The Globe and Mail, Report on Business
Published July 10, 2010

I’ve had a bias to owning higher quality companies since 2007. In a challenging economy with unpredictable credit markets, it seemed reasonable to pay a premium for stable profits, excess cash flow and strong balance sheets. I knew the companies would survive, and possibly thrive, in a tough business environment.

Buying the best sounds like a good strategy, but it can lead to poor returns if you’re not attentive to industry dynamics and stock valuations. We learned that in the 1970s when investors paid fancy prices for leading U.S. stocks known as the “Nifty Fifty” and were disappointed.

Most of my quality favourites continue to deliver profits and are in a better competitive position today than they were three years ago, but a number of them have seen their stock prices lag behind the market. Instead of being stars, stocks like Research In Motion, Ritchie Bros. Auctioneers, Shoppers Drug Mart and Rogers Communications just keep getting cheaper.

The question is, am I holding great companies at bargain prices, or getting caught in a value trap?

If it’s the former and the stocks are screaming “buys,” then it will be because of a double whammy. Earnings will turn out to be better than forecast and sentiment toward the companies will get less negative. The result is nirvana – a better valuation on better-than-expected earnings.

If, on the other hand, they’re value traps, we’ll keep waiting for good stuff to happen, but it never will. Growth will be slower than expected, or negative, and repeated efforts to turn things around will fail to pan out. Meanwhile, the stocks’ valuation metrics – price to book value, earnings and cash flow – will keep getting cheaper.

With the benefit of hindsight, it’s possible to identify some general themes that run through every value trap. There is usually a major trend that turns against the company. The product is being made or delivered in a different way, or customers are looking for something new. The change is secular in nature, as opposed to cyclical, and may bring new competition with it.

Established firms are unable to adapt to the new paradigm because their assets and competitive strengths lie in other areas. In some cases, management is unwilling to adapt. They’ve been successful with their old model and are reluctant to give it up. They don’t want to absorb the profit hit that a major shift will cause.

Of the names mentioned above, RIM is the one being most vigorously debated in Canada’s money management circles today. Only a few months ago it would have been inconceivable to mention RIM and “value trap” in the same sentence, but at a conference I attended recently, a panel of fund managers discussed just that topic.

This is the RIM that’s a world leader in the fastest-growing segment of mobile communications – smart phones. The maker of the iconic BlackBerry, which has a clear advantage in e-mail and texting, and is the most efficient user of bandwidth. The firm that’s done a masterful job of working with wireless carriers and corporate IT departments to dominate the business market. And yes, the same RIM that saw revenue grow 24 per cent last quarter, profit increase 41 per cent and cash on the balance sheet tick above $3-billion (net of debt).

So why is the stock down 40 per cent from its 12-month high and trading at less than 10 times earnings?

There are many reasons of course. The stock market has been skittish and hyper-sensitive to any hint of bad news. RIM is facing off against two of the most powerful forces in the world, namely Apple and Google. But the main issue is that the competitive landscape has changed. After being the technological leader throughout the smart phone revolution, RIM now finds itself playing catch-up. E-mail got the company to where it is today, but the new battlefield is Web access. The iPhone, and various devices based on Google’s Android software, have better browsers and a more appealing array of applications.

In high-tech, where a company’s assets are people and patents, it’s hard to catch up after there’s been a severe change of direction. Redesigning operating systems and rewriting major software takes time. Meanwhile, the competition keeps moving forward. Technology is a sector that value investors usually steer clear of, even if valuations look compelling.

If RIM’s next generation Web-browser is as good as management says it is, and proves to be less of a bandwidth hog than the Apple products, then the stock will make up a lot of ground. If the new version doesn’t get the BlackBerry back in the race, then the bears will be justified in using the words “value trap.”

The smart phone market is going through a jolting change, but I’m not willing to give up on RIM yet. Management has its head up and their team has the right skill set. And importantly, I’m not paying much to wait and see if they’re up to the task. But ah, that’s how we get sucked into value traps.