Avoiding Value Traps

A few years ago, I got my fingers burned investing in Carillion. Fortunately, it wasn’t a life changing catastrophe and taught me a very important lesson early on in my investing career. Sometimes companies are cheap for no good reason but other times, they’re value traps. In short, a value trap is a business which looks like a bargain but is actually a low quality company masquerading as a cheap deal.

As an investor, I’m often on the hunt for what I perceive to be undervalued opportunities; good companies selling at a temporary ‘discount’ to their real, long-term worth. Buying pound coins for fifty pence seems like a fairly easy way to make a profit, but what if those pound coins were no longer accepted in shops? You’d be buying fairly worthless lumps of common metal and far from being worth £1 each, you’ll be lucky to get a penny each for them in scrap value.

Of course, if you bought enough, you might end up with one of the rare ‘collectors’ coins that sells for a few hundred pounds. In that case, you could recoup your losses and still make a reasonable profit overall, despite being lumbered with loads of coins that on their own, aren’t really worth much.

Investing in ‘cheap’ companies often bears a similar risk. The companies you’re buying into might have declining earnings, weak profitability, high debts or assets that just aren’t really valued by the market anymore (consider a company trying to sell VHS tapes in 2020).

 So what are Value Traps?

In a nutshell, a Value Trap is a ‘cheap’ company (relative to assets, cash flow and its peers) but one with low quality (profitability, EPS growth, return on equity) and low momentum (the price is in decline).

They look cheap which is what initially attracts investors; they have high dividend yields (great!), and a significant discount to assets. Investors are tempted in, thinking that if they just ‘sit tight’ the company’s fortunes might well reverse. Unfortunately, the company continues to decline over time; revenues fall, profits fall, assets get written down year after year and debts rise. Eventually, like Carillion, the company collapses under the weight of trying to pay its debts, loses all its customers or simply gets absorbed by competitors.

Avoiding Value Traps

After Carillion, I sat down and went through every company in my portfolio, considering in depth whether it was a great company on sale, or a lousy company with a suitably cheap price. Today, I pay much more attention to the quality of a company, using traditional ‘value’ metrics as a buy signal once I’ve screened for companies with a high return on equity and a reasonably solid balance sheet.

I consider the company’s financial history; how consistent are earnings and has the company been able to convert these into profits? What has happened to free cash flow? Are net assets increasing or decreasing (and likewise with debt and the number of shares in circulation).

This issue of financing is a hugely important one. Conservative financing is vital to the long-term security of a company. A lack of long-term debt is an indication that a company has a durable competitive advantage. When reviewing debt levels, I also want to see how manageable the debt is; a solid company should be able to pay off debt from earnings, rather than having to sell assets to repay it. Likewise, if a company is constantly having to issue equity, my position is being repeatedly diluted

Future Prospects

The other important consideration when seeking to avoid Value Traps is the company’s future prospects. In a market economy, some industries thrive and others collapse. Eventually, technologies and consumer preferences change and the market moves on. As an investor, you can either move with it, or hang on to the ‘old’ companies of yesterday in the hope that they’ll make a comeback.

Buying pound coins for fifty pence can be a great way to make a quick profit but you need to be sure that the pound coins you’re buying – the companies you’re investing in – are real pound coins. Buying quality companies at great prices is the way to go to avoid the prolonged uncertainty of waiting for a Value Trap to change direction (either in price or underlying performance).

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