Finding true value and avoiding value traps

Value investing seems easy when you first approach it. Buy stocks that are undervalued and wait until they return to at least fair value. Finding those stocks that are cheap is also pretty easy. Pick your favorite ratio, arm yourself with a stock screener, and you can easily find a long list of ‘undervalued’ stocks. Well, at least cheap stocks. And therein lies the challenge. Most stocks are cheap for very good reasons. These are known as value traps. The art of successful value investing then lies in being able to identify stocks that represent true value as opposed to value traps. In this post I’d like to share some insights into how to do this successfully.

The easiest thing an investor can do to help avoid value traps is to limit the investing universe to high quality companies with proven track records. The best list of these companies is the dividend champions list. I’ve posted on this before. As of the end of June this list was made up of 473 companies that have raised their dividends for at least 5 years. Plenty of opportunities among this list of companies. The top echelon of these quality companies are the dividend champions, 105 on the current list, which have raised dividends for at least 25 years. Focusing on these companies goes a long away to eliminating the potential of value traps but is still not enough. Old quality companies can still enter declines and become value traps. The next step is to pick some potential undervalued companies and do some valuation work.

Lets be conservative and start with the dividend champions list. I usually sort this list by dividend yield and then start looking at P/E ratios and see what jumps out at me. I’m looking for high yields and low P/E ratios. At the end of June three companies jumped out at me as potential value investments; Pitney Bowes (30 yrs of div increases), Walgreens (37 yrs of div increases), and Aflac (29 yrs of div increases). The chart below shows some basic valuation measures and how they compare to the companies’ average over the last 5 years.

Which company is the most undervalued? Which has the highest chance of returning to average valuation? I’ll give you my answer – AFL is the best buy on this list. PBI is certainly the cheapest on this list but maybe for good reasons. The most important part of selecting the best value investment is projecting what is going to happen with these companies in the future. PBI’s business is deteriorating measurably and if this continues the stock will remain cheap and probably go down further. My method of projecting future returns is to use the magic dividend formula (see here for an explanation). A quick refresher; projected return = dividend yield plus dividend growth plus change in valuation. Lets look at how these three companies measure up.

First I ignore change in valuation. To be conservative I assume the market will keep the valuations of the companies the same going forward. In this case WAG offers the best forward returns followed by AFL then PBI. The tough part here is to estimate what the future dividend growth will be. These estimates can be judged by looking at earnings estimates, listening to earnings conference calls, etc.. The PBI growth rate is pretty much what they’ve done the past few years. The WAG and AFL numbers are just projections of earnings growth over the next year and if payout ratios stay the same then the dividends would grow at the same rate as earnings. On the fwd return measure WAG is the best deal of the three if valuations don’t change. The last step is to judge the potential catalysts that would drive a change in valuation back to an average level. Or it could be a lack of catalysts that keep the company at its current valuation.

Catalysts that drive valuation changes come in many forms. The situations I like are when the market makes a stock cheap for industry or macro reasons that have little to do with the fundamental of the company. The other catalysts I look for are those that are drive by short term concerns with the company. In our example, PBI has some fundamental challenges to their business driven by technology changes. Sales are headed down. This is more a turnaround story than a short term challenge. No thanks. WAG seems like a slam dunk but their battle with Express Scripts has hurt their business. Their rapid expansion into Europe smacks of desperation. I’m intrigued but need to see some more data before I invest. The WAG catalyst could in fact be negative. AFL’s cheapness has been driven more by macro headwinds. Financials and insurance companies in general are cheap and investors are concerned about AFL’s European exposure. AFL’s fundamental business is solid and has a good future. I’m a buyer. I’m looking to make 13% a year going forward with a good chance of a 30% upside when the market realizes its mistake. And as soon as I see that WAG’s issues are short term I’ll be pulling the trigger there. I’ll be staying away from PBI.

I hope walking through this example helps you to differentiate between true value stocks and value traps. Focusing on high quality companies with great track records and focusing on future returns, not past results, will get you a long way. You won’t always be right but your chances of a successful investment and market beating returns will go up dramatically.

Disclosure: long AFL