´´ Musings on Value Investing: The "Value Trap" Misconception Trap

Sunday, July 3, 2016

Musings on Value Investing: The "Value Trap" Misconception Trap

"A value trap is a stock that appears to be cheap because the stock has been trading at low multiples of earnings, cash flow or book value for an extended time period. Stock traps attract investors who are looking for a bargain because these stocks are inexpensive. The trap springs when investors buy into the company at low prices and the stock never improves. Trading that occurs at low multiples of earnings, cash flow or book value for long periods of time might indicate that the company or the entire sector is in trouble, and that stock prices may not move higher." (Investopedia)

The abovementioned definition of value traps is common, outright wrong and can be extremely costly for a value investor.

A genuine value trap, which is no laughing matter and a nightmare for any deep value investor, is one where a cheaply valued company has some kind of structural issue, cannot make any positive returns on invested capital over prolonged period of time, burns its cash and will eventually fail.


Seeing Value Traps Where Are None


Investing in value traps is detrimental because of the permanent loss of capital. But permanently proclaiming a “value trap” after experiencing and/ or witnessing a prolonged decline in operational metrics and share price weakness in a company is even more expensive. The cost of over and over missing out on outstanding opportunities will compound sky high on the long- run.
"Bargain stocks do not exist in a vacuum. They are always surrounded by high doubt and great fear. It is the inflicting pain of the relentless downtrend in the price chart and temporary operational issues of a company that creates them."
Seeing "value traps" where none exist is a common error, especially in the value investing community. Investors repeatedly call out "value traps" in companies with temporary, albeit often prolonged, operational and stock price weakness. They are unable to realize that the underlying profit potential of so called "value traps" are more often than not largely unimpaired.

Therefore it is paramount for a deep value investor always to recall that bargain stocks do not exist in a vacuum. That they are always surrounded by high doubt and great fear. That it is the inflicting pain of the relentless downtrend in the price chart and temporary operational issues that creates them. And that there are always a myriad of reasons uttered by fellow investors to avoid buying such bargains.

Real "Value Traps" Are Rare


There is no doubt that a "value trap" is a genuine investment risk in deep value investing. It is relentlessly fretted over by fellow investors when engaging in a deep value situation.
"Value traps are rare events for individual stocks. And for entire asset classes they are almost non- existent."
Given the regularity market participants spot and comment about them one would think that they are a highly frequent phenomenon. Unduly so. Assumed that a permanent loss of capital is represented by a 90% stock price decline in three years or less, with no recovery in the next three years, than at any given time only about 5% of all stocks in the broad U.S. market may be deemed "value traps". Thus, "value traps" are rare events for individual stocks. And for entire asset classes they are almost non- existent.

It is my believe that given the low statistical probability of falling prey to genuine "value traps", and the high number of so called value investors repeatedly calling them out, knowing what not constitutes a "value trap" is the name of the game in deep value investing. Because it is exactly the common misconception about "value traps" by fellow value investors that fools a great many of them.It is when the majority of fellow investors are trapped in the "value trap misconception" that incredible bargains on the stock market emerge.

Mabuchi Motors: The "Value Trap" That Turned Into a Hidden Champion


A prime example for what not constituted a "value trap", and the opportunities once again missed by those getting trapped in the "value trap misconception", was my investment in Mabuchi Motors.

I am convinced that it was the dramatic change in one aspect of Mabuchi Motor's market, i.e. the slow disappearance of the market segment for small motors in consumer electronics, in combination with a prolonged and severe decline in its stock price, which got all the attention of the value pretenders. I reckon a great many of them realized that the stock was cheap. Basically, the stock was almost a net- net when I mentioned it on the blog.
"‘Cheap but for a reason’ is actually close to a definition of a "value trap" for most investors. The great danger succumbing to such a definition for investors is not to contemplate reasons why a company should not be cheap."
Thus, why so few fellow investors dared buying into such a bargain? From comments I only can interfere that the majority of investors saw the stock as cheap, but for good reasons. Declining sales figures, pricing pressure, a lack of new (visible) applications for its RC Motors, etc. made them see a pattern of operational issues that let them believe that Mabuchi Motor's problem was structural. And in the end they failed again to realize that it was only temporary, underestimated the powerful forces of reversion to the mean and missed out on a multi baggar. Once again they were trapped in the "value trap misconception", because they saw a pattern that did not exist.

"Cheap but for a reason" is actually close to a definition of a value trap for most investors. The great danger succumbing to such a definition is not to contemplate reasons why a company should not be cheap.

At Mabuchi Motors investors did not reason that applications of its small RC Motors had become obsolete before (Record Players, Tape Decks, etc.) and the company having a history of finding new ones successfully shortly after (CD- Players, Hard disc Drives, etc.).

Falling Prey To The "Value Trap Misconception"


Mabuchi Motors, a hidden champion in many market niches, serves as a good example how a great many of so called "value investors" are ignorant and overconfident in their ability to spot "value traps".

Those investors will over and over miss out on great opportunities, because of their tendencies of repeatedly identifying companies as "value traps" that are not. They fail to realize that it is exactly this sort of "misdiagnosis" of fellow value investors, the falling prey to the "value trap misconception", that is a wet dream for any deep value investor. It can lead to even outstanding companies trading on the stock market insanely cheap in relation to their intrinsic worth. It allows more savvy value investors to compound returns on the long- run that are vastly above the market averages.
"As so often with investment, with the concept of "value traps" we are strait back in the realms of perception. In a world where most investors are unable to grasp that a company cannot be a "value trap" one day and not one the next. It either is or it is not."
Another good, but completely different, example for what does not constitute a "value trap" is my investment in Osaka Gas. Many will argue that a roughly 6% annual return (dividends excluded) on a 4 year time span does not seem that much of a bargain anymore. The assertion is true as far as it goes.

However, it is my believe that as a value investor our main concern should solely be about capital preservation. Making sure that our downside is protected and not be too bothered about any upside potential of a bargain stock. Three bagger stocks like Mabuchi Motors are the exception and not the norm. And they are entirely worthless in a portfolio that does hold just a few severely capital destroying stocks.

As so often with investment, we are strait back in the realms of perception. In a world where most investors are unable to grasp that a company cannot be a "value trap" one day and not one the next. It either is or it is not.

And in the end it all comes down to figuring out whether a business has a structural issue or a temporary one. Being aware of how rare "value traps" really are. Engaging in K- Level thinking, realizing when fellow value investors are trapped in the "value trap misconception", embracing uncertainty and plunging into such an investment surrounded by a cacophony of hollow words by so called "value investors" wholeheartedly.

Source:

A short pirmer: Value trap or bargain? (Value Walk)

Just an illusion - Investors often see a value trap where one simply does not exist by Nick Kirrage




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