June 22, 2015

On occasion, we’re asked why we don’t invest in the initial public offerings (IPOs) of stocks that receive much of the press coverage. Examples include social media businesses, such as Facebook or Twitter, or perhaps the alternative energy sector. While lofty valuations provide enough justification to look the other way (price-to-earnings multiples are frequently in the hundreds, assuming earnings even exist to begin with), the overriding reason is far more important than just one quantitative valuation metric.

In 2001, famed investor Warren Buffett – who avoided the technology bubble a year earlier – said, “I have an old-fashioned belief that I can only … expect to make money in things that I understand. … I mean understand what the economics of the business are likely to look like 10 years from now. … The internet isn’t going to change the way people chew gum.”

Many so-called investors are really speculators. They have very short time horizons and are guilty of failing to look a minute beyond the next calendar year. The consequence of making an investment based on a trend rather than a well-reasoned analysis of the sustainability of the business model often leaves them caught in a “value trap.” This exists when an investment appears cheap, but in fact is expensive because earnings and cash flow continue to erode as competitors steal market share and consumers switch over to another product.

It’s worth looking back over the past couple of decades to pinpoint some of the complicated products that turned out to be value traps.

1. Floppy disks (when was the last time you even saw one?)
2. Camcorders, the Go Pro of their day and now almost forgotten
3. Typewriters
4. Beanie Babies
5. VHSs, to which category we will soon add DVD players, BlueRay or otherwise
6. Tamagotchi pets
7. The Sony Walkman, portable DVD player, and soon the iPod and MP3 player
8. Palm Pilots
9. Beepers
10. Movie rentals (seldom in the course of retail have so many stores been vacated so quickly by one industry).

In at least eight of these examples, technological innovation made the product obsolete. The other two were fads that lost consumer interest.

Owning a value trap will haunt its victims for years after their sin. Consider this example. If an investor purchased $100,000 of stock in a company that dropped 90%, he would be left with $10,000. To recover the $90,000 he lost, he would need to earn a 900% return. If he invested that $10,000 into a stock that appreciated 9% per annum, it would take him 27 years to make back the $90,000 he lost owning the value trap. Perhaps this is why Peter Lynch said, “Owning stocks is like having children — don’t get involved with more than you can handle.”

At Baskin Wealth Management, we have a list of companies under review all 52 weeks of the year. We don’t invest in the vast majority of companies that we research. In deciding what stocks to buy, we ensure that the company has a history of successful operations, and is not only profitable but also has a moat protecting it from competition, meaning that it will likely remain a going concern a decade from now regardless of what new code a computer programmer may develop.