Sometimes, Even Wall Street Pros Can't Avoid the Value Trap (JCP)

Sometimes, Even Wall Street Pros Can’t Avoid the Value Trap (JCP)

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Dividend value traps abound this day and age, with many formerly strong companies seeing their prices plunge, creating dividend value traps. Here’s a story of one Wall Street pro who got sucked into the fray.

What are Dividend Value Traps?

Dividend value traps often prey on dividend investors seeking high dividend yields. Although many companies who offer dividends are well-established, successful companies, some others in serious decline only appear to be solid yield plays.

Many of these yields will seem “too good to be true.” One sign that a certain stock is a value trap is when the company is offering a yield much higher than other companies in the same industry.

As a stock’s price falls, its dividend yield increases, creating a false illusion of an attractive investment. Dividend traps can also occur when earnings or cash flow decline, and the dividend yield remains high. Without adequate funds, a company will have a hard time paying their dividend obligations. It is important for investors to always remember that companies can adjust their dividend payment amounts at any given time.

One such value trap is J.C. Penney (JCP), whose quickly plunging share price attracted a particularly famous investor a couple of years ago.

Enter Bill Ackman…

Bill Ackman is the CEO of hedge fund Pershing Square Capital Management. He earned both his Bachelor’s Degree and MBA from Harvard. In 1992, Ackman co-founded Gothham Partners, which had more than $500 million in assets by 1998. He later founded Perishing Square in 2004, which acquired positions in Wendy’s International (WEN), McDonalds Corporation (MCD), J.C. Penny (JCP), General Growth Properties Borders Group (GGP), Fortune Brands (FO-A), Ceridian Corp, and Alexander & Baldwin (ALEX). The hedge fund is run as an activist fund, investing in few companies and seeking to force them to change for the better.

Ackman’s investment in J.C. Penney

J.C. Penney, which was founded in 1906, began as a small chain store, which was typically located in smaller downtown areas. As the chain expanded and became more popular, it began to open in shopping malls, seeing great success. JCP also innovated some new retail practices, and was one of the first stores that allowed customers to make purchases over the phone. In 1996, they were also one of the first companies to offer products online.

In 2004, Myron Ullman III became the new CEO of the company, and revenues began to fall after a couple years. Revenue declined 15% in four years, going from $19.9 billion in 2007 to $17.3 billion in 2011. During the same time period, earnings declined from $1.1 billion to a loss of $152 million.

In the last five and a half years, JCP’s stock price declined by almost 80% from its all-time highs of $85 to around $17 today. On the contrary, shares of lead competitors including Macy’s (M), Target (TGT), and Wal-Mart (WMT) were mostly flat during the same period.

In October 2010, Ackman’s hedge fund took a 16.5% stake in JCP, which was already on a steep decline. By the second quarter of 2012, the hedge fund increased its stake to 17.87%, totaling 39,075,771 shares. Despite the company’s underperformance, Ackman has always had an optimistic attitude regarding JCP. The stock initially rose on news of Ackman’s investment, but wouldn’t be buoyed for too long.

After posted weak quarterly results and suspending its dividend, JCP plummeted in May 2012, falling from $36 to $26, reaching Ackman’s average cost basis of about $26 per share. The stock has continued to pull back substantially form those levels, but Ackman simply noted “we’re going through an extreme makeover.”

Losses Mounting

Based on Ackman’s $26 cost basis, he’s now down more than 33% on his investment with JCP.

Earlier this month, JCP posted a quarterly loss of 93 cents per share on revenue of $2.9 billion. These results badly missed analysts’ view for a 7 cent loss on $3.2 billion in revenue. Even worse, the company said the same-store sales plunged an almost unheard-of 26% in the period.

The Bottom Line

Even the most successful investors get sucked into value traps sometimes. The final chapter on Ackman’s JCP investment is yet to be written, but so far the investment looks like a bad one. For regular investors, a bad investment like JCP can be devastating, unlike Ackman, who manages billions of dollars.

Be sure to visit our complete recommended list of the Best Dividend Stocks, as well as a detailed explanation of our ratings system here.

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