Value Traps - how to avoid bargain stocks that might never recover

Monday, Nov 02 2015 by
47
Value Traps  how to avoid bargain stocks that might never recover

When Warren Buffett raised his stake in Tesco in 2012, little did he know that he was breaking one of his own investment rules. He’d initially taken a position in the UK retail giant some years earlier. After a profit warning and news of increasingly fierce competition, Buffett chose to buy more shares as price started to slide. It was an error that eventually forced him to take a £287 million loss on what had turned out to be a classic Value Trap.

With Tesco, Buffett showed that Value Traps can open up in front of even the smartest investors. Yet these disappointments are a particular risk for investors looking for a bargain. The bargain hunter’s favoured territory is the deepest, darkest corner of the market. It’s here that unloved, broken and misunderstood companies languish. In amongst them lie the turnarounds and contrarian plays that can deliver stellar returns if they rehabilitate. But also lurking are the “value traps” - stricken stocks that may either never bounce back or make you bear too much opportunity cost to make it worth the wait.

Deep value - the domain of the value trap

‘Deep value’ is an investing approach that was born in the writing of Benjamin Graham. Chastened by the losses of the 1929 stock market crash, Graham hatched a completely new brand of security analysis. He shunned the expensive ‘glamour’ stocks of the day in favour of unpopular shares that sold below their 'intrinsic value'. Importantly, he insisted that these potential dogs were priced so cheaply that there was a healthy ‘margin of safety’ in the price. With a well diversified portfolio, he reasoned that he could absorb a number of inevitable losers but ride out profitably on a wave of winners.

Graham’s value strategies have earned him a great deal of respect. But one of the risks of taking his approach is becoming overexposed to stocks that are risky and perhaps on the brink of bankruptcy.

Seth Klarman is one of the best known modern day investors to have modelled an approach on Ben Graham’s ethos. He’s become a billionaire through his stewardship of Baupost Group and even wrote a book called Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor.

In his 2012 letter to investors, Klarman pinpointed the subtle risk of falling into a Value Trap. He wrote that a bargain price is necessary but not…

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Tesco PLC (Tesco) is a retail company. The Company is engaged in the business of Retailing and associated activities (Retail) and Retail banking and insurance services. The Company's segments include UK & ROI, which includes the United Kingdom and Republic of Ireland; International, which includes Czech Republic, Hungary, Poland, Slovakia, Malaysia and Thailand, and Tesco Bank, which includes retail banking and insurance services through Tesco Bank in the United Kingdom. The Company's businesses include Tesco UK, Tesco in India, Tesco Malaysia, Tesco Lotus, Tesco Czech Republic, Tesco Hungary, Tesco Ireland, Tesco Poland, Tesco Slovakia, Tesco in China, Tesco Bank and dunnhumby. The Company's brands include Finest, Everyday Value, Chokablok and Technika. Finest and Everyday Value are the two food brands in the United Kingdom. The Company offers a range of personal banking products, principally mortgages, credit cards, personal loans and savings. more »

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3.4



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22 Comments on this Article show/hide all

Edward Croft 6th Nov '15 3 of 22
5

In reply to post #110658

Paul - we've been over this discussion many times, but it's worth me reiterating as I still think you are misunderstanding the Value Rank.

There's a difference between the academic definition of 'value' and the field of 'value investing'.

The academic definition of 'value' is simply shares that are cheap based on either a single valuation ratio - like the P/B, or a composite of multiple ratios (like the Value Rank).  This thinking has a very long lineage that goes all the way back to Benjamin Graham.   Cheap shares tend to outperform expensive shares for 2 reasons - firstly they are more risky (higher leverage, higher default risk) so investors expect a return for taking on that risk, secondly they are ugly so most investors just won't buy them.  (If you want to learn more about this definition of 'value' then please read this extensive article from earlier this year).

'Value investing' as a field has morphed over time.  The cheap shares basket became more and more filled with value traps over time as value investors got better at bottom fishing - even Warren Buffett eventually gave up on it.  So the typical modern value investor focuses on quality-adjusted value, or growth-adjusted value.  i.e. they take into account all the factors you mention.   

