Value Traps

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With the term “cheap” and “value” so often around, especially in a bear market, what are the characteristics of a value trap?

If my wife had to define value, it would be buying a Chanel handbag on sale. From firsthand experience,a 10% sale for Chanel is truly good value. On the other hand, a value trap would be where I bought the Chanel handbag on sale, only to realize it was a fake.

The following  characteristics as described by Investopedia, are some common traps.

Low Multiple Value Trap

Multiples certainly do help in providing a picture of the company, however, if the company has been trading at its low multiples for an extended period of time, there is a reason.

Some reasons for why the company may be so cheap:

  1. The company has difficulty generating meaningful and consistent profits and is unlikely to generate institutional or substantial retail interest.
  2. Management is reluctant to get out on the road and tell the company’s story to retail and institutional investors.
  3. Competition is extremely stiff, and the company is unable to differentiate itself.

No Catalysts

There are some investors that state the deep discount itself is a catalyst. I agree to some degree. A majority of net nets are value traps because they fail in their ongoing operations, yet they have extremely cheap multiples. But if we bought purely for its cheapness and think that management will turn it around sooner or later, we are in for a bad ride. Without a catalyst to unlock its value, the company is a value trap.

In the value investing realm, Sears is a big value stock. By looking at its balance sheet we see that Sears has a huge property value that is being mispriced. However, I believe this fact is well known. Many small investors are aware of it and I’m sure the institutions know it as well. The problem is, the property value has be to unlocked. Unless Lampert unlocks its true value, I wouldn’t be surprised if SHLD doesn’t travel upwards for a while.

High Insider Ownership

Although high insider ownership is a sign of faith by managers, it may also be a deterrent to institutions as it prevents change being enacted if the managers are not performing in the best way. If I am unfamiliar or don’t have enough information on the managers, I am hesitant in purchasing a company where insiders own more than 15%.

This includes companies that have a dual class share structure as it gives the owners an overwhelming authority over the direction of the company.

Investor Rear View Tendencies

One of the problems I faced is placing too much emphasis on the history of the company. If a company has performed admirably for the past 5-10 years, I placed a heavy emphasis that it can continue. This tendency is much like falling for the low multiple trap. Just because the company did well in the past, it doesn’t mean it will continue in the future unless it has a moat and strong market share.

Disclosure

No positions in any stocks mentioned at the time of writing.

  • http://www.nurseb911.com/ Nurseb911

    I think a value-oriented investor needs to really be conscious of looking past what are considered “value metrics” by many of the greats: low P/E, P/B, etc

    I think that a value investor needs to be much more focused on the sustainability of the business model of a company more than what it’s assets are worth on the books. Far too often stocks are cheaper than their assets because their ability to produce earnings (or earnings growth) is dramatically affected and don’t have the resources or capacities to revive the business in a meaningful way to produce the return a value investor is anticipating.

    Nurseb911’s last blog post..Fixed Income Alternatives:

  • Jim

    I have never used P/E when fixating a value to a business.

  • http://www.oldschoolvalue.com Jae Jun

    @Nurseb911
    When I first started out I was always looking for companies with low multiples but now I know better.

    @Jim
    I wish more people realised what it really meant before quoting that it has a low PE.

  • EFN123

    Is the simple solution to this to look for low P/E and/or P/B and/or P/CF and/or P/S combined with very high ROE and/or ROA? This significantly reduces the number of companies passing the screen but perhaps helps avoid the value trap?

  • http://www.oldschoolvalue.com Jae Jun

    That is exactly what Dreman says to look for in his book Contrarian Investment Strategies. (I just posted his 41 rules). Although the screen will filter out many companies, the unfortunate thing is that value traps will always be present even with a screen like that.

  • http://www.motiwalacapital.com adib

    GreenBlatt’s magic formula also looks at cheap as defined by EV/EBIT and quality as defined by Return on Invested Capital. I believe this is a good place to start. (not the only way by any means).

    It just depends on what your time horizon is. At some price, any business might be attractive..even one that is not growing…