Value investing is a tricky blend of art and science. The science part is usually quantifiable with information obtained from annual reports, proxy statements, industry surveys and various other sources. The art part of value investing generally involves a decent and sometimes even an uncomfortable amount of judgment to be made about the future of the business involved. The best value investors are as much great scientists as they are fabulous artists. However, even the best of the best fall into value traps. Just think about
Warren Buffett 's acquisition of Berkshire Hathaway and Seth Klarman's purchase of Hewlett Packard. Naturally, one may ask, if even the sharpest minds are ensnared by mirage-like value traps occasionally, are they just unavoidable?
Unfortunately, the answer is yes. If you live close to the ocean, you will get wet one day. Value investors search for bargains in a sea of beaten-down stocks. Some are no brainers, some are value gems and some are value traps. The one common and defining characteristics of these stocks is cheapness, which is the reason why value investors are enthralled. Sadly, there are a variety of reasons why they are on sale, and it is not obvious how to differentiate between the legitimate ones and the twaddling. The only way to never get yourself into one of these situations is to shop somewhere else, but that would potentially lead us out of our circle of competence.
I think the best way to think about how to deal value traps is to adopt Charlie Munger's witticism, "Why fret too much about what you can't fix? Just put your head down and do your best." Since we can't tell the market to stop throwing us value traps, we'll have to deal with whatever Mr. Market is offering us with diligence and competence. If the odds are in our favor, over a long time period, we will do reasonably well. Let's accept that value traps are inevitable and all we can do is to try our best to minimize our losses that arise from investing in value traps. To achieve that, I think it is essential to understand
(1) Common characteristics of value traps.
(2) Behavioral biases behind investing in value traps.
Common characteristics of value traps are discussed many times on GuruFocus. Readers can search the key words "value traps" and many articles will pop up, my favorite of which is:
The behavioral biases that make value investors prone to catching "falling knives," however, have not been examined extensively. I venture to contribute my two cents on this subject because as I look back to some of the worst investment decisions that I have made (e.g. Radio Shack, Nokia), all of them involved the interactions of at least a few cognitive and emotional biases, or what Charlie Munger called the Lollapalooza Effect.
The confluence of these biases is so powerful that it is almost impossible to escape once you are in. The most rational way to cope with situations like this, is to understand the biases in force and to develop a strategy of mitigation. While almost every behavioral bias can be related to investing in value traps, I found the following ones particularly powerful:
- Availability bias
- Conservatism bias
- Confirmation bias
- Overconfidence bias
: Investors are likely to have an anchor price prior to making an investment decision. It is not necessarily a bad thing if you have the right anchor. For experienced value investors, the anchor price should undoubtedly be the conservatively estimated intrinsic value of the whole business. However, novice investors often commit the mistake of anchoring to the wrong price such as the 52-week high per share price or even the previous all-time high price.
I still vividly remember three years ago, prior to Research In Motion (BBRY)'s precipitous drop, I bought RIMM at a little over $50 per share (now BBRY) because I naively anchored myself to RIMM's 52-week high of more than $80 per share. Our brain releases dopamine at the anticipation of rewards. Dopamine’s role is for us to act to get the reward, so we would not miss out. Therefore, if we set the anchor wrong, we will be temped to react in order to reap the imaginary rewards.
In this case, my imaginary reward was about $30 based on my wrongfully chosen anchor price, and my brain pushed me to act so that I would not miss the reward. In hindsight, this is all amusing, but when you experience it the first time, it's real and powerful. As stated above, to overcome the anchoring bias, or more precisely, to set up the right anchor, we should use the conservatively estimate intrinsic value as our anchor price. Failure to do so will likely result in unsatisfactory results.
Availability Bias: Investors estimate future outcomes based on how easily past events can be recalled. This is especially dangerous when past memories are biased or incomplete. An investor may select investments based on promotional advertising or a shout-out from Jim Cramer, both of which are often easily retrieved because they are inherently more memorable. An investor may also exhibit the availability bias when choosing to invest in a stock because he or she incorrectly estimates the preferences of others based on his or her own preference.
Many value traps are stocks of companies such as RadioShack (RSH, Financial) and Nokia (NOK, Financial) with great brand names. If you are an investor and you like to shop at RadioShack or you like Nokia phones, you are prone to extrapolate that others should also like RadioShack or Nokia when in reality they don't, or at least not as much as you do.
I purchased Nokia more than years ago for this exact reason. I had always liked Nokia's cellphones and I know a few other close friends in China who are die-hard Nokia supporters. Therefore, I thought the business deterioration is not as bad as other investors thought. Boy, what a lesson that was. The availability bias combined with the confirmation bias (I diligently looked for information that confirmed my belief), and the conservatism bias (I put more emphasis on Nokia's past record) created my worst investment loss. I am still a fan of Nokia but now my memories with Nokia are indeed bitter and sweet. This episode of my investment fiasco taught me to disassociate my feelings towards the target company and conduct more diligent research before making an investment decision
Conservatism bias: Investors subconsciously place more emphasis on old information and place less value on new information. The human brain is wired to resist changes. Assumptions or events that have worked well during the past tend to be continually applied to new situations. With regards to value traps, this bias kicks in when an investor cling to a particular view usually regarding a previously successful business and react slowly to information that could signal a change in trend or underlying business fundamental. Recent examples include Kodak, Nokia, Radio Shack and Hewlett Packard (HPQ, Financial). These are iconic brands that were once dominating in their respective fields. Investors, who had previously followed the stocks of these companies may think the brands name remain intact or not as tarnished as the general public thinks.
