What is a value trap?

[i4value]

If you are a value investor, you are looking for cheap stocks. This mean that every stock you look at is either a bargain or a value trap.

How do you tell which is which? You would have thought that with so much interest in value traps, this would be a forgone answer.

Let me share the results of a survey I did by searching for the phrase “value traps” and classifying the results of the top 100 sites based on Google page rank.



Of course comparing current price to historical price is the wrong definition. The correct way is to compare current price to intrinsic value.

If you are a value investor, you would be investing when the price is at a significant discount to intrinsic value. The question is whether your assessment of intrinsic value is accurate



If your valuation is wrong, then the stocks are really cheap for a reason and you have a value trap

But if your assessment of intrinsic value is correct, then you have a bargain

From the above perspective, value traps and bargains are two sides of the value investing coin.

So how can you avoid a value trap? You need a good analysis so that we you say that is company is sound or is able to turn around, you are correct.

Secondly you need a good valuation approach so that when you find that the stock price is lower than the intrinsic value, your estimate of the intrinsic value is correct.

If you want further insights into this question go to An Effective Way to Screen for Value Traps

[Shiyi]

That begs the question: what's intrinsic value? Is it a static concept or subject to change as the business conditions change?

Warren Buffet sold the airline stocks at a loss as the airline industry took a turn for the worse. He also trimmed his holdings of TSMC as the US-China relations were strained. In both cases, did he get the "intrinsic value" wrong or the intrinsic value was less than what he initially thought?

[i4value]

I think of intrinsic value as the "net worth" of a company. Since the way it is computed depends on the assumptions, no 2 person will get exactly the same value. At the same time, as time goes on and the business conditions change, the assumptions also change. So you should not expect the value to be static. I have done intrinsic value calculation for over the past 20 years and I do track of the value of a particular company. You should not be surprised that it is not static from year to year. But the difference is still within my 30% margin of safety.

[weijian]

In the local context, I see that there are generally 2 kinds of value traps.

(1) The one where intrinsic value doesn't change much (may even slightly increase) but OPMIs will never get to extract the difference between market price and intrinsic value via capital reduction/SBB/dividends as much as they envisioned (or believe they deserve). The OPMI might not be losing money by investing in it, but he/she has actually lost a lot of opportunity costs. So a lot of OPMIs are still happy holding it in their portfolio. They do not want to regret when the discount finally closes.

(2) Something has turned for the worst wrt fundamentals but the balance sheet is still strong and the reputation is a "household name". Market has discounted its prospects and so the big gap between market price and intrinsic value, makes it "look" cheap. OPMIs purchases it and waits patiently for a turnaround. Unfortunately, more often than not, the Market's discount turned out to be right in future financial reports, the calculated intrinsic value drops further and the discount turns even bigger in a feedback loop. Since the value-oriented OPMI bought because it was cheap, it is perfectly rational to average down when it goes cheaper, especially when market value is still lower than the updated intrinsic value. The feedback loop between "market proven to be right" and "averaging down" continues. By the time the turnaround finally arrives, the OPMI realizes the value stock needs to be a multi bagger from that turnaround point, for him/her to just break even. The only problem is that the value stock now needs to behave like a growth stock for the OPMI to make money.

[Wildreamz]

@Weijian

For the case of (1) does it mean the intrinsic value calculation is wrong? Intrinsic value should ideally grow with time (e.g., a 10% Owner's Earning Yield company with moat, should continue to accumulate cash and assets at 10% per year, which is more than the risk free rate etc. even with no growth). 

If, for example, an investor thinks the book value is trading at 30% discount to where it "should" trade at. But it never closed the gap. It also doesn't accumulate excess cash, hence, book value never increase, dividends also less than risk free rate etc. Is that ultimately the investors mistake for investing on flawed reasoning?

Playing Devil's advocate here.

[i4value]

I think the concept of a "value trap" is that what you though was a "value" stock turned out to be a dud. There is only one way this can happen. You were wrong about the underpricing ie your valuation was wrong. I guess in practice, you have waited for years for the price to turn around and it never happened. I don't think it applies if you waited for only a few weeks or months.

