Avoid Value Traps and Spot Fake Profits
Discover the tricks of corporate fraud and how to protect your portfolio from similar pitfalls.
A warm hello to all new readers! I’m glad you are on board.
New here? I’m Michael and on a mission to make beating the stock market as easy for you as choosing your favorite ice cream. I write an algorithm that does exactly that.
How it all started. The journey so far.
Ever wondered how to avoid investing in a stock that's too good to be true? Learn how to spot fake profits and protect your portfolio from financial disasters. Dive into the essential strategies that will make you a smarter, more cautious investor.
Last week we talked about WorldCom and its epic belly dive into oblivion. It’s a fascinating story that we investors can learn from, especially in avoiding value traps.
What is a value trap?
It’s a stock that looks mouth-watering and attractive compared to its price, with profits that seem as robust as a bodybuilder’s biceps. But those profits might be as bloated as my stomach after a portion of beans - full with hot air and temporary. The important question is.
How can companies tweak their profits? And more importantly.
How can we spot fake profits and avoid these stocks like the plague?
There are many ways companies can manipulate their financials, but let’s take WorldCom as an example again.
The Tricks of WorldCom in a Nutshell
Cost Allocation: WorldCom booked operating expenses (OpEx) as capital expenditures (CapEx). Operating costs are expenses that are expensed immediately in the income statement, while capital expenditures are amortized over several years.
By incorrectly booking operating costs as capital expenditures, WorldCom significantly reduced its expenses in the income statement, thus manipulating its reported profits.Manipulation of Accruals: WorldCom also manipulated accruals to affect earnings. Accruals were created and released to disguise the financial situation and stabilize or increase profits. This practice allowed the company to project an image of stability and continued growth when the actual financial situation was much worse.
The first trick Cost Allocation is harder to detect in financial statements because it happens behind closed doors at the desk of an employee. Only he or she knows about it. But the second one, Manipulation of Accruals, is more “visible” because accruals are reported to us investors. If they’re bloated compared to other metrics, it stinks right into your face.
A very rough way to get a first feeling of whether profits are bloated is to subtract Cash Flow from Operations (that’s the way the company really makes money from its products or services) from Net Income. It’s just a first sign though.
A more detailed look involves the so-called “Scaled Total Accruals” (STA) or Sloan ratio.
Let’s get technical for a split second.
The formula is:
STA = (CA−CL−DEP) / Total Assets
Where:
CA is change in current assets – change in cash and equivalents
CL is a change in current liabilities – change in long-term debt – change in income taxes
DEP is depreciation and amortization expenses
If you are more interested, have a look at the paper “Do Stock Price Fully Reflect Information in Accruals and Cash Flows about Future Earnings” by Professor Richard Sloan.
The lower the STA, the better it is for long-oriented investors.
This “forensic” data analysis helps us to weed out the crap and focus on genuine, high-quality stocks. It’s a good second filter and there are many more you can pull into your analysis.
How real are these fake profits?
The first results of my analysis show that there are potential candidates you should avoid (on the right side of the picture below). The good thing is, they are the exception.
This brings me to how I will implement this into my code.
Behind the Scenes
The Progress
I’ve been deep in the weeds to improve the picking quality of my algorithm even further. The goal is that it only picks solid businesses at fair prices while avoiding these value traps. The above techniques and more will help me to achieve this.
I’ve also been wrestling with the liquidity topic and finally beat it. But before that, I got ahead of myself and burned a lot of midnight fuel, only to get stuck because things got too complicated.
I tried replicating a principle from a paper, but the results weren’t convincing—only about 10% of it was statistically relevant. So, back to the drawing board I went, stripping it down to the basics and I’m about to finish the code.
Third.
Testing: Equal vs. Weighted Investment
I’ll test two approaches:
Spread the investment amount equally between all stocks (the current way)
Investing in a weighted manner, where I put more money into companies with higher market caps and less into smaller ones.
Why this makes sense and when?
The idea is to avoid market movements or irritations with our investments. Investing too heavily in small companies can move the stock price. There’s a sweet spot where the strategy must shift from evenly spread to weighted spread.
Finding the Sweet Spot is the goal.
Literature suggests that investing max. 1-5% of the daily traded dollar volume of each stock is the area to avoid too much market impact. The less we invest, the more we can put into smaller stocks with higher growth (and probably more volatility). Conversely, the more we invest, the more we need to focus on larger stocks with smaller growth and (hopefully) less volatility.
To get a feel for this, we can calculate the market cap percentiles of our stock universe and tie it to the minimum investment amount we can invest without moving the market. After that, I’ll create investment amount buckets where the selected tickers are paired to fit the potential investment amount.
Fair Market Access for Our Money
The goal is to give everyone fair access to the market with this approach. Over-investing in a strategy optimized for smaller total investment amounts can be detrimental because it moves the market, leading to self-deception that no prudent investor wants. The stocks must match the investment amount; otherwise, it backfires. If the demand on TheValueVantage.com becomes too high (which I doubt initially), I can and will limit the number of reports available on specific days for specific buckets to ensure the market remains neutral for us.
So, that’s been my week.
The Plan
Finalize, implement, and test these three last ideas— (1) Red Flag for Value Traps, (2) the liquidity topic, and (3) Equal vs. Weighted Investment—before the final launch. It will take more than a week, that’s for sure, but it’s worth it. For me, these are the essential last pieces needed to ensure the algorithm works effectively in the real world. With these in place, I can launch with confidence.
What’s on my head
It’s amazing how much research on stocks has been done. Some are pretty solid and some are more like a theory dance from a professor. The more I read, the more I wonder how much of this actually gets put into practice.
Nuggets
Seneca kept me sane this week. While grappling with the results of my liquidity analysis, I took a break to read a few pages of “Letters from a Stoic.” One sentence, in particular, helped me refocus on what truly matters:
“To be everywhere is to be nowhere.”
Reflecting on this made me realize that, amid the disappointing results and the time I’ve invested, I’ve still learned something valuable. But I was losing sight of the bigger picture, stood there, kind of sidelined, and couldn’t see the forest for the trees. My takeaway. Trying to get too fancy is seldom worth it. I’m satisfied with the approaches I have now because they are straightforward, clear, and packed in nice formulas.
Hit that heart if you love honest companies!
Michael
Recommend The Economy Rocket to your readers and friends
I share my stock investment story without sugarcoating – you get the good, the bad, and those tricky ego trips. I'm developing a service with a mix of smart code and proven investment strategies, making stock analysis a thing of the past if you wish. Why? Because life offers so much more beyond the confines of stock analysis.
Disclaimer:
The information in this article is my personal opinion. I’m not a certified investment professional. It is not consulting, nor does it constitute investment recommendations.
I do my research carefully and follow my personal investment strategy.
The stock market is a complex building with its own rules. There are no rules set in stone, like the rules of physics.
Therefore, use the contents of this newsletter at your own risk and do your own research as well. Investing in the stock market can lead to a total loss of the capital invested.
Creating Wealth With Creative Thinking https://open.substack.com/pub/michael880/p/creating-wealth-with-creative-thinking?r=3b6pw1&utm_campaign=post&utm_medium=web
I would suggest also exploring the limits of your approach. It may come to work really well for a large class of companies. But it will never handle ALL companies. My own main expertise is in REITs, a land where GAAP distorts a lot. While much relevant detail can be found in 10-Ks and supplementals, it is not presented in a form easily computerized.