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.

6 Responses
  1. Nblumer2011

    Financially a company can show high EPS, better than average ROE, good dividend but oh it just happens to be losing market share. In some industries its ok to let a bit of your market share slip – after all, if you are a well run leader in the industry it is inevitable that new players will gain some ground. However, for a competitive tech industry your best bet is not to buy any tech stock losing market share. I would not hold MSFT or INTEL until they truly demonstrate that their market share is rebounding

    1. I don’t disagree, necessarily, though I would add that market share can be hard to define.  MSFT and INTC both have strong and stable market shares in PCs, servers, etc.  But if you view the entire computing universe (smartphones, tablets, etc.) then you obviously get a different story.  

      Again, I don’t disagree.  But I would say that market share can be a surprisingly murky concept in tech.  

  2. Michael Bruce Rosmer

    I’d argue it’s much harder to spot a value trap than a value stock and consequently the discipline isn’t in trying to identify and steer away from value traps but rather identify and buy value stocks, which automatically rules out the former. Microsoft hasn’t been and isn’t a value stock, Intel at various times has been (I’d argue the price isn’t so low anymore but back in April I was long on it around when they were trading around a 10 times multiple my projection was they’d eventually rise to closer to a 14 times multiple). What’s the difference? Next to impossible to replicate assets. In the case of Intel they have manufacturing technology and capacity that few in the world can match and regardless of what happens with their processors the manufacturing assets will remain. Microsoft has no such thing, their biggest best asset was their partner network and the distribution it brought with it, that remains a powerful asset in the business space, unfortunately they never leveraged it into the consumer space or should I say into mobility. Microsoft could well fall much further from grace than they have to date, Intel realistically won’t see such a fall. Companies with this sort of durability are rare but they definitely exist. Most recently some of the big banks fit this mold, some of the major communication companies, etc. Their positions are virtually unshakeable in large part because the barriers to entry in that space are so high and because they have a competitive advantage that’s difficult to supplant even if you enter the space.

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.