One thing that floors me regarding my readers, is who reads me. ?I have many professional readers who read me regularly, and I thank you for doing so. ?Tonight’s piece stems from an e-mail from one of my professional readers:

Hi David,

Big compliments for your blog, it?s probably the best on the net and one of the very few I am reading these days. I really like your overall approach to investing and I am using some of your methods myself with success in my ZZZ?Fund (ZZZ on Bloomberg) like having an even-weighted portfolio of 30-40 stocks with regular rebalancing or focusing on the strongest players in weak industries (southern European banks anyone?).

Now my question for you that might interest all reader is how you handle potential value traps like Staples that spring on you in slow motion. I think you had that one in your portfolio some time ago, but the specific case doesn?t matter that much. For full disclosure, I am holding Staples in my fund at the moment.

The typical pattern is something like this: You find a stock that has some growth issues, but is attractively valued with a 10% FCF/EV yield, which implies no growth or a slow decline forever. Then there?s a profit warning, the profit or FCF estimate goes down by 10%, but the stock price drops even more by 15% or so. And again and again? or not. It?s especially tricky in cases like Staples where it is not so obvious that their business model is becoming obsolete compared to, for example, Nokia or Blackberry/RIM a few years ago.

In my experience, that?s one of the situations where I tend to lose the most money. How do you handle them? Sell at the first profit warning, reasoning that the investment case got fundamentally altered even though the stock dropped even more? Or keep it and wait for a confirmation of the negative trend? For how long?

Out of experience, I probably should sell Staples asap and have another look in year or so. But the value guy in me can?t sell much hated stocks with high FCF yields and some potential for a fundamental turnaround.

I used to own Staples, but I think their lunch is getting eaten by Amazon. ?I sold somewhere in the $16s. ?Retailers are tough, in my opinion. ?They are so cyclical and faddish.

There are many reasons that a stock can be a value trap. ?Let me try to list them:

• The accounting is liberal, with revenue recognition policies that let more revenue accrue than will be realized. ?Or, the assets aren’t worth as much as the book value posits. ?This is particularly common with financials.
• Many value traps are lower quality companies. ?They may seem cheap, but there is a lot of debt, and will they earn enough to refinance the debt?
• Some companies waste their free cash flow buying back stock, or acquiring companies that do not add to value. ?When valuations are high, issue special dividends rather than buying back stock. ?Your?shareholders have better opportunities for the money.
• They are up against stronger competition. ?Try to understand the industry as a whole, and see whether the?company’s?profits are likely to come under pressure.
• The high dividend has attracted a lot of yield investors who push the price up, but the yield is not sustainable.
• And there are likely more reasons…

I’ve lost significant money in a few stocks in my life, but only once in the last 10 years. ?It was a highly levered mortgage REIT that did it “the right way” as I saw it, and was opportunistic with debt assets. ?I lost 90%+ of my money on that one, one of my worst losses ever. ?Had I paid greater attention to the amount of leverage, particularly heading into the crisis in 2008, I would not have lost so much.

As a friend of mine once said, “There are lousy companies, but to really see the price fall, it has to have significant debt.” ?I tend to buy higher quality companies. ?That’s not a panacea, but it tends to prevent large losses. ?Avoid overly indebted companies relative to the??industry.

Analyze the accounting. ?How much of income is coming from accruals? ?How often do they deliver negative earnings surprises? ?How is cash flow from operations versus earnings? ?Is book value growing a lot more slowly than earnings less dividends would indicate?

Is this a stock held by those sucking on dividends? ?Is the dividend sustainable? ?Think of the ’70s where dividend-paying stocks got whacked when they reduced their dividends.

Analyze the competition. ?It is rarely a good idea to buy the stock of a weak company in a competitive industry, regardless of the valuation. ? Better to buy the more expensive competitor.

Finally, stock buybacks and acquisitions are not always good. ?Many stocks, like IBM, tread water because of the buyback. ?The stock price is too high, and remains too high because of the buyback. ?There is no good solution to this for IBM management, aside from new avenues of profitable organic growth, and those solutions are rare. ?Thus I avoid IBM.

My methods aren’t perfect, but they are pretty good. ?I stumbled into a lot more value traps when I was younger, but not so much anymore. ?Live and learn.