The Unwritten Rules Within a Company That Create a Value Trap

There’s a problem that security analysts have when they create EBITDA projection spreadsheets for the stocks they like. They start to believe them. Putting together a spreadsheet takes a lot of time as you have to input the data from SEC documents then confirm your assumptions with company management.

Typically, after you have done that work, an analyst will call competitors and suppliers and ex-employees etc. Its allot of hours. At this point, an analyst knows more about the company’s financial and competitive position than 90% of the employees. Armed with a detailed Excel spreadsheet and field work due diligence the analyst is feeling great.

They are now under what I call the illusion of control. They think you they know more than the public investors who have been selling the stock driving it down to such bargain levels.

However, they have no control especially if the value stock is just beginning a downturn from record margins. The odds are high you may be entering a value trap.

Typically, what the spreadsheet won’t tell you and management won’t discuss are the unwritten rules of the company. Every company has their own individual unwritten rules they follow. These are the bad practices everyone knows about but never discuss in public. A few examples are product lines that are bleeding cash but won’t be eliminated because a senior manager protects it. Important customers that will be given large price discounts and better terms to stay with the company. Inventory that will pile up because production runs won’t be cut due to managements unrealistic optimism. New products introduced that don’t make sense but get the go ahead because the CEO is desperate to grow sales. I can go on and on.

This is why I often watch and wait for value stocks to ripen. Typically, a bad earnings announcement is followed by two more and then comes a new CEO who will often produce huge write-off’s 6 to 9 months later surprising investors. Look at GE as a recent example.

When you are investing in value stocks it’s very easy to be early. This is why I always want my fundamental research to be confirmed by a stock chart.

You can’t trust your spreadsheet or fundamental due diligence on its own. The reason is the unwritten rules of the game. The stock price though is aware of the unwritten rules and that’s why value stocks often stay in downtrends and break bases year after year confounding investors who can’t believe how cash flow could fall to such a low level.

When you see your great value stock beak critical support with no explanation take notice. You are likely entering a value trap.

All value investors including me fall into value traps. However, I don’t sustain large damage as I cut my losses and then watch and wait from the sidelines. I wait for the fundamentals and technicals to align again. If they do I reenter, if not I never buy it again. I am proud of recognizing my mistakes.

Because I invest in stocks that have a 5 to 1 reward to risk ratio, follow the 20 / 80 rule and cut losses, I can experience value traps and still make money. Every value investor will continually experience value traps that is part of the nature of investing and the inability to recognize all the unwritten rules of a company. The key is to not let value traps destroy you the way it has for Bill Ackman and Marty Whitman who refused to sell financial stocks in 2008.

If you want to find stocks that meet the 5 to 1 reward to risk ratio become a member of turnaround stock investing.