How to avoid value traps

In my last article, I described how value investors tend to be fairly agnostic to market conditions. Instead of spending a lot of time predicting inflation, interest rates, or when the market will bottom, they focus on buying businesses when they appear cheap during periods of worry and selling them during periods of exuberance.

Many investors will have been hunting for bargains amid the market downturn. However, markets can remain in the doldrums for extended periods. Waiting for the market to recognise undervaluation may require a long wait. For this reason, many value investors also like to search for catalysts.

Catalysts

A catalyst is a specific event that may be foreseen by an investor that may cause other investors to notice that a business is undervalued. Modern markets generate so much information, from specific company results to economic data, and an investor can't hold all that in mind. Hence it is unsurprising that many companies become overlooked. This is even worse amongst the smallest companies where professional research (if it exists at all) may consist of a hopelessly biased house broker note. Identifying factors that can shine the spotlight on undervalued companies can therefore accelerate price discovery. Investors who consistently find undervalued companies with near-term catalysts will generate very good returns.

Typical examples of things that are likely to act as catalysts are:

• Positive results that are unexpected by the market but have been anticipated by the investor.
• Broker upgrades. This effect is particularly prevalent in mid-caps, where smaller funds tend to rely on the broker views much more due to their smaller internal research teams.
• The presence of an activist shareholder on the share register. Such a shareholder will publicly or privately push the management to improve shareholder value.
• Stake-building by a known acquirer. While not every stake ends up in an offer, some funds and companies are known to be serial acquirers of listed businesses. Therefore, when they appear on the register, it could indicate an offer is being considered.

While the logic behind investing in a company with a potential catalyst is sound, value investors often overweight the potential of a catalyst in their investment decision-making. This is because for a catalyst to be effective, it must be anticipated by the investor but not by other investors. Unfortunately, finding such an analytical edge around short-term events can be rare. Also, investors cannot discount the role of randomness in the timing of investment returns. Sometimes a company remains unloved for years and then rapidly re-rates on completely unexpected news or simply because an influential investor mentions it in a public forum. The risk of overweighting catalysts in investment decisions is perhaps best illustrated by a couple of my recent investment mistakes.

Mistake 1 - Appreciate (LON:APP)

Appreciate provides savings and gifting products to individuals and corporations. Its history as a Christmas savings provider may seem strange to savvy investors who would never tie up capital for no return. However, many of us will have received their Love2Shop vouchers as small bonuses or incentives. Both sides of this businesses have the feature that they hold a lot of customers' cash, often for extended periods. Although there are rules on using this cash to buy risk assets to generate a return, they benefit from changes in the risk-free rate.

So as gilt rates rose rapidly in October 2022, the company was sure to benefit from this extra interest earned on customer deposits or receivables. Although the share price did respond somewhat to this improved outlook, the company was already trading at a relatively low valuation. However, in the short term, it appeared to be dead money. They had guided in line with expectations, and as a seasonal business with a strong H2-weighting, the results to 30 September were unlikely to drive a re-rating.

This lack of an obvious catalyst deterred me from investing at this time despite realising that it was potentially cheap. However, the lack of catalyst didn't deter PayPoint (LON:PAY), who came in and made an approximately 44p cash and shares offer for the company. In this case, my insistence on an obvious catalyst for a re-rating led me to miss out on this significant takeover premium.

Mistake 2 - Capital (LON:CAPD)

Capital Limited provides drilling rigs, mining equipment and ancillary services, mainly to the gold mining industry in Africa. I surmised that this company would trade very well in the current market conditions. Gold producers need to replenish reserves that had been run down during the gold bear market from 2013-2019, while the current price of gold means that exploration projects look attractive. In this environment, Capital Limited should generate strong returns. A conservative estimate of the valuation of the business based on the multiples listed peers trade on makes me think that the market currently materially undervalues the business. At the start of 2022, I also believed the company would beat the market's expectations. This had the potential to act as a catalyst for a re-rating. Hence I had an overweight position (for me) in the stock.

Subsequently, the company did beat expectations, increasing its expected revenue range. More importantly, the 2022 EPS consensus rose from 14.9c to 20.3c during the year. And the 2023 consensus rose by a similar amount.

Considering that these estimates are in USD, and the pound has weakened against the dollar in this period, the 2022 earnings consensus has increased by over 50% in sterling. On top of this, their broker, Berenberg, increased their price target eight times in the year:

However, despite identifying the presence of potential undervaluation and a catalyst, the share price is largely unmoved this year:

It is clear that 2022 is not a great year for many stocks, particularly ones that may appear risky to many investors, and a flat finish may look like a win. However, the presence of a catalyst did not overcome the general market weakness, and despite beating expectations, the earnings multiple actually derated in 2022.

So, investing in undervalued stocks with potential catalysts and avoiding those without catalysts is not a foolproof method. Sometimes undervaluation alone is a catalyst, and trying to be too cute on timing can backfire. Still, when considering an investment, doing some second-level thinking about why this stock looks cheap and what could happen to change that perception is likely to improve decision-making. One of the biggest concerns for a value investor is that the perception of a stock never changes. These types of stocks are commonly known as value traps.

Value Traps

A Value trap is often defined as an investment where there appears to be a discount between market price and intrinsic value due to the presence of low multiples, large amounts of assets or similar attractive qualities. This definition makes it sound like simply an investor has made a poor investment. That they have used the wrong metrics, or the assets have proved to be worth a lot less than expected. While this may well be the case, I think value traps represent a specific subset of poor investments in that they tend to have one or more common characteristics:

• They trade at a discount to asset value, but the value of those assets keeps declining. This puts the value investor in a quandary. The stock still trades at a discount, which was the original reason for purchasing. Hence they are unlikely to want to sell a stock that looks undervalued. However, because the assets keep declining and the discount remains constant, they are losing money.
• The management are unwilling to adapt the business to changing market conditions.