Now we can get lost in semantics or we can learn how to use the Value Rank properly.  The whole point of Ben's article is that investors should be very wary of high Value Rank shares where there aren't any confirming factors.   The profile of a stock on the right is a classic Value Trap profile which we've shown underperforms.   Your comments on Monitise, Glencore, Lonmin, HSS etc all simply reiterate the point that Ben is making in the article - these are very risky and potentially Value Traps and investors might be wise to steer clear.

The Value Rank has a long lineage.  Value investors will prefer to focus on shares that have a higher Value Rank in tandem with a higher Quality Rank or Momentum Rank (or all 3).


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HIC 6th Nov '15 4 of 22

Very interesting and helpful article - thank you

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Mark Carter 6th Nov '15 5 of 22

That Amec one: it's almost like you knew what was going to happen.

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valueman 6th Nov '15 6 of 22
2

Ben
Useful article thx.
One of the most useful tools to establish whether a company is improving or worsening is the change in annual Roce . Buffett swears by this as his indicator . I note that Terry Smith , who follows Buffett value investing disciplines. Used this measure to prove how you could see reducing returns in Tesco for several years thereby maki g the divestment case more apparent .
I wonder whether you can show this measure ( annual Roce ) on a graph otherwise it's a pain to calculate .

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Mark Carter 6th Nov '15 7 of 22
4

Terry Smith once said that the problem with low quality businesses is that, every day, a little bit of their value is eroded.

One company that seems to have caught investors by surprise lately is Pearson (LON:PSON). I think people think it's safe because it is a big blue chip company that has been around for a long time, earns a nice dividend, and has a reasonable PE. But look at its debt pile. Look at the fact that its average ROCE of 6 years has only been around 7%. That sort of thing can land you in a bad place, as we've seen. People need to put a sign above their monitors: "Just because a company is in the Footsie, doesn't mean it's safe".

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andrewdb 6th Nov '15 8 of 22
2

In reply to post #110721

Quite right, also Pearson 5 years ago is not Pearson today.
They have sold off Penguin, FT, Economist
They have bought many training companies and a lot of their income now comes from the US

i.e. it has pivoted from publishing to education in a big way.

This uncertainty is what may have hit the SP - that and the management has a history of wasting money.

I have no idea whether this strategy will work or not.

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laurie89 6th Nov '15 9 of 22

If we sum up a value trap stock by saying 'gosh thats cheap!' can we spot a fund that specialises in the opposite ie 'gosh thats expensive'', look at the PE etc but ultimately is a good buy?

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underscored 6th Nov '15 10 of 22

In reply to post #110760

I think the point to all of this is that one dimensional models have major draw backs. Cheap expensive is an extremely simplistic uni-dimensional model. On average a basket of cheap stocks is better than a basket of expensive stocks, within that there will be significant dispersal of returns. Paul adds an extra dimension/(s) to cheap to filter down to stocks he thinks will do better than the overall average basket of cheap stocks. Ed and the Stockrank system add to other dimensions, momentum and "quality" to search for stocks with a better than average chance of suceeding.

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pka 7th Nov '15 11 of 22

In reply to post #110760

Laurie89 wrote: "If we sum up a value trap stock by saying 'gosh thats cheap!' can we spot a fund that specialises in the opposite ie 'gosh thats expensive'', look at the PE etc but ultimately is a good buy?"

Scottish Mortgage investment trust seems to me to specialise in owning such stocks. Its share price went down a lot in the last bear market, but it has recovered very well since then and is now the largest investment trust by market capitalisation on the UK stock market. Here is some information about it:

http://www.trustnet.com/Factsheets/Factsheet.aspx?fundCode=ITSMT

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Graham Ford 9th Nov '15 12 of 22

Surely the idea of a screening tool is that it filters OUT companies that are not worth looking at in the first place. Those it leaves IN then require further scrutiny using whatever techniques you choose. In other words, its purpose is not to select the stocks for you, but rather to chuck out the non-starters to save you time.

So to my mind the Value Rank is great for screening out expensive stocks but then you are going to have to drill down further to find those few that don't have some sort of unacceptable downside. The article seems to make this point very well.

