How To Avoid Potential Value Traps With Net-Nets And Other Deep Value Stocks
Summary Rejecting ideas fast is a key aspect of making one’s stock research and investment process more efficient and effective. I provide several categories of companies and specific stocks that I rejected as potential value traps, as I ran through my raw stock screens. My exclusive research service, Asia/U.S. Deep-Value Wide-Moat Stocks, flags potential value traps with corporate governance issues, financial statement manipulation risks and other red flags. Background On The Idea Of Rejecting Potential Value Traps I have been a keen follower of Nate Tobik’s (Oddball Stocks) writings and work on deep value investing. In October 2014, Nate participated in a value investing seminar, where the video of his presentation was posted online here. In Nate’s presentation, he spoke about the process of finding and investing in oddball stocks. What caught my attention was this first bullet point on his slide titled ‘Evaluating Ideas’ where Nate wrote “Fail fast: Want to reject ideas as quickly as possible.” In the sections below, I outline certain (non-exhaustive) categories of companies and specific stocks that I rejected as potential value traps, as I ran through my raw stock screens. Past Dealings With Minority Shareholders Wong’s Kong King International (532 HK) operates under two segments: Trading and Manufacturing. The Trading segment is engaged in the trading and distribution of chemicals, materials and equipment used in the manufacturing of printed circuit boards and electronic products; while its Manufacturing business is involved in the manufacturing of electrical and electronic products. Wong’s Kong King is a net-net trading at 0.60 times P/NCAV. Based on its share price of HK$0.65 as of September 25, 2015, Wong’s Kong King’s share price is approaching its 5-year low, while its P/B ratio of 0.34 is close to the 10-year low of 0.32. In August 2006, Wong’s Kong King announced that Chairman Mr Senta Wong proposed to privatize the Company via a Scheme of Arrangement at HK$1.38 per share. The proposed privatization did not go through because it was not approved by the majority of independent shareholders (excluding controlling shareholders/interested parties) in October 2006. In April 2007, the Company announced that it will dispose of substantially all the operating businesses and assets of the Company to Mr Senta Wong and distribute the sales proceeds of approximately HK$1.17 billion or HK$1.65 per share to shareholders (“Proposal”); the Company will become an empty shell and subsequently be delisted. At the Special General Meeting in June 2007, the resolution relating to the Proposal was not passed by independent shareholders. Only 47.22% of the votes were cast in favor of the Proposal, falling short of the 75% required. Mr David Webb, a well-known activist investor, owned more than 3.16% of Wong’s Kong King’s shares at that point the Proposal was announced, and highlighted that he “would veto it at the shareholders’ meeting on June 28.” According to a South China Morning Post article dated June 7, 2007, Mr David Webb said that “We estimate that fair value of this stock to be around eight times trailing earnings, or over HK$3 per share. We would reject an offer below HK$2.50.” According to the circular issued by the independent financial advisors, comparable companies trade at mean and median P/Es of 9.64 and 8.84 respectively, compared with a 4.68 times implied P/E based on the HK$1.65 per share disposal value. While Wong’s Kong King is enticing as a deep value net-net stock at current valuations, the Company’s past actions indicate that it is less likely that an attractive or reasonable privatization offer will be on the cards anytime soon. Sub-Optimal Capital Allocation Miko International Holdings (1247 HK) is “a mid-to-high end children’s apparel brand in China. Its “redkids” brand is ranked second among mid-to-high end children’s apparel brands in China,” according to its company profile . Miko is a net-net valued by the market at 0.54 times P/NCAV. Net cash also accounted for approximately 124% of Miko’s market capitalization, implying the investors are getting the Company’s core business operations for free at current valuations. In June 2015, the Company announced it was issuing 85 million new placement shares (10.3% of the issued share capital) at HK$1.03 per share, or 10% discount to its closing share price of HK$1.15 on June 24, 2015. In the end, the placement was terminated in July 2015, due to “continued high volatility in Hong Kong and PRC securities market and unstable political and economic conditions in Europe.” Nevertheless, the proposed placement did not make sense considering the significant amount of net cash (HK$528 million of net cash on its books as at end-June 2015 versus HK$87.6 million to be raised) it has on its balance sheet and the stock’s low valuations (even at that point in time). Good companies engage in value-accretive capital allocation practices by placing out new shares when their stock is overvalued, and repurchasing shares when their stock is undervalued; companies which are potential value traps do the reverse. Target Of Short-Sellers China Zhongwang (OTC: CHZHY ) (1333 HK) is the world’s second largest and Asia’s largest producer and developer of industrial aluminum extrusion products.” China Zhongwang is a deep value stock trading at half of its book value, which is close to its historical P/B low of 0.46. Dupre Analytics (DA), a short-seller research firm, issued a report on China Zhongwang and disclosed its short position in the Company in end-July 2015. DA claimed that the Company’s “real revenues are much lower than reported,” and “overstated CAPEX expenses” among other allegations. China Zhongwang has since made clarifications in announcements here and here , rebutting DA’s claims. In the announcements, the Company’s Board “reiterates that the allegations in the DA Report are groundless, and that the DA Report contains various misrepresentations, malicious and false allegations and obvious factual errors.” I follow a couple of short-seller research firms and their work; I tend to avoid stocks highlighted by them as I prefer not to bet against the “smart money.” I also use the Beneish M-Score as a tool to filter for potential value traps. Takeaways I always liked the quote “Losing an illusion makes you wiser than finding a truth,” and I found that this applies equally to value investing. The earlier that one loses the illusion that all deep value stocks are unjustifiably cheap, and rejects certain potential investment candidates and adds them to his or her list of value traps to be avoided, the closer he or she will get closer to finding and picking the truly undervalued stocks. (Note: I am not a English major; I might have misinterpretated the quote and applied it incorrectly.) Note: I flag potential value traps with corporate governance issues, financial statement manipulation risks and other red flags as part of my Asia/U.S. Deep-Value Wide-Moat Stocks exclusive research service. My subscribers get access to the list of value traps for both deep value & wide moat stocks, in addition to monthly top ideas, potential investment candidate profiles and potential investment candidate watchlists.