As an investor who is primarily focused on receiving income from my investments, I am aware of the dangers of falling into a ‘yield trap’. After several years of actively managing a portfolio of investments, I have become better versed with looking beyond the initial headline yield of an investment and learning to assess the value of the asset itself.
Once I had overcome the initial hurdle of developing a widely diversified portfolio of assets, I began to reassess the quality criteria I use to judge whether to continue holding a particular asset. As I did this, I realised that I should also be adjusting my acquisition criteria to reflect the issues I encountered within my portfolio.
One thing I quickly recognised was that something I classified as being ‘good value’ could be trading at a discount to what I perceived that value to be. This concept wasn’t particularly ground-breaking, but provided me with an intellectual framework against which I could differentiate potential opportunities to acquire assets at a discount.
It is important to me to firstly understand why a discount exists. There are a multitude of reasons someone might value an asset differently to myself, but fundamentally, I need to be reasonably certain that these individuals do not possess some crucial piece of knowledge which might justify the existence of the discount, indicating \’cheapness\’ as opposed to undervalued quality.
Typical examples of this might be companies which have poor standards of corporate governance, or a risky debt structure, or perhaps an asset which has fallen out of taste (80s jewelry, for example, is often only valued as scrap metal and gemstones, as the settings and style are so out of modern taste).
When trying to identify why the discount exists, I’m trying to identify opportunities where a discount to true value is simply a temporary misperception or anomaly, reflecting a wider inefficiency in the market.
By doing this consistently over time, an investor can acquire a competitively priced portfolio of assets which produce strong cashflow, and with minimal intervention can be sold at a profit over time.