CHAPTER 7
Failures, Errors, and Value Traps

The earnings are good and its stock valuation looks low. But it is actually a cyclical business that is at its peak. Cyclicals like automakers, airlines, and durable goods producers have good earnings at the peak of the cycle, which makes their P/E low and the stock attractive. P/S and P/B ratios relative to their historical range are better indicators of where they are with valuation. If the company produces commodities like oil, coal, steel, gold, and so forth, it is also necessary to consider where the prices of the commodities are relative to their historical range. When they are at the high end of the historical range, they are likely to go lower. I will explain more about investing in cyclical companies in Chapter 9.

We have heard a lot of turnaround stories with cyclicals. But usually it is not because the management has special skills, but instead simply because their market comes back. If recession hits again, the management will probably discover that “we succeeded in turning around the business … just in the wrong direction.”

We want to avoid cyclicals, but if you are determined to buy, the best time is when cyclicals are at the bottom of the cycle, when the news is bad, and they may be losing money. Many of them cannot make it through and in turn go bankrupt. Buy those with the solidest financial strength and that are able to make it through the bad times. Also, remember to sell them when things look good and they are again generating large profit. Unlike the consistently profitable companies, cyclicals will again fall into trouble when the industry gets into a down cycle.

It Is Growing Fast

You want the company you buy to grow, but you don't want it to grow too fast. If a company grows too quickly, it may not be able to hire enough qualified employees to maintain quality of products and customer service. This is what happened to Krispy Kreme in the early 2000s and Starbucks in the mid-2000s. Starbucks had to close more than 900 unprofitable locations and focus on its core business.

Furthermore, such companies may need more capital than they can generate to fund the fast growth, causing a cash crunch and forcing them to borrow. If there is any hiccup in the economy or the business itself, they may not be able to service their debt and could face bankruptcy risk.

Tesla is growing fast, with its Model 3 wait time said to be three years. The company is spending heavily to ramp up its manufacturing capacity. In the meantime, as it sells more cars, it loses more money. Tesla's stock has done well for those who bought before 2013, so far. And remember, it just bought SolarCity, which was also a fast grower facing an even worse cash-flow problem. With Tesla's mounting loss and debt, and a merger with a company that was in worse shape, I will stay away from it.

Growing too fast is dangerous. When a company is growing fast, watch its cash.

It Is an Aggressive Serial Acquirer

Companies can also grow through acquisition, which is even more dangerous. I can find far more examples of companies that get into trouble by acquiring others. Driven by ambitious CEOs, many companies grow by acquiring their competitors. They pay a high price for the acquisition and get themselves deep into debt. This was what happened with Canadian drugmaker Valeant. After Michael Pearson became its CEO in 2010, the company went on a shopping spree. Through multiple acquisitions every year, its revenue grew from less than $1 billion in 2009 to more than $10 billion in 2015. For quite a while, Valeant was the hottest stock from the United States to Canada. Investors cheered the growth by driving its stock up more than 20 times. Pearson was considered capable and was the highest-paid CEO in the world. In the meantime, the company's long-term debt ballooned from $380 million to $30 billion. Then its luck ran out and the company found itself under SEC investigation. Its acquisition growth model collapsed and Pearson was ousted. The stock has lost 85 percent from its peak, with Valeant still losing money and the debt bomb ticking.

If a company is too aggressive with acquisition, watch its debt.

Its Business Is Too Competitive

No business is immune to competition, which is why a business must build an economic moat with high quality, low cost, brand recognition, high switching cost through network effect, and so on. Different businesses compete in different ways and at different scales. A restaurant mainly competes with other restaurants in the same area. A technology company's competition can come from anywhere on the globe.

If a company sells commodity products, it cannot differentiate itself through products. It has to compete via prices. The ones with the lowest cost win. Commodity products include oil, gas, agricultural products, airline tickets, and insurance. Over time, many high-tech products become commodities, too. Think TVs and computers. Now even smartphones are becoming commodities.

Retail is an especially tough business because almost everything a store sells can be found somewhere else, and everything it does can be easily imitated by its competitors. Retail stores' competition used to be local, but now is global and online. Those with higher costs cannot survive, and we have seen many closed. Still remember Circuit City, Sport Authority, and K-Mart? Department-store business is among the most competitive; somehow there are always too many of them. In 1977, Warren Buffett lost money on a department store called Vornado Inc. He wrote: “It turned out that the industry was over-stored, and Vornado and the rest of the discounters were getting killed by competition from K-Mart stores.”¹ Even K-Mart is long gone, and the industry is just as overstored as it was 40 years ago.

The shift of consumers to online shopping makes the department-store business even worse. We will continue to see the struggle of the likes of JC Penney, Macy's, Sears, and so on. In an industry that competes at such fierce intensity, no one wins.

