If you able to find a stock in this market that appears cheap, perhaps the attractive valuation is due to market inefficiency, and you have unearthed genuine value … or perhaps there are negative fundamental factors or industry dynamics at play. A ‘value trap’ is when you believe the former, but get the latter. Avoiding value traps is therefore essentially a function of having a rigorous analytical process, and following it. To find out how some of Australia’s most successful value investors do it, including John Abernethy, Roger Montgomery, Wayne Peters and Ben Rundle, Livewire posed the question: “What are the common characteristics of a classic value trap, and how do you avoid them?” Read below to hear what these Managers consider the most important parts of their process in sorting the ‘value’ from the ‘traps’.
Only invest in what you understand
Wayne Peters, Chief Investment Officer, Peters MacGregor
Value traps mean you’ve overpaid for a series of future cashflows. The stock market owes you nothing, and the only way to reduce mistakes is to do your homework. Only invest in things you understand and make sure your position sizes reflect the risks.
Ego and greed are your biggest enemies, particularly as luck and randomness plays such a large role in business. The easiest way to turn a manageable loss in to a disaster is investing too much in a single, risky business.
Mistakes are part and parcel of investing. If you’re not making a few mistakes, then you’re probably not taking enough risk to produce decent returns. But to minimise errors, stick to companies you understand, and buy when companies are under pressure. Stocks priced with low expectations reduce the risk of bad luck and analytical errors producing losses. The lower the price you pay, the larger your margin of safety and the higher your prospective returns.
Quality management and clear strategy is critical
John Abernethy, Chief Investment Officer, Clime Asset Management
Part of avoiding value traps comes down to assessing the quality of management. We look for consistent evidence that management act in the best interests of all shareholders, which often coincides with management owning a meaningful stake in the business. Having a clear focus and conviction in the business strategy is also paramount. We typically see value traps falling into one or more of the below categories;
Unfavourable industry dynamics, such as: diminished pricing power; low profit margins; or current or likely disruption through technological advances (e.g. traditional media).
Heavy debt burden, which varies by industry. As a broad rule of thumb, we believe businesses with >50% net debt/equity (asset based) and/or net debt/EBITDA >2x (cash flow backed) require careful evaluation.
Cash conversion/collection: generally speaking, the longer it takes to receive cash after incurring the expenses/capex, the riskier the business becomes.
Four questions to ask to spot a value trap
Ben Rundle, Portfolio Manager, NAOS Asset Management
As a rule of thumb if we believe a company is unable to grow their cash flow and increase intrinsic value we will tend to stay away from it no matter what the price. We will reconcile the income statement to the cash flow statement. We will monitor the debt levels. If a company has too much debt it is effectively giving the lender the right to call game over. It is also important to ask; is the industry going through a permanent structural shift? Is the Company too reliant on one product? Do management have a poor history of capital allocation? Is the stock cheap using traditional valuation methods or those methods used by management? Relying purely on reversion to the mean can lead to a lack of understanding of business dynamics.
Ultimately all about business quality
Roger Montgomery, Chief Investment Officer, The Montgomery Fund
A value trap is the purchase of a business with a falling share price, but a business that will decline in value in the future too. The share price may seem cheap today but it will be even cheaper in the future because the intrinsic value of the underlying business will be lower as well. Avoiding these is a matter of ensuring that the businesses one acquires continue to display bright prospects for their products and services sales growth.
The businesses need to grow their equity at an attractive rate while maintaining a high rate of return on equity. Any deterioration that is permanent rather than temporary offers the potential to become a value trap.
We want to buy businesses whose value we are confident will be materially higher in five, ten or twenty years from now. So if we are comfortable that our estimates and thesis are intact, a falling share price represents a genuine opportunity.