A Simple Method For Avoiding Value Traps

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A Simple Method For Avoiding Value Traps

By Alan Gula, Chief Income Analyst

In April 1968, Sony Corp. (SNE) released its ground-breaking Trinitron cathode ray tube television set. The prominent brand would go on to sell 280 million units.

Even more revolutionary was the Sony Walkman, which was released in July 1979. Sony sold 200 million units of the iconic portable cassette player.

Then, in December 1994, Sony introduced the PlayStation. It was the first video game console ever to reach sales of 100 million units.

Unfortunately, Sony’s halcyon days are long gone. The firm has failed to keep up with the pace of technological advancement in the industries in which it operates, and on Wednesday, the (former) electronics giant made a stunning decision . . .

Sony announced that it was canceling its dividend, which had been paid since 1958.

The company also admitted that it will lose over $2 billion in the current fiscal year, largely due to a write-down of its floundering smartphone business.

Sony’s shares fell as much as 13% in Tokyo trading on the news (Sony’s American depositary receipts trade on the New York Stock Exchange under the ticker SNE).

But even though shareholders reacted violently, Sony’s woes are nothing new. Management has continually promised a turnaround that hasn’t materialized, as you can see from the chart below:

Still, many investors – including activist hedge fund manager Dan Loeb – have seen value in Sony shares over the years.

However, management has been sending a simple, yet overlooked, signal that we should stay away . . .

Signs of a Value Trap

A management’s inability or unwillingness to raise a company’s dividend payout is often a warning sign that the stock may be a value trap.

Indeed, up until now, Sony paid a constant 25-yen dividend for years without an increase.

What’s more, Sony’s experience is reminiscent of a long-struggling U.S. retailer, J.C. Penney Co. (JCP), which has ensnared many value investors.

J.C. Penney paid a constant $0.20 quarterly dividend from 2007 to May 2012, when management canceled it entirely. Activist hedge fund manager, Bill Ackman, tried to turn the company around, but he ultimately failed. Doesn’t all of this sound eerily familiar?

Since killing its dividend, JCP has declined 68%, which isn’t surprising . . .

Ned Davis Research (NDR) has conducted analysis showing that dividend cutters and eliminators significantly underperform the market.

NDR has also shown that dividend growers and initiators outperform the broader category of dividend-paying stocks.

Bottom line: Keeping an eye on dividend growth is a great way to avoid companies in death spirals and sidestep stocks that will eventually pull the plug on their dividends.

Sure, we’ll miss some successful turnarounds, but we’ll also avoid the biggest dogs. Our average returns will improve by seeking value but requiring dividend growth, thereby avoiding the nastiest value traps.

Safe investing,

Alan Gula, CFA

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By Alan Gula