Declining Asset Value

Declining asset value tends to occur in two types of companies. The first is closed-end funds. These are listed funds where investors buy shares in a company that invests in other assets, usually the shares of listed companies, usually in the secondary market. Unlike an open-ended fund, where additional capital invested goes to the manager to deploy, the manager has a fixed pool of investment capital. Closed-end funds trade like any other company on the stock market via order books and market makers. This means that the price of the trading share can vary significantly from the Net Asset Value (NAV) of the underlying assets. So if an investor buys these assets at a discount, they may be getting a bargain. Many value investors like to look at these sorts of situations. There is even a listed investment manager whose strategy is to take advantage of the fact that many such funds trade at a large discount: City of London Investment (LON:CLIG) .

However, Investors should never forget that they are really buying the underlying assets, and if these are poor quality, then no amount of discount makes up for the declining asset value. Indeed, if the NAV is declining, the discount is often more likely to widen rather than narrow. For example, I once owned the closed-end fund Crystal Amber Fund (LON:CRS) since I was attracted by a historic (at that time) 20% discount to NAV. Unfortunately, several of their investment turned out to be significantly less valuable than they expected. Particularly Hurricane Energy (LON:HUR), leading to the share price falling significantly at the end of 2019:

Today the discount stands even wider, at around 28%. And while this may or may not represent good value going forward, investors should always remember they are buying the underlying holdings, not just a discount.

The second type of company with declining assets is a trading company that has ongoing losses and is not able to stem these. This tends to happen in companies that are either financially distressed or facing obsolescence. The risk with a financially weak company is that they lack the funds to make the drastic actions needed to turn around the business. For example, lay-offs may be required to break even but paying severance costs may cause further financial distress. This type of company is caught between a rock and a hard place.

Not every company facing that faces obsolescence is necessarily a bad investment. Take Smiths News (LON:SNWS) , for example. The business of newspaper and magazine distribution is undoubtedly a dying one. The shift to digital means that we consume much less daily physical media. Yet the company manages that decline by cutting costs, and the excess cash is paid out as a relatively large dividend. Because everyone knows this is a declining industry, no new competitors will appear. So Smiths News (LON:SNWS) has a geographic monopoly allowing them to earn reasonable returns. However, Smiths is a profitable and cash-generative company. It is the combination of obsolescence AND ongoing losses that risk making a company a value trap.

Management Unwilling to Adapt the Business

Successful value investing takes advantage of the power of capitalism. Underperforming companies are pushed by their owners to improve their efficiency, reduce their working capital, invest in better products, or shut down unprofitable business lines. This is why the earnings of companies show significant mean reversion.

However, the management of some companies are resistant to making the necessary changes to improve their fortunes. Many investors like to see the managers of their investments have significant skin in the game. However, if a company has a controlling shareholder, this will prevent activist shareholders from building a stake of sufficient size to force any changes. There are many reasons that a controlling shareholder may not want to make the required changes. Perhaps they don't want to appear like the bad guy closing unprofitable operations. Perhaps the status of being a listed company Chairman is more important than the economic success of the business for them. In many cases, the controlling shareholder(s) pay themselves so well as a salary and bonus that growing the business is not a priority for them. Whatever the underlying motivation, such companies tend to have one or more of the following traits:

A lack of ambition

Northamber (LON:NAR) is a company that trades at a discount to its working capital. However, as a distributor, this working capital is an essential part of its business. These assets are not productive, though, and the company has been loss-making for the last decade (apart from a one-off gain from a property sale in 2020):

62.88% of the equity is owned by Managing Director Alex Phillips, who inherited it from his father, David, in 2021:

Perhaps the only thing that can be done with such a business to make it productive is an orderly wind-down. There is little sign that this will happen any time soon.

Slow pace of change

A company that I think falls into this category is Camellia (LON:CAM) , which I previously looked at here. The company is an eclectic mix of various businesses picked up in its long history. On the surface, a discount to Tangible Book Value looks attractive:

However, the company has been far too slow to sell off non-core businesses. While they have been rationalising these over the last few years, the money has gone to paying down debt or into working capital. The dividend is a rather meagre 3%. A family trust effectively controls the company. Minority holders cannot exercise any influence on changes, and the trust can block any takeover interest that may accelerate the sale of assets and return of capital.

High board pay

Investing in MS International (LON:MSI) is a bit of a UK value investor's right of passage. It is a cyclical business that often looks cheap when it is going through a bit of a boom time, as it is at the moment. They often hold significant amounts of cash, which looks attractive to the value investor. However, whatever the business conditions, that cash rarely makes its way to shareholders. Dividends have averaged about 8p per share over the last decade costing £1.4m each year versus an average cash balance of around £17m over the same period.

The annual report shows that for FY22 the directors took home £1.7m:

They appear to pay themselves handsomely, whatever the prevailing business conditions. Perhaps unsurprising, when the same report shows that the directors effectively control the company:

This means that this state of affairs is unlikely to change any time soon.

Poor shareholder communication

With this level of board remuneration, it is perhaps also unsurprising that MS International (LON:MSI) delivers no management presentations and the only option to interact with the company as a minority holder is to physically attend their AGM in Doncaster. Companies resistant to interacting with all of their owners are likely to resist changes that may increase shareholder value too.

These are just a few examples. There are many other value traps out there that may catch the unsuspecting investor.  However, if investors look for these warning signs, they should be able to avoid being stuck as a minority shareholder in a cheap but permanently low-return business. And that is a Christmas present we can all wish for.

Happy Christmas!

[Disclosure: Mark owns shares in Capital (LON:CAPD) ]