Value Investing is all about identifying stocks with unidentified or underappreciated potential and waiting for that value to be realised over time. However, it's always worth remembering that some stocks are cheap for a reason. Of course, we all hope that the market will come to recognise what a bargain our latest investment was. But, every now and then, a price fall may lure you into every value-investor's nightmare - a false bargain, better known as a value trap.
What is a Value Trap?
A value trap is a company that appears cheap because of a large price fall, but which is actually still expensive relative to intrinsic value. In effect, it is masquerading as a value stock. It looks like a bargain price because it has come down so much but, despite the allure of a low price, a value trap's price is low for a good reason - unlike a true value stock, these companies are experiencing a fundamental change in their business prospects and could basically dying companies. As Warren Buffet said, “price is what you pay, value what you get".
Timothy Fidler of Ariel Focus suggests that there are two main types of value traps:
- Earnings-driven value trap - This is where the mirage of a low price/earnings valuation vanishes as EPS evaporates over time - every time you think it looks "cheap" again, earnings fall further. This process is usually persistent and can last for years. More often than not, the misguided investment thesis is some variation of "They used to earn X, so if they could just get back to something near X, the stock would work well".
- Asset-based value trap - Also known as "cigar-butts", these types of stocks look exceptionally cheap in terms of asset valuation (e.g. the price/book ratio relative to current profitability). In some cases, the trap is simply that the reversion to the mean of unsustainably high profitability. However, Fidler suggest that the real danger comes from companies with opaque or ill-defined risks where the flawed investment thesis is "I know the risk is there, but I think it is already in the price or over-discounted".
How to avoid Value Traps...
Of course, it's easy to say with hindsight that a failed investment was a value-trap but are there any ways to flag this in advance? Fundamentally, the key to avoiding value traps…