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.

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