Wednesday, 11 July 2012

Value Investing: The trap of investing in declining industries

Value investors are currently in buyers heaven at the moment.  The opportunities seem endless with multiples at close to all time lows with the market offering up specials to anyone who bothers to have a look and do their research.  However there is a trap out there for all value investors.

The trap, simply is that many traditionally cyclical stocks look cheap on their current valuations when in fact they are not.  The stocks look great as they are trading at super low LTM and LFY multiples as well as very low forward multiples as well (a note for all those who are not familiar and easy way to find out consensus forward multiples is to take a few broker reports and average what they are saying about the next few years).

The problem is that when industries are in structural decline the ability to spot good value is totally dependent on your ability to forecast how fast the revenue and earnings figures are going to drop and whether the stock is actually undervalued or whether your (and the market's) assumptions are just too optimistic.
  • I got caught in this particular trap approximately 12 months ago when I invested in Fairfax, a newspaper and publishing business which looked spectacularly cheap
  • I wasnt totally naive though and accounted for the fact that earnings were declining and I also created a sum of the parts (SOTP) analyses for their business applying much lower multiples to their future (declining) earnings than I though was fair
  • My investment rationale was further supported by the fact that my valuation was significantly lower than any of the brokers reports

However what actually ended up happening was that the revenue for their newspaper print business (the vast majority of their earnings) declined much faster than anyone expected with the company downgrading their earnings guidance (and consequently the market reassessing it's forecasts of future earnings) and the share price reacted accordingly.  The earnings multiples I had originally bought the shares on turned out to be useless and the price I bought at was way higher than the new 'fair value estimate'

The natural reaction to this is 'well why haven't you sold yet?' and this is where the trap comes into play.  The stock is now trading at below what the fair value is even when you account for all the downgrades and the gloomy future outlook.  Thus if you are an objective investor and are waiting for a 'fair price' you are trapped waiting for the stock to go up but with the risk that earnings will once again surprise on the downside.

Any investors looking to invest in declining industries should be aware of the above trap.  Unless you are truly confident that your sensitivities are good enough it is probably a game worth staying out of.  Do you have any stocks or investments where this has happened to you?  I would love to hear your story and the lessons you learned from it so please comment below.

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