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dinadan 13th Jul 13 of 22

Just a comment on the methodology of comparing the performance of value traps v the FTSE 100. You are rebalancing the portfolio every year. This means that if a Value Trap starts to perform, you then remove it from the test set.

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mmarkkj777 14th Jul 14 of 22

Just read this article for the first time, as Dinadan's comment brought it back to the top.

Great article and interesting comments with different views, mainly about interpretation of the ranks and the intention behind them.

I've only been using Stocko since April, but it has quickly become apparent that how you use the ranks, etc. is as important as the information itself.

The ranks and the information within can be used in an infinite number of ways by an investor, from simply using the preconfigured results to select a bucket of stocks for semi-passive investing, or using the ranks and filtering criterion to really drill down to support your own methods of analysis and preferred style of investing (or any combination of the two approaches in any ratio).

The tool if perfect for this and like any tool, learning to use it better will augment investment and (ultimately) results.

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shine66 14th Jul 15 of 22
9

It's nearly three years down the road and I thought I'd take a look at the performance of these ten value traps identified by Ben in November 2015, and examine the rise and fall in their market caps. If you'd prefer to do it another way, please feel free to join in : ) and if I've goofed on any of the numbers let me know.

Ben's Value Traps Portfolio 02.11.15 - 13.07.18

Enterprise Inns: 732 m (529 m) + 38%
Glencore: 45 bn (14.5 bn) + 210%
HSBC: 140 bn (100 bn) + 40%
Premier: 391 m (281 m) + 39%
Morrisons: 6.04 bn (4.0 bn) + 50%
Lonmin: 115 m (139 m) - 17%
HSS: 59 m (92.5 m) - 36%
Amec: sold for 2.2 bn (2.8 bn) - 21%
Monitise: 70 m (64 m) + 9%
Minds & Machines: 57 m (75 m) - 24%

Portfolio gain + 28.8%  (FTSE All Share + 20.5%)

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schomosport 10th Nov 16 of 22

And how about "Super stocks that turn into value traps in a (relative) twinkling of the eye - and how to spot them?" e.g. LWB?
Superstock September 2017 (SR92) to Value Trap (SR59) by January 2018. OK there were 2-3 profit warnings and downgrades but is this truly a transition from successful company to approaching junk, or is it just an algorithmic interpretation based on short term thinking?
Another example is Indivior, current price about 40% of what it was in July. Again, there are concerns about generic competitors and disappointing performance from new products which has caused much of the fall. Is it possible for you to summarise the major factors that determine these classifications? In Indivior's case in particular, it is only going to take a change in sentiment to send the momentum indicator back up and then it will be being touted as Super stock again. I think you need to take care with the use of these classifications since having too many stocks that transition from super stock to value trap back to super stock (or vice versa) over say 12 -36 months will undermine the credibility of these designations and hence your product. Don't get me wrong, I am not precious over you calling on one my holdings a value trap but there are many commentators who argue that investment is a long term exercise where one should be buying based on a 5-10 year view and not on the turn of a share price over short periods.

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Edward Croft 10th Nov 17 of 22
3

In reply to post #417759

@schomosport - how you use the data and classifications is entirely up to you ! 

A change in classification is merely the result of the change in the underlying QVM ranks.  These factors change either due to a change in fundamentals, or a change in market sentiment.  

In LWB's case there was a change in both fundamentals and sentiment which led to the decline of the Quality Rank and the Momentum Rank.  In a situation like this, it's entirely reasonable to expect a resulting change in classification. 

In LWB's case, the classification dropped from "Super Stock" through the classifications via "Contrarian" at the end of last year to end up a "Value Trap" in February 2018.   A 'losing style' classification does not mean that a company is 'junk' - it just means that the company's stock has low odds.

5be71a73dd75cImage_2018-11-10_at_5.50.38


At that point LWB had a StockRank of 31, and a share price of 62.6p.  It is now below half that price at 29p.  The change in classification to "Value Trap" appears to have been quite predictive in this particular case - foreseeing a further decline of over 50%.

5be71ae510d71Image_2018-11-10_at_5.51.50

Yes - LWB may be a good business, and the stock may rise again, in which case Momentum would pick up, and it may transition to a "Turnaround" situation.  