Now there have been cases where the value did not deteriorate after many years eg the performance of the company improved. But the market still fail to reprice it. Is this a value trap? Not by my definition. I think it is wrong to use changes in market price as the basis. Rather if you are going to be wrong about the valuation, then it must be based on fundamentals.

[Shiyi]

If we accept that "intrinsic value" is a dynamic concept subject to changes of market conditions and a lot of other factors such as geopolitics and the willingness of the company to share profits etc, then we are actually dealing with two moving parts: intrinsic value and share price performance. Therefore, whether the "value trap" is due to the change of the intrinsic value or what the market thinks it's worth is not all that clear anymore.

[weijian]

@wildreamz,

In general, the calculation of intrinsic value isn't the problem. We all accept that intrinsic value calculation just needs to be good enough - ie. it is approximately correct (not accurate). The problem is that our behavioral biases might actually make it accurately wrong.

Normally for (1), companies with good earnings yield aren't going to turn up on the value screen (of course, it may still turn up, but more exception than norm). So it is with those companies with "relatively poorer" earnings yield but have decent assets. OPMIs hope that some of the asset-valuation-to-market-value difference can be monetized and shared. But unfortunately, that sharing, that takeover, or that asset monetization never happens....The Market finally gives up, re-rates it and the OPMI suffers a capital loss. OPMI might have gotten dividends while waiting but because of the capital loss, it's going to be atmost a breakeven or slight loss/gain (and if compared to opportunity costs while waiting, it will be worst).

[weijian]

Now there have been cases where the value did not deteriorate after many years eg the performance of the company improved. But the market still fail to reprice it. Is this a value trap? Not by my definition. I think it is wrong to use changes in market price as the basis. Rather if you are going to be wrong about the valuation, then it must be based on fundamentals.

hi i4value,
Do you have any names? I would love to look at it.

In the Spore local market, we have B**T W***D that sounds similar. Search the thread in VB and you will find. There is a good reason for Mr Market not re-pricing it though. OPMIs have to assume much uncertainty and the premium for assuming that risk is not very clear.

[i4value]

Have a look at Bursa Malaysia CSC Steel. This is a cyclical company that I went in big when it became a Graham Net Net in 2014. It got out of the Net Net valuation when profits improved in 2017 but then went back to being a Graham Net Net in 2018/19 when profits declined. In 2021/22 its profits were double those in 2019 but it is still a Graham Net Net today. All these years it was profitable. I am still holding onto the shares because its dividend yield based on my purchased price is > 5 % over the years (better than the bank FD rates). To be fair, the market price doubled my cost in 2017 and I sold a bit. But I help back a lot as it did not reach my "overpriced" target. So is this a value trap? Not by my definition. I have a blog post about this company.

The other one is Eksons that I invested when it became a Graham Net Net in 2014. Its plywood segment was in trouble and it was diversifying into the property sector to turnaround. But the Malaysian property sector started to get soft in 2016/17. Today it still has the plywood problems although the property sector is recovering. It is still a Graham Net Net. But unlike CSC Steel it was not profitable all the past 8 years although its losses was sort of "steady" yearly. It is a value trap? I had depended on a plywood business turnaround to move the market price. Unfortunately there was Covid and its own plywood business model was more problematic. But as a Graham Net Net, there is very low downside risk (permanent loss of capital) even if it disposes of the plywood business. I also wrote about Eksons in my blog. I think that in 2 or 3 years time when the profits from the property segment comes back, the market would re-rate it. I did not want to wait and I actually sold all off with some losses for a better Graham Net Net. Self inflicted permanent loss of capital.

As a value investor, you rely on Mr Market to make money. So if Mr Market is not behaving as expected so far, does it make your value investment a value trap? I don't think so because your basis is the intrinsic value. Value investors know that we don't control Mr Market. Value investor don't focus on market price. They focus on intrinsic value.

My view is that if you assessment of the intrinsic value is wrong and the company actually is not able to perform, then you have a value trap. So by my definition, CSC is not value trap. I would not consider Eksons as unless you say that the Graham Net Net is not reflective of the liquidation value.