Avoiding value traps is one of the hardest parts of value investing. Unfortunately, it is also an occupational hazard of value investing. Value traps and value investments are challenging to separate into different buckets. Both have similar qualities, but they achieve vastly different returns.
Avoid melting ice cubes
A different way to look at value traps is to label them as "melting ice cubes." This means that the company's earnings are declining, and while it may look cheap now, investors must rely on the market to adjust the price before income declines too far. The chances of this happening are very slim indeed.
I'd be willing to bet that every value investor has fallen into this trap at one point or another. Newspaper companies are a great example of melting ice cube businesses. The newspaper industry is suffering some significant structural problems. For the past 20 years, newspaper circulation has been declining. Hundreds of small publishers have gone to the wall as a result. This trend is unlikely to change anytime soon. The newspaper industry is, therefore, much like a melting ice cube. It keeps getting smaller and smaller.
As such, anyone buying a newspaper business today is effectively betting that a greater fool will come along in the future and pay a higher price for the same company with lower income. Though the company may seem undervalued on paper, if earnings don't improve, those "greater fools" will not appear.
In some respects, this seems to question the very underlying principles of value investing. Traditional value investing was based on the idea of buying cigar butt type stocks. To put it another way, if you buy a stock cheap enough, you'll earn a return from the one last puff left.
This may have been an acceptable and highly profitable investment strategy for 50 or 60 years ago. However, with so much information available to investors at the click of a button today, is anyone going to be willing to buy a stock just because it looks cheap if the business is suffering from significant structural issues? It seems unlikely.
That's why it is now more critical than ever for value investors to stay away from melting ice cube type businesses that are suffering from declining sales and earnings. These companies may look cheap, but there's never any guarantee they will recover.
Research is key
How do you find these companies? In my experience, the best strategy is with research. Brushing up on a company's history over five or ten years should give you a great idea of how it has performed in different environments, if it has missed growth targets or under-invested in research and development.
Having said all of the above, in some cases, a company might start to look appealing due to a change in management or sudden infusion of cash. These investments can be tempting, and there's no reason to ignore them entirely. But, it is essential to remember Warren Buffett (Trades, Portfolio)'s favorite piece of advice when investing in companies which appear to be on the verge of dramatic change: "A bird in the hand is worth two in the bush." This means that it's better to trust what you know, rather than gamble on what you don't.
As is the case with so many investing topics, there is no one clear answer to give to the question of how to avoid value traps. Nevertheless, by avoiding melting ice cubes, you might be able to improve your chances of avoiding diminishing businesses. The best way to understand if a business is declining is to look at several years of company-specific data, as well as industry data, to see how it compares.
This might require extra time and effort, but it should pay off in the long run. You can't cut corners when looking for high-quality investments.
Disclosure: The author owns no share mentioned.
Read more here:
- Buffett, Tobacco Stocks and RJR Nabisco
- Buffett: Keep Learning and Remain Open to New Ideas
- Berkshire Hathaway: A Premium Business Deserves a Premium Multiple
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