It Does Everything to Gain Market Share

It is not always good for a business to have more customers. A business needs to be selective with customers and price its products at a level that is competitive but profitable. Attention should be focused on the customers who are loyal and profitable. Trying to gain market share through aggressive pricing puts a business's survivability in danger.

Doing everything to gain market share can be fatal to financial institutions like banks and insurance. The adverse effect usually doesn't show up until several years later, which is why they need a strict underwriting process to qualify customers and price the potential loss properly. It wasn't long ago that banks relaxed their underwriting standards and gave loans to subprime borrowers who would otherwise not qualify. They got into price wars with loans that offered “zero down, zero percent, and zero payment.” The financial crisis caused by subprime loans eventually drove the world's financial system to the brink of collapse. The banks that had the most exposure were punished most heavily, too. Many of them are gone and forgotten.

Insurance companies can get into deep trouble if they take on too many customers without pricing the risk properly. In the early 1970s, GEICO almost destroyed itself because it wanted to gain more market share. It charged too little for its car-insurance policies. The company was on the verge of bankruptcy before increasing prices and getting out of the states where it was unprofitable. By doing that, it lost market share but became profitable again. When I bought my first house in 2000, I insured it through an insurer called Texas Select. The insurance premium was considerably lower than other insurers for the same coverage. But in 2006, the company went bankrupt, and I had to switch to another insurer at a higher premium. Texas Select's low rate may have worked on a very small group of well-qualified customers, but being too aggressive with pricing drove the insurance company out of business.

In his 2004 shareholder letter, Buffett called Berkshire Hathaway subsidiary National Indemnity Company a “disciplined underwriter” because from 1986 through 1999 the company would not match its “most optimistic competitor” on pricing and was willing to lose customers to maintain its underwriting profitability.²

If a company tries to gain customers without watching its bottom line, stay away.

It Faces Regulatory Landscape Shifts

For many years, for-profit education was a lucrative business, as it provided career training and college-level education to people who would otherwise not qualify for accredited colleges and universities. Revenue and profit were soaring for decades, and for-profit educators' stocks were among the best performers during the first decade of this century. But suddenly everything came to a stop. Their students could not find jobs and were deep in debt with student loans. And the government, having provided billions in financial aid, is on the hook for the loss with student loans. For-profit education companies are under investigation by the government, and new laws were established that would greatly limit their capability of enrolling new students. The industry collapsed and shareholders lost big.

Be sure to consider the regulatory risk with the companies in which you invest. After the financial crisis in 2008, new laws were enacted to regulate the banking industry. Many revenue sources disappeared. Hospitals and healthcare insurers have had to do business differently after Obamacare became law. These are the risks involved in investing in regulated industries.

It Becomes Aged

A company being aged does not necessarily mean that it is in business for too many years. It means that the company cannot adapt to the shift of the industry dynamics; its products have lost their appeal and are replaced by new technologies. Newspapers, once dominant news providers and advertisers in the areas they serve, are now being displaced by the Internet. Blockbuster, the brick-and-mortar store that rented video DVDs, was replaced by Netflix. Kodak's film was replaced by digital cameras. And retail stores have been replaced by online shopping.

Canadian smartphone maker BlackBerry once dominated the corporate world and had more than 50 percent of the smartphone market share. Every executive in the corporate world had a BlackBerry. Even I used two BlackBerry phones. But the company was too slow to adapt to touchscreen phones, and it never built an ecosystem that would increase the switching cost for customers. I remember the days when I could never memorize the combination of keys on BlackBerry to delete blocks of emails. Now BlackBerry is a forgotten player in the smartphone market.

The problem with these aged companies is that they do own a lot of assets: real estate, patents, brands, business subsidiaries, and so on, and those can look attractive to value investors after the stock has declined by a large percentage. But often they are value traps, and this is where value investors lose most of their money. I will discuss value traps in greater detail in the next section of this chapter.

If the warning signs in the previous chapter are the symptoms of the disease, the behaviors discussed in this section are the internal problems that cause the disease. A company that displays the warning signs of the last chapter is not necessarily sick. You can still buy these companies if you understand the reason behind the signs and take these into consideration for purchase price. But if a company is displaying the behavior that I just described, it should be altogether avoided.

The tricky part is that these companies don't necessarily fail quickly. Although they are actually “dead companies walking,” as termed by hedge fund manager Scott Fearon in his excellent book that carries the same name,³ they can continue to exist for years, especially when the market is booming and funding is easy to find. They can be enticing to those who look for price bargains. But, as Peter Lynch said, “Just because a company is doing poorly doesn't mean it can't do worse.”⁴ With these companies, things can get much worse.