One of the biggest challenges value investors face is distinguishing between value stocks and value traps. Both have similar characteristics, but one usually generates significantly better returns than the other.
The biggest problem is it is never going to be entirely possible to have a 100% accurate record of determining the difference between value traps and value stocks. There is always a risk the company you think might be undervalued is circling the drain and will never recover.
Buffett on value traps
I've been reminded of this problem recently in the aftermath of the bankruptcy of Sears Holdings (SHLDQ, Financial). What is interesting is Warren Buffett (Trades, Portfolio) predicted the decline of Sears many years ago. When Eddie Lambert tried to save the department store by merging it with Kmart more than a decade ago, Buffett was skeptical the deal would actually yield the results desired. In 2004, he told an audience in Kansas:
"Eddie is a very smart guy, but putting Kmart and Sears together is a tough hand...Turning around a retailer that has been slipping for a long time would be very difficult."
He went on to ask, "Can you think of an example of a retailer that was successfully turned around?"
The Oracle of Omaha didn't make this statement out of hand. He has some experience in the retail sector. He did try to invest in the space in the 1960s, buying the ailing Hochschild Kohn department store in Baltimore. Here's what he learned:
"We learned quickly that it wasn't going to be a winner, long term, in a very short period of time. We had an antiquated distribution system. We did everything else right. We put in escalators. We gave people more credit. We had a great guy running it, and we still couldn't win. So we sold it around 1970. That store isn't there anymore."
This is only one example, but I think it does help illustrate the difference between value traps and value stocks.
What is a value trap?
There's no golden rule to defining what constitutes a value trap, but you could loosely define these investments as companies that are struggling to stem a decline in sales.
Research suggests companies that invest the most in research and development and spend the most making sure the customer is happy, succeed over the long term. Falling sales can drive management to react by cutting costs, which means smaller investments in research and development and lower investment in customer initiatives. This can start a vicious circle where buy sales fall, the company cuts cost, hurting its reputation and dragging sales down further, which leads to further cost-cutting and a further decline in sales.
If the company's problems become so big they start being reported on in national newspapers, then you have a real problem because consumers begin to lose all trust in the business.
This negative feedback loop is not limited to just the retail sector; you can argue almost any company in any industry could succumb to it. For example, would an oil exploration and production company sign a five-year service agreement with a company it thought might be on the verge of bankruptcy? It is unlikely.
In comparison, value stocks don't have to have falling sales. I think this is a common misconception. Many investors believe that for a company to be a value investment, it has to be struggling in some way. That's not the case. The stock can be both cheap and still growing.
More often than not, if a stock is cheap, there is a reason why. Most of the time, it is because investors have given up on the business and these companies are not value investments. They are value traps.
On the other hand, Mr. Market will occasionally throw out a real opportunity where you have a business that is still growing and possibly thriving, but trading at a deeply discounted evaluation.
These opportunities are rare, but when they present themselves, it pays to act rapidly and with conviction.
Disclosure: The author owns no stocks mentioned.
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