Hi Investors,
SUMMARY
Value investing is based on the idea that investors can purchase a stock that is selling at a price below what their intrinsic value. However, are there reasons why a stock would logically sell below their book value? Are there ways investors can differentiate between a good bargain and a value trap?
(A) Introduction
With the stock market hitting new highs almost every other day, investors would be hard pressed to find companies with a price-to-earnings ratio below than the market average. That makes finding a cheap stock even more appealing.
The famed value investor, Warren Buffett, has been known by many to be able to spot undervalued businesses – businesses on the stock market that is selling for less than their actual intrinsic value. Add to that a margin of safety and a little patience and anyone can make money on the stock market.
His approach makes sense – given a chance, anyone would buy a two-dollar bill using a dollar. However, determining the intrinsic value of a company is extremely difficult to do. Most of the work performed by value investors round to an estimate at best and if one were to place an intense focus solely on the numbers, then the picture might be overlooked.
(B) What is a Value Trap?
A value trap is a stock that appears to be cheap because it has been trading at low multiples of earnings or other measurements of earnings for an extended period of time. In value investing, one of the most important and challenging aspects of stock selection process is determining whether you have a found a genuine bargain or a value trap.
Think of it this way: Is the business in question facing short-term or long-term challenges? Long-term challenges are extremely rough to navigate because there is a higher risk now that the business might be permanently impact. If the challenges are short-term, one can purchase the stock knowing that there will be a time when its price will rebound.
(C) Spotting a Value Trap
So how can we spot a value trap? Here are four ways you can do it.
- The financials of the business is deteriorating year-over-year
If the stock’s price is very cheap as compared to past earnings or the market’s PE ratio at that point, this could be a warning sign that the business is a value trap. In reality, it should not be easy to spot a business that is selling below its book value for a reason that is misunderstood by the majority of market participants. While there are instances when a business is selling for less than what its worth, the reasons tend to be due to short-term shocks in its share price – a lawsuit that is being settled (Starbucks in 2014 when it was sued by Kraft Heinz) or a one-time expense that dragged down profitability (First Solar in 2016 as it transitioned to newer products).
Markets are forward-looking in nature and future cash flows will be discounted to the presents value to reflect what the business is worth today. If a stock has fallen to the point where it is absurdly cheap compared to past earnings, it may be a potential red flag that something is wrong with the business.
- Management has under-performed and corporate governance is lacking
Poor stewardship of a business by an incompetent management team can always sink a business. Investors can take note of the management’s near-term goals which can be found in every quarterly and annual conference calls and compare it with prior year’s goals. Stocks which are truly value investments should reflect an operational performance that is robust with metrics that can be measured. If management has a reputation for over-promising and under-delivering, it would not be favorable for investors to commit any capital.
Secondly, investors can also observe whether management’s compensation structures have changed according to the business performance. A management team that has vested interest in the company that they manage would put the interest of stakeholders first. If earnings and stock price has declined while no changes were made in the compensation packages to those who are in the C-suite, fundamental business changes are very unlikely to come by and hence, that stock may be a value trap.
- The company takes on an unreasonable amount of debt without delivering on returns
Debt is a four-letter word regardless of how they are used. If they are kept under control, it is very easy to go down a slippery slope. In fact, debt is the actual trigger for the deadliest value traps, snapping shut before management can turn things around. This can come in many forms including working capital requirements, leases and short-term refinancing. While taking on more debt can change the weighted average cost of capital for the business, management must deliver on the returns that it aimed for when it set out to take on more leverage. The “trap” comes from not using that capital efficiently to reinvigorate the business. By definition, the old ways of allocating capital do not work anymore.
- The company’s prospects are not as promising as before
A company that lacks strategic advantages to overcome competition can lose their ability to compete. There are many retailers that are selling at low PE valuations now. However, many analysts are considering if the business models have been inpaired by entrenched competition from online retailers like Amazon.com.
Does the company have what it takes to stay ahead? Being a market leader or having economies of scale and pricing power allows a company to stay float while it pivots to fight for market share.
Value traps often occur with companies that are ceding ground to new competition. Until market share trends higher, the stock seldom does.
(D) Conclusion
The goal of investing is to maximise one’s returns and even the sharpest value spotters make mistakes by buying into value traps, use the four factors highlighted above and one should stand a better chance of spotting a value trap.
Marcus Ho
Research Analyst, Mind Kinesis Value Investing Academy
Disclaimer: Please note that all information stated in this article is just for education purpose only and should not be used as any form of recommendation or advice.
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