The ‘value trap’ is a genuine investment risk but actual examples are a lot rarer than one might think given the frequency with which the market seems to spot them. A common misconception is a value trap is a company whose share price stands still or falls over a prolonged period of time and yet, within that definition, there still lies scope for stocks with the potential to double in value tomorrow.
Arguably such a definition says more about an investor’s own time horizons than it does about whether or not a company is a value trap. Here at The Value Perspective, therefore, we would suggest a genuine value trap is one where the business has some kind of structural fault that means, over time, it simply cannot make returns.
A classic recent example would be HMV, where a change in one aspect of its market – the internet – fundamentally affected its business to the extent it could no longer make returns. While such instances are very much the exception rather than the rule, however, investors tend to see ‘HMVs’ everywhere – and perhaps nowhere more so at present than among pharmaceuticals businesses.
Many people see the sector as cheap but for good reasons, including pricing pressure, a lack of new drugs coming onto the market and a recent history of slower growth. ‘Cheap but for a reason’ is actually close to a definition for a value trap – always providing there are not also reasons why a company should not be cheap.
In this instance, we would point out pharmaceuticals businesses can still generate prodigious cash flows, still demonstrate huge – and growing – demand for their products and continue to be able to pay high dividends.
So what has this meant for investors? To answer this question, we have examined the performance of GlaxoSmithKline, which has attracted more than its fair share of ‘value trap’ accusations in recent times. For each year going back to 2004, we have calculated its ‘internal rate of return’ (IRR) – that is to say, if you had bought the company at its average share price for a particular year, then merely held it, collected your dividends and sold it yesterday, how would you have done?
The IRR can then be compared with the average total return from the broader UK market over the same periods, which is what is shown in the table below. Thus, for example, if you had bought Glaxo at the average 2004 price, collected your dividends and then sold up in 2013, you would have averaged 9.2% a year from your investment, compared with 8.1% from the market – so 1.1 percentage points of outperformance from the UK pharma giant.
Source: Schroders, Nick Kirrage as at 30/04/13
As you can see, the average annual return from Glaxo has beaten the market in every scenario while, in absolute terms, the lowest return from the stock was the 6.7% a year you would have received if you had bought it in 2006. That is not a bad showing from a company many investors have dismissed as a value trap or, at best, as dull.
To be clear, the purpose of this piece is not to shout about how good an investment Glaxo has been in recent years – indeed we could have used several other stocks in the above table to make the same point – but to underline the sort of potential the market can miss out on when it wrongly identifies a company as a value trap. This sort of ‘misdiagnosis’ can lead to companies trading more cheaply than they ought to and thus allow more savvy investors to compound greater returns.
As so often with investment, we are back in the realms of perception and reality but a company cannot be a value trap one day and not one the next. It either is or it is not and, as we said earlier, to our minds it all comes down to whether a business has a structural issue. Glaxo never did, which is why we were very comfortable buying it.