By Valerie Newman
Value-oriented investors are rightly attracted to stocks that have sold off significantly from their highs, are in the press for all the wrong reasons, and appear alluring on a variety of valuation metrics. The purchase of a low-valuation stock may provide the buyer a measure of downside protection and, should operating results and valuations turn higher, significant upside potential as well.
There are challenges involved in the pursuit of these stocks, most notably falling into “value traps,” which are stocks that have fallen out of favour and appear cheap, but will nonetheless continue to underperform the market over time. In our view, many of the industries and stocks which have declined the most in recent years are more likely to prove value trap than bargain.
There are a variety of value trap “types”. The following five “classics” are not the only possibilities nor are they mutually exclusive, but they’re essential knowledge for the informed buyer.
The Cigar Butt: Synonymous with Benjamin Graham and his original formulation of value investing, the “Cigar Butt” trap comprises generally low quality companies which do not compound value over time but may trade cheaply. While a profitable trade is possible – the last “puff” of the cigar, so to speak – compounding significant value over the long-term is very unlikely. Should business value erode over time, an investor may be left holding a stock with mostly downside risk.
Cheap on Peak: Commonly having economically sensitive or product cycle driven businesses, these potentially high quality companies see wide variance in their earnings streams. When they trade cheaply on unsustainably high sales and margins – watch out! While these companies may be market leaders, when the cycle turns lower estimates of business value also come under great pressure and scrutiny, often leaving the “value” buyer wondering what happened.
Competition Catches Up: A once high quality company watches other industry players improve their operating capabilities, leaving the former star player with much lower profitability, and perhaps sales, than were achieved historically. Competition is the rule, not the exception, across sectors and geographies. If the star player doesn’t maintain its competitive advantage, then both profits and valuation multiples may permanently decline. The transition of a stock from “market leader” to merely ordinary can be a painful one for investors.
The Melting Ice Cube: The hallmark of a melting ice cube is a structural flaw of some kind relentlessly eroding business value, often taking many years to play out. In the meantime, a cheap valuation entices the value-minded investor. While the business generates free cash flow and thus has some value, that value is in decline. Thus, the market is not incorrect in assigning a low multiple, and a re-rating upwards is unlikely. Buying a stock when time is the enemy is a very difficult way to make money, regardless of price.
Volatility Trap: This variant of value trap is characterized by a sudden and significant drop in a stock’s price, typically due to some news event. In the heat of the moment, the value buyer may conclude the stock is therefore out of favor and cheap. However, fundamentals can change and perspective is warranted. That a stock is down meaningfully over a short period of time does not necessarily equate to an attractive investment opportunity. Maybe it was too expensive to begin with, or maybe the new facts are truly troubling. As for “buying the dips,” we’d offer a slightly modified mantra: Examine the dips, buy value.
A familiarity with these common “types” can help to avoid them. However, deeper analysis of fundamental and valuation characteristics informs the type of trap, and ultimately is required to gain a clear understanding of a stock’s risk/reward profile. One over-arching principle is to ask a lot of questions.
Perhaps no single question is more important in the effort of value-trap avoidance than: How (and how much) could this investment lose? Midway through 2016, many cyclical stocks had been under pressure, populating the radar of value investors. Earning power under various economic scenarios is therefore a key consideration. What if that key commodity price stays down for years, what will earnings be? Balance sheet strength, can the company endure a severe downturn? Is the debt burden manageable with a much weaker end market and resulting lower revenues and profits?
There is a lot to consider…
Valerie Newman is a senior client portfolio manager at Perkins