But for me, investing is all about minimising opportunity cost.  Given the historical average record of Turnarounds is positive, while the record of Value Traps is poor - I would personally be happy to avoid holding Value Traps and reinvest elsewhere. 

I'm very happy to miss out on the rise from the lows of a Value Trap, to minimise the risk of capital being tied up in a non performing situation.  I know nothing about the particulars of LWB - so this is certainly not investment advice... I just prefer to play the statistics !  

And the stats show that for every one Value Trap that has recovered from a slump, there have been a higher percentage of Super Stocks that continued their market beating momentum. 

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Velo 10th Nov 18 of 22
1

Interesting read - thanks.

If you click on the full list as indicated in the article that states: "Subscribers can view the full set of 65 Value Trap stocks here" In amongst that full list is Vodafone.

Now Vodafone has been going through hell all this year - terrible, no doubt about it - it's in the dog's kennel! (Luckily I don't hold it, but I'm sniffing around with interim results due next Tuesday).

Also mentioned in the article is the Piotroski F-Score in helping sort the wheat from the chaff.
And the F-Score is my TOP fav metric on Stocko and a feather in Ed's cap to make it available to subscribers, I take it seriously. It almost never let's you down. ( Can't think of an occasion where it has ).

Here's the thing - The F-Score is currently showing a glorious top-dog reading of F-8 for Vodafone (LON:VOD)

8 ! ! !

I always pay heed to the F-Score, so now I'm confused. Yes Vodafone has been a dog this year. It deserves to be on the list of shame. But the F-Score is saying this could be salvageable.

Confused.

PS. Yes I've seen the red Altman Z2 score screaming Vodafone could be bankrupt in 2 years. I hold the F-Score in far, far, greater respect than the Z-Score. Altman's Z-score has been screaming bankrupt in 2 years against Vodafone .............for 6 continuous years now!!!

(80% accuracy forecast in becoming bankrupt in 2 years, is the success rate mentioned all over the internet).

Wonder what the % success rate is for saying it continually for 6 years+ ?

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dfs12 10th Nov 19 of 22

In reply to post #417789

Interesting to see the progression through the classifications and how the move to Value trap did indeed foresee further price declines. I agree that dumping stocks that have fallen into a duff classification is a good idea. However, it is clear that some stocks can be on the edge of two classifications and can flip almost on a daily basis. So personally I leave things a week or so to ensure the change isn't a short term wobble. I currently have Aviva (LON:AV.) in my portfolio and it has turned into a Value trap in the last day or so. It isn't a large holding fortunately. But if it consistently stays a Value trap it will provide me with the nudge I need to start getting rid of my holding.

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mmarkkj777 10th Nov 20 of 22

I used to own Low & Bonar a couple of years ago,

It was, at the time, a reasonably good outfit. I bought at around 60p and made about 18%.

Personally, I think it could well turn around and have had my eye on it as a potential recovery (it has been over 400p many moons ago).

However, it has deserved its lowly rank of value trap of late. It has fallen into making a loss and the current debt is larger than its market cap and has been growing.

On the plus side its Price/book is good and its Peg is excellent.

Value trap basically means (in my opinion), on average, your investment capital would probably be better allocated to another stock with a better stock rank style).

However, I like bottom fishing, even juggling with falling knives occasionally, but I do it with a tiny fraction of my capital, for fun. It stops me tinkering too much with my main portfolio. I use the stock rank and style to help my decision process, but I will buy any rank or style in this scenario, if I think it is undervalued and is gaining momentum.

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Velo 11th Nov 21 of 22
1

In reply to post #417834

markkj77,

I too, look out for an efficient low Price to Book metric to include in evaluations. However, it's a truism held by advocates of Price to Book, that often a low Price to Book metric is low for good reason, and comes with a downside, that in many cases it can also signify many, many, long years of waiting for the pay off.

I still like to see a good low Price to Book though. (But obviously not just that on its own :)

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mmarkkj777 11th Nov 22 of 22

In reply to post #417944

Hi Velo,

Yes I agree, not P/B on its own.

I usuall look for a bunch of factors, then momentum to return first.

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