Avoiding Value Traps

A value trap is like quicksand for your money. First your money gets stuck… then it slowly sinks (in value).

Also see 2017 letters from top value hedge funds

jackmac34 / Pixabay

Or better… imagine quicksand that’s covered with a nice picnic blanket, set with the best pizza/chicken and rice/bangers and mash/insert your favourite dish here… and then you clamber over to it. But it turns out that the yummy-looking food is made out of plastic… and worse, now you’re stuck, and sinking into the quicksand.

In investing terms, that’s a value trap.

 

History has shown that buying cheap stocks gives you better returns over the long term, than buying expensive stocks. But in order to get those returns, you have to be sure that “cheap” is not a permanent state of affairs.

If that’s the case case, you won’t be getting the return you expect. And you might not get any return at all. Your money will just be stuck… and slowly sink in value.

A brief primer: How to know if a stock is really cheap

Whether a stock is cheap or expensive depends on its valuation… not on the share price itself. A stock that trades for only US$1 can be expensive if it trades at a high valuation. And a US$100 stock can be cheap if it trades at a low valuation.

There are a number of ways to measure a stock’s valuation. We’ve previously discussed two of the more popular methods to value a stock – the price-to-earnings ratio (P/E) and the price-to-book-value ratio (P/BV). These involve looking at the fundamentals of a company – things like how much they earn, how much they sell and how much debt they have – and measuring them against the market price of the stock.

Of course, there are a lot of ingredients to a stock’s valuation – and reasons why a cheap stock might not be as cheap as its valuation suggests. Bad management, a long-term track record of poor capital allocation decisions, deteriorating assets, product obsolescence… all of these are the ingredients of a value trap.

An earnings-driven value trap happens when a stock seems cheap because it has a low P/E ratio (calculated as the price of the stock divided by the amount of earnings per share). But if earnings keep falling, the P/E ratio will climb. For example, a stock trading at US$5 per share, with earnings of 50 cents per share, will have a P/E ratio of 10. But if the share price stays the same, and earnings drop to 35 cents per share, the P/E ratio would climb to over 14. That’s a lot less cheap.

Investors fall into this trap when a stock price falls slightly, and the stock looks cheap. But then earnings drop, and what was cheap is now less cheap – even though the stock price hasn’t moved up. Then earnings decline again, and what once looked cheap is now downright expensive because earnings have fallen so much.

One of the biggest value traps today

Entire markets, like the Russian stock market, can also be value traps.

New investors looking at Russian stocks are sometimes drawn in by the market’s low valuations, like a low P/E ratio. Russian shares have for years traded at a much lower valuation than other emerging markets. This discount has been there for years. But it still persuades people to buy.

The graph below shows the cyclically adjusted price-to-earnings ratio (CAPE) for a range of markets. The CAPE uses the average for ten years of earnings, and adjusts them for inflation. This smoothens the cyclicality of a single year P/E. It’s more difficult to calculate, but it’s a more complete valuation measure than the normal P/E ratio. According to the CAPE, Russia is the world’s cheapest stock market by far.

A lot of people think that this means that Russia’s stock market is worth buying. I recently did a quick Google search for articles in recent years about how Russian shares are a buy… based largely on the fact that they’re cheap.

 

The table below shows a handful of these, when they were written, and how the Russian market – based on the VanEck Vectors Russia ETF (NYSE; ticker: RSX), one of the biggest Russia ETFs – subsequently performed.

As you can see, most of the “Russian shares are cheap, buy them” recommendations were wrong. Most people who put their money into RSX saw their investment shrink over time.

Now, a value trap can stop being a value trap – and become an attractive, under-valued investment – if there’s a trigger for change. A change in management, a big change in the industry, higher commodity prices, a regulatory change – all of these things can turn a value trap into a great investment.

For a country, the trigger for revaluation – which could help close the valuation gap – can stem from political issues. In the case of Russia, as long as the perception (and reality) remains that political risk is higher than many other markets, the stock market’s CAPE will remain lower than comparable markets. (And the past weekend’s so-called elections, which saw the re-election of Vladimir Putin to a fourth term, will do nothing to reduce political risk.)

How to avoid value traps

How can you avoid value traps? For starters, don’t invest just because valuations seem low… they might have been low for a long time. Don’t necessarily take valuation metrics at face value.

In the case of companies, look carefully at a company’s debt profile. Also look for revenue growth – a company that isn’t generating more in sales every year will have a difficult time earning more money every year. Is the industry or sector as a whole growing? If not, that’s another reason why a company might have a difficult time increasing revenues and earnings. Does the company (or country, for that matter) operate in a cyclical industry (like commodities, for example)? If so, you’ll need to time your purchase so that you don’t get sucked into a value trap. And if the company is in what’s called a “structural” decline, it means that demand for the business, and sometimes the industry, will never recover.

In short, cheap is usually good. But not always. Value traps can punish your portfolio even more than buying a stock that’s too expensive in the first place.

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