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Economic Value Traps

In response to my post yesterday, Hey Brad; Where You Been?, Karim asks the following question,

Do you think Industrial Alliance (IAG) and Sunlife (SLF) are value traps at the beginning of their incessant failure or that they are potential good investments on dips?

I’ll first disclose that I have only ever quickly examined Industrial Alliance (IAG) and never held an equity position in the company. I have always preferred to hold Manulife Financial (MFC), Great-West Life (GWO) and Sunlife Financial (SLF). Holding an additional insurer, in my opinion, is a little too much exposure in my portfolio to insurance even though I really like their business model.

The question that the reader asks is a loaded question in my opinion. By definition a Value Trap is an investment or company that has depreciated significantly and is mistaken to be of greater or significant value. Often this value is perceived from a number of categories such as company fundamentals, stock price, internal valuation or external factors. The problem is that a true Value Trap can only be determined after the fact; if value was perceived and no actual or increased value exists.

The reason that the question is difficult to answer is that in this current economic climate there are a lot of value traps if investors are looking solely at internal aspects of a company.

In 2007 I presented a post titled, The Situational Analysis, which was an introduction to a fundamental lesson presented to students in business schools around the world. A textbook situational analysis (SA) includes four categories that compromise a SWOT: Strengths, Weaknesses, Opportunities & Threats. A more detailed SA may include a PEST: Political, Economical, Social & Technological. While a SWOT examines internal factors a PEST examines external factors that affect a business or industry. In my SA I do a thorough examination of a company & industry by completing a SWOT, PEST, Competitive Analysis & Customer Analysis to gauge the environment a company is operating within and against.

To examine a brief but detailed analysis of how I conduct a Situational Analysis see my post Taking Stock in IGM from 2008.

Currently and historically most investors have ignored external factors that impact business directly. Most of us learnt this in 2008-2009 as we saw external factors (such as the economy & political) have a massive impact on fundamentals and valuations.

The business model of insurance companies isn’t broken; they’ve simply decided to seek profitability in new directions away from their core competencies. I believe that Sunlife has done a better job of managing risk than say Manulife, but Sunlife is also a much smaller company (only 55% of MFC’s Market Capitalization) and mistakes are magnified across the profitability of the company much quicker and more significantly.

Sunlife closed yesterday (November 3rd, 2011) at $20.42 and based on that price I get a Dividend Discount Cashflow valuation of $29.61 (25% discount & 17.0% growth rate) based on the company’s recent financial information. That presents a 30% discount to current valuation based on that metric alone (DDCF).

If you look at Sunlife’s historical P/E (16.2), Book Value Growth (8.1%), Dividend Growth (13.3%) & P/B (2.1) you find a very compelling buy in my opinion. What is lost on these internal valuations though is the company’s exposure to external factors such as economic factors, interest rates, regulation & the competitive landscape.

If you can afford to build a position in Sunlife, collect your dividends and hold for the long-term despite short-term (1-5 year) volatility I think Sunlife is an excellent investment such as the other insurers are for a long-term investor. The valuation of the company in the market’s perspective may go nowhere in the next 3-5 years (as the dividend has) but for each investor you have to make an educated and informed decision on what is best for you. Sunlife for me comprises 3.4% of my entire Dividend Growth Portfolio. Each investment is important, but I’m diversified across many fronts that will minimize the impact of any one company doing poorly or expiring. I certainly don’t perceive Sunlife expiring and the company, even in the face of a catastrophe, would be a prime acquisition for MFC, GWO or any of the 5 large Canadian Banks. It depends on what price you paid, what price it was purchased for but the decision to buy or sell is an individual decision.

Value Traps, in my opinion, often have a glaring fundamental flaw that most investors ignore as something of insignificance. I’ve learnt this lesson with my previous investments that have turned out to be Value Traps and protect myself now with more detailed analysis and a strategy of risk reduction. If I were creating a portfolio of only 5 Canadian companies and capital preservation was my top priority I would likely hold only Great-West Life (GWO) rather than MFC or SLF. That’s my personal opinion of course, but from a risk perspective GWO would likely hold the lowest risk and possibly the lowest reward. Time will tell whether that is true or not, but investing is not risk-free.

Disclosure: I have positions in SLF, MFC, GWO, TD, RY & BNS

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