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An Investment Mistake to Avoid

Have you ever made an investment in a share that looks attractive based on its fundamentals, yet its price just seems to get cheaper with each passing year? If so, you might have bought into a value trap.

A value trap is a share that seems statistically-cheap on first glance based on valuation methods like the Price to Book ratio or Price to Earnings ratio. But on closer inspection, its business has stagnated or, in the worst case scenario, is doomed to fail in the future. In such an instance, you might never see an improvement in the price of the share.

“Net-Net” Companies

A “Net-Net” investment is a type of investment that was popularized in Benjamin Graham’s classic investment tome, Security Analysis. A company with shares trading at a price lower than the difference between its current assets and total liabilities would classify it as a “Net-Net” investment.

The theory is that for such a company, even if you liquidate just its current assets (consisting of cash, inventory, and the likes), which should be relatively easy to convert into cash, and pay off all its liabilities, you will still end up with a profit in your investment.

Although there are no “Net-Net” investment opportunities within the 30 blue-chips that make up the Straits Times Index (SGX: ^STI), there are a number of S-Chips – Chinese companies listed in Singapore – currently in this category.

But, there are good reasons why a company within the “Net-Net” category can turn out to be a value trap:

1. It is a fraudulent company

The company might be running a fraudulent operation with unreliable accounts. Calling it ‘difficult’ in trying to place a value upon such companies would be an understatement.

2. The fundamentals of the company are deteriorating

A company might turn out to have declining business value if its fundamental worsen. In fact, an entire industry might even be facing tremendous head winds; think of horse-buggy manufacturers when the automobile first came onto the market.

Companies that require low technology input find themselves more at risk of facing deteriorating fundamentals. As a country grows and wages increase, it will be hard for the company to compete against other companies from poorer countries that can provide cheaper cost of production through low cost labour.

3. A company’s assets might prove too difficult to be converted into cash in a timely manner

An easy understanding of a current asset is any asset that can reasonably be converted into cash within a year of the reporting period. But even so, not all current assets are equal and some of them are not easily convertible to cash.

For example, a property developer might classify its “properties under development” as a current asset. However, if the company goes bankrupt before the project can be completed, the half-completed project that’s left hanging at the construction site might not be worth much at all.

4. The company has huge hidden contingent-liabilities

Lastly, a company might be in the middle of a court case that entails the possibility of disastrous consequences if it loses.

As the court case isn’t finalized, a company might not have booked any potential court-related-costs as liabilities in its balance sheet. If the company eventually loses the case and has to cough up huge amount of fees and damages, it might face bankruptcy and wipeout its shareholders.

There is thus no value at all for investors in such companies.

Foolish Summary

In investing, a bargain is hard to come by. A value trap might appear to be a bargain for investors, but as Curtis Macnguyen, founder of investment management firm Ivory Capital once said, “A bargain that stays a bargain is not a bargain”.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.