How to Avoid a Trap That Snares Even the Best Investors

Kodak was about to go bankrupt…

For more than a century, camera maker Eastman Kodak was an innovator.

From black-and-white photos to digital color slides. From still images to motion pictures. Kodak was the leader in its space.

The company had a simple money-making model:

• Sell inexpensive cameras on the front end to get people into its ecosystem.
• Then make large profits selling them high-margin products on the back end. (Like film, chemicals, and photo paper.)

The model was successful. By 1975, Kodak controlled 90% of the camera market.

The company’s cameras were so famous, they inspired the tagline “Kodak moment.” People used it to describe any big event recorded for posterity.

But somewhere along the line, Kodak lost its ability to innovate. Competitors caught up. Profits became a distant memory. The model no longer worked.

By 1995, Kodak’s market share had dwindled to 44%.

And by 2012, the company founded in 1888 by George Eastman and Henry Strong was broke.

Kodak couldn’t pay its bills. At the time of the bankruptcy, the company had $1.7 billion more liabilities than it had in assets.

We’re not here today to eulogize Kodak… Instead, we present Kodak as a cautionary tale for investors. Especially those who may be unwittingly boarding a sinking ship.

During Kodak’s long slide from greatness, plenty of investors jumped aboard thinking they were getting a great deal as share prices plummeted.

They thought the company was cheap and prices would rebound.

Instead, they were falling into a “value trap.”

These traps are hard to avoid… But we’ll show you some signs to look for to keep you from making a Titanic mistake…

Don’t Take the Bait

A value trap is a company that appears cheap because of a large price drop in its shares. Yet it’s actually expensive compared to future growth.

Now, when great companies drop in price due to some short-term fixable problem, it can be a good strategy to buy shares. They’ll rise again once the problem is solved.

But if a once-great company is in terminal decline, you may be falling into a value trap.

There are many warning signs that a stock might be a value trap. Here are five of the most common:

• The company’s industry is in long-term decline.
• The company is losing its position as an industry leader.
• Revenues are shrinking.
• Profit margins are shrinking.
• There are accounting irregularities.

If you see any of these signs with your own holdings, you should investigate right away.

In the case of Kodak, two of these signs started flashing in the mid-1990s…

Losing its position as an industry leader: That’s where Kodak faltered. It didn’t adapt fast enough to two huge changes in the industry.

First, competitor Fujifilm beat Kodak to market with the disposable camera in 1986.

People gobbled these up. They were about the same price as a roll of film. So there was no need to buy a more expensive reusable camera.

This disposable camera ate away at Kodak’s market share.

Second, Kodak was slow to pick up on the digital photography trend.

Ironically, Kodak engineer Steve Sasson invented the first digital camera in 1975.

Sasson said management didn’t care because it was “filmless” photography. They told him: “That’s cute—but don’t tell anyone about it.”

Somebody found out… Today, digital cameras dominate the market.

Shrinking revenue: Kodak’s revenues peaked in 1991 at $19.4 billion. By 2001, revenue was down 32% to $13.2 billion. Revenues fell another 50% from there.

The stock price was $94.25 in February 1997. It dropped to 3 cents in September 2013, when the company was finally delisted (see the chart below).

In retrospect, the signs were showing that Kodak had lost its edge. Revenues were declining, market share was decreasing, and products were inferior to the competition.

Yet at seven times earnings, Kodak’s shares tempted investors into a trap. (Its 10-year average P/E ratio at the time was 19. So seven looked cheap by comparison.)

If you had looked at revenue and gross profits, you would have seen both were down about 15% over the past four years. And the “value” was just a mirage.

Plenty of investors took the bait. (In fact, Kodak even snared one of the world’s best investors. More on his story tomorrow…)

Avoiding these traps isn’t easy.

In tomorrow’s Daily, we’ll show you how to escape any value trap you may unfortunately fall into…

Regards,

Nick Rokke, CFA
Analyst, The Palm Beach Daily

Last week, the Dow broke 20,000 for the first time. But the Dow only tracks America’s 30 largest companies.

The Wilshire 5000 Index measures the performance of over 5,000 U.S. companies. And it also set a new all-time high (see chart below).

Investors are excited about the future. And they’re pumping up stocks of all shapes and sizes. The U.S. market appears strong.

—Nick Rokke

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20,000 Reasons to Worry: Plenty of investors celebrated when the Dow Jones Industrial Average (DJIA) broke the 20,000 barrier. But there may be more reasons to worry than to cheer. Although no one can predict which way the market will go… at this level, the downside is much greater than the upside. And if it falls too far too fast, you may not have time to cut and run.

A Golden Rally: Gold has recovered considerably with over 5% gains so far in 2017. But more could be in store. Global financial firm UBS says the growing weakness in the U.S. dollar could push gold prices even higher. And as we noted last week, gold isn’t the only metal on the rise. Political uncertainty in the United States is boosting commodities in general, and uranium in particular.