Market Analysis, January 13, 2025, published with permission from Colin Twiggs.

Avoiding Value Traps

Thank you to the subscriber who sent the following question that I think would be of interest to most readers:

“I was wondering if you personally use any tools to help you gauge the value of individual stocks? I know that your readings show massively overpriced $SPX, but I believe their may relative values out there if we get a pullback.”

My reply starts with a caution:

The biggest challenge is to avoid value traps, where value looks deceivingly sound, but the low price reflects weaknesses that may not be evident in financial reports. The grass is often greenest over the septic tank.

The chart below shows Magellan Financial Group (MFG)'s rise on the ASX, with a strong balance sheet, excellent cash flows, and stellar return on equity. However, the excellent financials hid inadequate management of key person risk in a company dominated by its founders.

MFG's January 2021 break below its long-term moving average was not a buy opportunity but warned of internal upheaval:

In December 2021, Brett Cairns abruptly resigned as CEO. In the same month, St James’s Place—Magellan’s then-largest investor—also withdrew its mandate. This was followed by co-founder and CIO Hamish Douglass’ indefinite leave in February 2022, which led to his resignation from Magellan in June 2022. (Morningstar)

The Trend is Your Friend

We follow a two-step investment process:

1. Buy on technical analysis signals. Wait for a strong uptrend before you buy, no matter how good the value appears on first inspection. The greater the apparent fundamental value, the more wary you should be. The trend is your friend.
2. Then, do your homework on the fundamentals and decide whether to keep your position, increase it, or sell if the numbers don't stack up.

Payback Formula

Our simple valuation formula, with adjusted EBITDA, is based on a payback period. This eliminates the need to make assumptions about the weighted average cost of capital (discount rate) and an exit value at the end of the cash flow projection.

Here is a quick summary:

1. Calculate free cash flow by adjusting EBITDA for expected capital investment and increases in working capital needed to fund future growth.
2. Adjust for expected corporate taxes at a suitable tax rate. Australian investors will need to consider franking credits from the dividend imputation system.
3. Project future growth in after-tax cash flows based on past performance, capital investment, market share, and expected market growth. This may be reasonably straightforward for a company like Coca-Cola (KO) compared to a complex operation like Elon Musk's Tesla (TSLA), which we would avoid.
4. Sum the resulting net cash flow for a suitable payback period. We typically use a period of between 9 and 14 years, depending on the expected risk and stability of income. Cyclical businesses such as discretionary retail would be on the low end, while Australian consumer staples like Coles (COL), Woolworths (WOW), and some industrial REITS would justify a more extended payback period.
5. Compare the resulting sum of free cash flow for the payback period to the company's enterprise value, based on market capitalization plus debt and capitalized leases, to determine whether the stock is at a discount or premium to fair value.

The model ignores the likely exit value if you had to sell the stock at the end of the payback period, which is treated as a "margin of safety." A more extended payback period means less margin of safety and should only be considered for stocks with lower investment risk.

You can find more details at The Patient Investor.

Conclusion

Valuations require considerable time and effort and should not be attempted by inexperienced investors. However, they can provide additional assurance when holding stocks in a strong uptrend.

Always approach any valuation exercise with a view that the stock market may not have perfect knowledge, but it knows a lot more than 99.999% of investors on the planet.