Hewlett Packard is a great example. The old information will suggest that HP is a great brand with a decent market share in the PC market, companies are still purchasing HP laptops for business uses, free cash flow is still positive and the valuation multiples are low compared to historical averages. The new information will tell you that HP is still a great brand, but the growth of smartphones and tablets is gradually eroding the PCs market, gross profit is declining, free cash flow is declining due to the increase in capital expenditures as well as the increasing number of acquisitions. If you are subject to the conservatism bias, you will shrug off the new information, which signals fundamental changes in the business, and put more weight on the old information, which suggests HPQ is cheap. I did not buy HPQ, but I was very tempted because Seth Klarman had a large position in it. I overcame my temptation by intentionally paying more attention to the new information, especially with the declining margin, and the increasing number of acquisitions, which are often characteristics of a value trap.
Confirmation bias: Investors subconsciously seek evidences that confirms to their own beliefs and ignore disconfirming evidences. As a result, this bias can often result in terrible decision making because prejudiced information tends to skew an investor's perception, leaving him or her an incomplete picture of the situation. This bias is probably the most widely known bias because it has been discussed extensively. However, in my opinion, most investors who are aware of this bias nonetheless suffers from it because it is just too damn hard to disapprove yourself. Frequently, there are many seemingly attractive things about value traps. They are cheap; they have loyal customers; they are doing xyz to turn themselves around. Going back to my Nokia experience, once I purchased the stock, I started to seek all kinds of information that will justify my position such as the increase in the number of windows phone apps and positive online comments from loyal Nokia fans. I subconsciously defied disconfirming evidence such as Nokia's declining market share. When I realized that I was suffering from psychological biases and objectively reassessed the situation, I sold my shares at a substantial loss. Charlie Munger has summed up the antidote to the confirmation bias nicely in his speech to USC graduates:" One of the great things to learn from Darwin is the value of the extreme objectivity. He tried to disconfirm his ideas as soon as he got'em. He quickly put down in his notebook anything that disconfirmed anything that disconfirmed a much-loved idea. He especially sought out such things. Well, if you keep doing that over time, you get to be a perfectly marvellous thinker instead of one more klutz repeatedly demonstrating first-conclusion bias."
Overconfidence bias: Investors think they know more than they do or they can interpret information better. You can overestimate your ability of predicting the future, the probability of the success of your investment thesis, or the role skill played in your investment performance. Value investors tend to be humble. However, when making investment decisions, a value investor may indeed overestimate his ability to predict the outcome. Even the greatest investor, Warren Buffett, suffered from this bias when he made investment in US Airways, Berkshire Hathaway and Hochschild, Kohn and Co. In each case he may have overestimated the probability of a positive outcome and underestimated the speed of deterioration of the underlying business.
Seth Klarman said the following when interviewed by Charlie Rose: “You need to balance arrogance and humility… when you buy anything, it’s an arrogant act. You are saying the markets are gyrating and somebody wants to sell this to me and I know more than everybody else so I am going to stand here and buy it. I am going to pay an 1/8th more than the next guy wants to pay and buy it. That’s arrogant. And you need the humility to say ‘but I might be wrong.’ And you have to do that on everything.”
There is no easy way to conquer the overconfidence bias. Learning from past mistakes will certainly be beneficial and figuring our why the company is selling cheap if you think it is undervalued may well worth the time.
Having discussed the above biases and how to address them separately, it seems logical to come up with a master checklist that one can use before making an investment decision. I stumbled upon this reminder list from Charlie Munger while doing some research for this article:
- Look for disconfirming evidence – killing your own ideas.
- Emphasize factors that don’t produce lots of easily available numbers.
- Under-weigh extra vivid experience and overweigh less vivid experience. Same with recent events, i.e. cool off.
- Remember the lesson: One idea or fact is not worth more merely because it is easily available to you.
- There’s no logical answer in some cases except to wring the money out and go elsewhere.
I don't think I can come up with anything better than this. This list should be incorporated into every investor's investment process as a psychological check point.
Value traps have been producing the most devastating losses even for renowned investors. Over a very long time period, avoiding major losses is necessary if one wants to achieve superior returns. The analysis of the aforementioned behavioral biases is by no means intended to prevent an investor from buying value traps. Behavioral finance is based on theories, and we all know that "in theory there is no difference between theory and practice but in practice there is," to quote Yogi Berra. All we can do is to be cognizant of these biases and minimize their influence on us.