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Five signs your stock could be a value trap

26/07/2012

Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

In articles such as Some rough with your smooth, we have noted one of the key risks facing value investors is falling into ‘value traps’. Value traps are investments that appear undervalued but turn out to be cheap for a reason, often because a company’s ability to make profits has been severely, and permanently, impaired in some way.

Ensuring we don’t invest in value-traps is a key part of what we do and so it was instructive to see a recent presentation on the subject by the immensely successful investor Jim Chanos who has made his reputation by shorting the shares of overvalued businesses. Among a number of high-profile examples, he famously worked out what was going wrong at Enron.

Chanos has observed that he often finds himself shorting companies that appear cheap and often does so whilst value investors are going long. In other words, he has a very good track record of making money at the expense of value investors by identifying value traps, so knowing what he thinks the key characteristics of a value trap are should help value investors avoid falling into them.  Chanos pointed to five common features of value traps, which are summarised below:

* Overdependence on one product or cyclicality: this is where a company’s profits are unsustainably high but the stock market has priced in that the current level of profits is sustainable. When economic conditions change or a key product falls out of favour there tends to be downside to both the company’s profits and multiple leading to a significant share price fall. Companies with cyclically high earnings at present might include some in the resources sector, especially those whose profits are driven by the price of one particular commodity over which they have no control. A striking example of overdependence on a single product is Kodak, whose reliance on photographic film left it exposed when digital camera technology left film obsolete and led to the company going bust.

* Hindsight drives expectations: this is closely related to the first point. When value investors consider the profits a business should make they tend to look at history rather than trying to predict the future. Overall, in our view, this is probably the right strategy but can lead to a failure to recognise where a company’s earnings power has permanently deteriorated and the 4x PE on historic profits is actually 12x future profits. Historic profits can potentially provide a false sense of security and whilst they are often a good guide to future profits, investors shouldn’t be complacent about this.

* ‘Marquis management’ and/or famous investors: ‘marquis management’ is the presence of a successful or well-respected management team that can lead investors to be blinded to the challenges a company faces. rather than focusing on the fundamentals of a business, investors can take a potentially false sense of security from the belief management knows what it is doing and will sort things out or that if high profile investors have bought shares in the company the risks must be less than they appear.

* Appearance of cheapness on management’s metrics: this is where a business’s management, sell-side analysts etc. stop focussing on traditional metrics, such as earnings, and comes up with its own. A classic example is a company’s reporting of ‘adjusted earnings’ which may show profits calculated before various costs or charges at the management’s discretion. A current example is the use of metrics like ‘price per eyeball’ to justify the valuations of internet focused companies and divert attention from the fact that on traditional valuation metric these companies can look very expensive.

* Accounting issues: in one sense this takes the fourth point to an extreme - the stock market’s valuation of a company is flawed, not because it’s focusing on the wrong metrics but because profits or other key financial data are being flattered or even fabricated by company management. In some cases, like Enron, the accounting issues may be hiding that a company is in financial difficulty or even insolvent. When the market adjusts to reflect the ‘real’ level of profits the company’s valuation looks much less attractive.

 

Author

Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.

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