and added to his already large holdings in technology and industrials (see Greenblatt’s portfolio here).

Greenblatt is conspicuously under-allocated to the financial sector because much of the money he runs today follows his “magic formula,” which stresses high returns on capital.  Suffice it to say, the big banks are a little light on profits these days, so financials are not showing up on Greenblatt’s screen.  But with more than 40 percent of his portfolio invested in the cyclical technology and industrials sectors, Greenblatt is every bit as aggressively invested as Pabrai.

Prem Watsa

Finally, let’s take a look at Prem Watsa.  Watsa is the CEO of Fairfax Financial Holdings and is considered by many to be the “Warren Buffett of Canada.”  He has certainly earned the nickname.  He and his team have grown Fairfax’s book value per share by 25 percent per year for the past 25 years.  He was also one of the few managers that made money during the crisis year of 2008.  Not a bad run indeed.

Watsa’s portfolio moves will certainly raise a few eyebrows. In the 3rd quarter his added to his already large position in battered BlackBerry maker Research in Motion ($RIMM). He also increased his position in Citigroup ($C) by 50 percent.  Overall, his exposure to the financial sector rose from 9 percent to 24 percent in the third quarter (see Watsa’s holdings here).

Watsa was a slight net seller in the 3rd quarter, though the composition of his portfolio hardly suggests excessive bearishness at the moment.  More than 80 percent of his equity holdings are in technology, financials, and telecom.

As a caveat, there is a limit to what you can glean from reading SEC 13-F filings.  For example, only long positions are reported; short position and derivatives hedges are not.  And Prem Watsa, for example, does indeed hedge his equity positions.  Still, his willingness to be so heavily invested in some of the most volatile sectors would imply that he’s not quite as bearish as some of his public comments would suggest.

So there you have it.  Given the recent volatility, it’s entirely possible that the Dow has moved 100 points in the time it has taken you to read this article.  That’s nerve-racking, of course, even for an experienced investor.  Still, I see compelling bargains at current prices, and I consider the pervasive fear and bearishness among rank-and-file investors to be a contrarian bullish sign.  And when I start to get that feeling in the pit of my stomach, I take comfort in knowing that I’m on the same side of the trade as some of the brightest value investors in the business.

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