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Strategies & Market Trends : Value Investing
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To: Grommit who wrote (56544)1/5/2016 6:42:01 PM
From: Graham Osborn1 Recommendation

Recommended By
mopgcw

   of 78774
 
The quintessential "value trap" arises when value investors apply ratios to fundamentals in flux. One of Graham's core assumptions was that the historic operating performance of the business would predict the future better than modeling. When you consider the basic format of the ratios we use:

Market valuation/ Balance sheet metric
Market valuation/ Operating or Cash flow metric

You see the problem:

Market valuation (all future cash flows) / Balance sheet metric (right now)
Market valuation (all future cash flows) / Operating or Cash flow metric (generally TTM cash flows)

So your ratio-based investor will get screwed using these ratios if the fundamentals are changing. For this reason, I have decided to generally never invest in businesses that are shrinking their revenue or tangible book value. And in general, I like 10% growth on both. With those assumptions I can use the ratios and know that I am dealing with real value vs the "shriveling cash flows" illusion of value. You might call it the Buffett qualifier.

90% of the stocks discussed here fail on one or both criteria.
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