Understand how value traps can lure you into significant losses in the stock market
What are value traps?
In the world of money management, the term “value traps” refers to a situation that superficially appears to offer investors an opportunity to acquire assets and/or significant profits compared to market price, promising the chance for above-average returns in the broader stock market, but in reality proves to be illusory due to a number of factors.
What leads to the development of value traps?
There are many reasons that value traps can emerge. Here are some common scenarios that lead to their development.
Permanent changes in the industry
Sometimes a permanent change occurs in the forces generating cash flow for a company or industry, rendering previous comparisons of limited value. Think of horse and carriage manufacturers after Henry Ford began producing the Model T. Their days were numbered, and their product lines were doomed to cyclical decline as families swapped their stables for gasoline. If you saw a price drop and looked at past net income and thought “Wow, this is cheap compared to the fundamentals!” you would have been very wrong. The company’s past operating results were of limited value in determining its intrinsic value.
Peak earnings traps
There is a phenomenon known as the “peak earnings trap” that can cause significant financial harm to inexperienced investors. This occurs when they buy shares of companies in cyclical industries experiencing booms and busts – think homebuilders, chemicals, mining, and refining – at the peak of the earnings cycle. This is when conditions are better than they have been in years, or even decades, as cash flows into the income statement and balance sheet of the companies they have invested in. This makes the price-to-earnings (P/E) ratio appear dramatically undervalued. Paradoxically, many cyclical companies are actually the most expensive when the P/E ratio looks low and the cheapest when it looks high. In such cases, it is better to look at the price-to-earnings growth (PEG) ratio or the earnings-adjusted price-to-earnings growth ratio (earnings-adjusted PEG).
Severe cash flow problems
If you have ever taken an undergraduate accounting course, you may have studied famous examples of profitable companies that were generating good profits at the time they went bankrupt. This can happen for various reasons. During the Great Recession from 2008 to 2009, a number of profitable financial institutions were wiped out, including a few of the largest investment banks in the world, because businesses were funded by long-term liabilities with current assets; a capital structure error that leads to certain economic death when the world collapses but is repeated every generation as lessons from the past are forgotten. In other instances, retailers experience what is known as high operating leverage; fixed cost structures mean a bottomless pit of losses if sales drop below a certain threshold, as everything above that amount drops to the bottom line as profits. For example, if analysts expect sales to decline below this threshold for one reason or another, a 20% drop in revenues can translate into an 80% drop in profits. In other cases, the company may be doing well, but capital market conditions may be tough, or there may be a large upcoming corporate bond issuance, raising doubts about the company’s ability to refinance. Additionally, the company will have to pay much higher interest expenses, reducing profits in subsequent periods due to the increased cost of capital. Perhaps a major competitor has entered the scene and is swallowing market share, taking key customers, and has efficiencies in manufacturing or service delivery that put the company in a poor competitive position; in this case, the low stock price is not the issue at all, as the earnings per share will catch up to the stock price over time, and fall to an appropriate level relative to the market price.
How
Can you avoid value traps or protect yourself from them?
For most investors, the answer to avoiding value traps is to avoid individual stocks altogether because they lack the financial, accounting, and managerial skills necessary to evaluate specific companies; instead, you can regularly and consistently buy index funds and trade them at the best dollar average prices, preferably within the confines of a tax shelter such as a Roth IRA.
Otherwise, the answer can be found by trying to discover the reasons – the reason – that led other owners to dispose of their stakes in the company. Find the bad news: the forecasts that make everyone become angry with the business. Then try to determine if you:
- Believe that their negative forecasts are likely to come true
- Have they been overvalued or undervalued
- The extent to which they have been overvalued or undervalued
Examples of false value traps
In rare cases, you may find a gem. You may find a wonderful company being offered practically for free.
American Express
A classic example of doing your homework to find what seems to be a value trap and isn’t is the American oil scandal of the 1960s. Young Warren Buffett made a lot of money – which became the foundation of his wealth at Berkshire Hathaway – by calculating the maximum potential damage that a credit card company would face if everything possible happened, and realizing that investors had become overly pessimistic. The company would be just fine.
Starbucks
Recently, many disciplined investors were buying high-quality, financially strong stocks during the collapse from 2008 to 2009 when they found that other investors were selling not because they wanted to dispose of their ownership, but because they were facing liquidity crises and needed to raise any cash they could to pay their bills! Starbucks, the giant coffee company, is a great case study. Before the collapse, the company had a strong asset base and growing net profits. When the economic storm clouds appeared, families suddenly began losing their homes, investment banks began failing, and the Dow Jones Industrial Average started collapsing, this extremely profitable company, which was pumping out massive profits and cash flow, dropped from its peak of around $20.00 a share in 2006 to a low of about $3.50 in 2008. This is a company with a lot of expansion opportunities remaining, with a whole world left to win in expanding into China and India. It was a once-in-a-lifetime opportunity to become an owner in the best-selling coffee brand on the planet. Those who took advantage of it not only collected cash dividends in the years that followed but also watched the stock price rise again to over $100 a share. With a dividend yield of around 1.5% in the summer of 2021 after the board’s decision to send more money to the owners, it means that someone out there could be collecting a cash return of over 18% on the cost of stocks bought at the absolute bottom. (Remember – there has to be a buyer and seller in every transaction; it’s the nature of the auction.)
Source: https://www.thebalancemoney.com/watch-out-for-value-traps-358155
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