One of the biggest risks value investors have always had to deal with is the risk of finding themselves in a value trap. There is no exact definition for "value trap," but it is generally accepted that any stock that looks cheap and has deteriorating fundamentals is one.
Unfortunately, it seems as though value traps are only becoming more prevalent.
According to a research report from Asian investment bank CLSA, the valuation gap differential between value and growth stocks has grown significantly over the past decade, and currently stands at one of its widest levels in modern history. However, the average return on equity of these so-called value stocks has been steadily deteriorating since the financial crisis.
In other words, while value stocks might look cheaper than growth stocks overall, the figures seem to suggest that many of the companies deserve a low valuation, particularly when compared to high return-on-equity growth stocks.
The value trap maze
Looking at these findings, it is not unreasonable to say that finding high-quality value stocks is becoming harder. That's not to say that these stocks do not exist; it just seems as if the chances of investors falling into a value trap are now exceptionally high. Some parts of the market might look cheap, but they deserve to.
This is got me thinking about value traps and the best way to determine if a stock is a value trap or an attractive value investment. This is something I have spent much time on in the past, primarily because value traps have no concrete definition or set of rules they conform to.
That being said, the one thing all value traps seem to have in common is overleveraged balance sheets. Some debt is okay, as long as it is sustainable (indeed, some research shows that highly leveraged stocks that have the ability to pay down debt actually outperform over the long term), but too much debt that consumes the majority of a company's free cash flow can end only in disaster.
Klarman's three value trap tips
The highly acclaimed value investor Seth Klarman (Trades, Portfolio) has his own version of what constitutes a value trap. He once said that value traps are "cheap for a reason -- perhaps an inept and entrenched management, a poor history of capital allocation, or assets whose value is in inexorable decline."
The quote makes no mention of debt, but it does add some other great factors into the equation. Inept management is probably the single most significant contributor to poor company performance, although it is difficult to measure, unlike other quantitative factors such as return on equity and return on capital investment, which measure how effective a company has deployed capital.
Rather than concentrate on return equity figures, Warren Buffett (Trades, Portfolio) once said that a company's price-book relationship should tell you everything you need to know about whether or not it is a value trap:
"If anything, we are less likely to look at something that sells at a low relationship to book than something that sells at a high relationship to book, because the chances are we’re looking at a poor business in the first case and a good business in the second case."
This quote slightly muddies the water because it suggests that value investors rule out stocks trading at discounts to book value, even though this is precisely the strategy Buffett followed in the early part of his career. Still, there's no denying that a company's book value offers an invaluable insight into the quality of the business. If book value is growing, declining or standing still, you can establish whether the business is creating or destroying value for shareholders.
My purpose here is not to define a set of rules to help value investors find value traps. It is to explore some ideas around value traps and offer some insight into how they might be avoided.
Or you could take Mohnish Pabrai (Trades, Portfolio)'s view that there is no such thing as a value trap -- it is just an excuse some investors use to cover up their lack of research as to why something did not work out:
"I’ve never felt that there is any such thing as a value trap. They are investing mistakes but I don’t think they are value traps. If an investment flat lines or declines on you, people have a cute way of saying it’s a value trap. If you were intellectually honest, you would find a proper reason for why things didn’t work out."
Disclosure: The author does not own any share mentioned.
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