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2 Characteristics Of A Value Trap And How To Avoid Them

When I first started investing in the stock market years ago, I did so using the concepts that Benjamin Graham had penned in his timeless investment book, Security Analysis.

Graham, the widely-regarded intellectual father of value investing, popularized the idea of buying a security at a price well below its “intrinsic value.” And for Graham, this intrinsic value depended largely on a company’s assets and so, he focused on companies that were trading well below their asset values when he invested.

But, investors who invest in such “cheap” companies are at risk of running into value traps. A value trap is an investment that appears to be cheap but in actual fact, the discounted value might never be realised or would slowly witter away.

So, how would we know if we are investing into a value trap? Having being caught in my fair share of value traps, I found two common characteristics in such stocks.

Lack of growth opportunities

A typical value trap would be trading at a very low multiple to its book value or to its earnings. In other words, it would have a very low price-to-book (PB) or price-to-earnings (PE) ratio.

Theoretically, if we invest in a company with a PB ratio of below one and its assets are fairly valued, we are getting a discount. That is because we would end up getting more than we paid for if the company liquidates all its assets and returns the cash proceeds to its shareholders.

But, this type of reasoning might be flawed. It is because management might never liquidate a company with an operating business. So, if the assets are never sold, then the “value” that we hold may never be realised. The company essentially has trapped value.

In the case of a company with a low PE ratio, if the company has no growth prospects, its earnings might never grow. Without growing earnings, there is no catalyst for the market to value the company at a higher earnings multiple. Therefore, without a growing earnings multiple or rising earnings, the share price of the company may stagnate indefinitely.

Declining fundamentals

Although a company with no growth prospects may be an investing disaster, what is worse is a company with declining business fundamentals.

Berkshire Hathaway is a huge conglomerate today, but when billionaire investor Warren Buffett took control of the company back in the 1960s, it was a struggling textile manufacturer with a textile business that was sliding downward. Buffett has called his purchase of Berkshire one of his biggest investing mistakes.

If you find a company with declining fundamentals and a management team that refuses to change its business model, then you might be investing in a value trap. This is because the company may be destroying value for shareholders when it reinvests its profits back into a dying business that produces diminishing returns. In such a case, the value of the company may be in a race to zero over the long run.

Foolish Summary

As the cliché goes, investing is a mixture of both art and science.

It is easy to obtain quantitative measures of a company such as its PE and PB ratios and so, it is tempting for an investor to base his or her decisions on such numbers. But, it is also important to think about the intangible aspects of a business, such as its growth prospects and the flexibility and capability of a company’s management.

If we only look at one side of the coin all the time, then there’s a chance we might end up investing in many value traps in the future.

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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 writer Stanley Lim owns shares in Berkshire Hathaway.