The Value Trap: Why You May Never See Your Money Again
BY IVAN HO, Millionaire Investor graduate
What is a value trap? A value trap is the unfortunate situation of buying into companies that offer a decent or great margin of safety due to their low share price or low P/E multiple coupled with the prospects of some seemingly exciting growth. Yet these companies turn out to be far from being good investments as their share price seems to be stuck in a stubborn range for a very long time. Or worse.. it goes lower and never seems to rise again.
Value traps are one of the most discouraging things to have in a value investor’s portfolio as these stocks can confuse the investor for many years despite the good past records. It is only then upon further understanding of the company or the industry does one suddenly realize what these companies truly are: mediocre entities or simply trash.
Many value investors I know have bought into such traps and have suffered greatly in terms of absolute return. Perhaps the reason for this is that many a times, looking at figures is much easier then looking at the qualitative side of things.
In Millionaire Investor, we were taught about the right business (this includes the right industry), the right management and the right price, but seriously how many of us really understand the true the meaning of right business & right management? If I may make a general assumption, most of us just simply look at the annual reports, read a bit here and there and then buy when other value investors are buying because it is simply a cheap company and seemingly has some growth prospects into it. Right?
Value trap – type 1
So allow me to share with you some of my encounters with value traps and maybe shed some light on what they are truly are. One of the stocks I bought during the Great Recession (2008/2009) was FSL (First Ship Lease Trust) – a shipping trust. I bought it at a cheap $0.47 because of eight reasons and this is what I wrote during that time:
- Diversified ships and clients, ships are young and have substantial value
- Does not take up operational costs of the ships, unlike other shipping trusts
- FSL has very high dividend payout of at least 15 cents per year.
- NAV per share is $0.83
- Estimated contract value per share is $1.78
- Strong cash flow
- Intrinsic value $0.70 or $1.10 based either on dividend discount or NAV
- Therefore at a price of $0.43-45 per share, it was significantly undervalued
At the time, the annual yield was whooping 22%-25% and the shipping industry was crumbling. The counter shouted “VALUE!” As some of you who follow this counter would know that one of their major clients had defaulted, the shipping industry today has took a turn for the worse (Japan crisis, slowdown in China, slow growth in the US, etc.) and given the gearing ratio of a business trust forced FSL to drastically reduce their dividend since. As of today the unit price of FSL hovers around $0.33 to $0.40, and much to my amusement and frustration, they recently issued out more units to buy another ship to lease.
Going forward, this counter in my personal opinion doesn’t look that promising and drum roll* please..this stock could very well be a value trap.
So this bring me to review one type of a value trap, “buying companies which seemingly have an edge over other competitors and are able to generate a high yield or high ROE, but the problem with them is that these figures are just temporary as it may be at the peak of its earnings cycle.
Value trap – type 2
My next experience with value traps is buying into Sino Techfibre, a China textile company that produces polyurethane and synthetic leather, to make items like fashion and sports apparel. I bought the stock way back in late 2008. Why did I buy into this company? Because of these 9 reasons:
- Sino Techfibre is supported by the People’s Liberation Army. The Chinese People’s Armed Police Force to be specific
- The company is growing into new area (PMP production). Being the first Chinese company to go into this area (competitive edge)
- Fallen from a high of $1.70 to $0.58
- ROE ranges from 25%-28%
- Price to book ranges from 1.6-2 times
- PE ratio is only at 6-7 times
- Free cash flow remains healthy
- Accounting irregularities are not present, but very high amount of cash, management doesn’t seem to know what to do with it
- Intrinsic value is at least $0.81 or even higher
Looking back at what I wrote and the reasons why I buy this stock, I almost fall off my chair. Once again this counter shouted “VALUE!” and I bought three lots at $0.50. Luckily I sold this counter off since the end of 2009, sought forgiveness from God and never looked back since. As of today this firm still isn’t doing very well either, it has since been suspended for some accounting irregularities and the last traded price was a miserable $0.09. This experience then brings me to review of the second type of value trap “buying companies which seemingly have a value proposition and some competitive edge, but actually value pale in comparison to competitors in their industry”.
There are many more value traps out there; the most common of these traps involves buying into very small market cap companies that appear “cheap” in every sense of the word but many analysts and investors are simply not interested until that particular niche industry grows as a whole – which may take many years to manifest.
This is why they say value investing is simple, but not easy. The fact that I was myopic in my business & industry assessment of the companies that I own, too lazy to even pick up the phone and call investor relations, ignorant of the industry and clueless of who actually runs the business; rendered all my prior financial analysis irrelevant.
You need to fully understand a business before you buy into it. You would if you were paying a million bucks to take over and run an Italian cafe by the street corner. Why not the same when buying stocks of public listed companies? They are all the same. Next week, I’ll share with you steps you can take to reduce the possibility of buying into value traps.Earning Disclaimer
“Please note that the material here is provided to you for general information and illustrative purposes only, or as descriptive case studies on how our value-investing principles may be applied. It is not intended to be and should not be construed as any form of general or specific financial advice. For the avoidance of doubt, we do not recommend or provide opinions on how or what you should or should not be investing in, and you should always do your own research and independent assessment before making any investment decisions, taking into account your own specific circumstances. If you require any financial advice on investments or any other financial matters, please consult the relevant professional financial advisers.”