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, but let’s talk about a value trap in tech that ensnared yours truly: BlackBerry maker Research In Motion (NASDAQ: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 smartphone war to Apple (NASDAQ:AAPL) and Google (NASDAQ: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 still were growing at a decent clip. At the price at which it traded, RIMM didn’t have to win the smartphone war 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 RIMM has a future. But its future lies as a software and services company, providing enterprise email, 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 likely will 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 (NASDAQ:MSFT) and Intel (NASDAQ: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.
Charles Lewis Sizemore, CFA, is the editor of the Sizemore Investment Letter, and the chief investment officer of investments firm Sizemore Capital Management. Sign up for a FREE copy of his new special report: “Top 3 ETFs for Dividend-Hungry Investors.”