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 do not invest in value traps is a key part of what we do and so it is instructive to highlight a presentation on the subject by the immensely successful investor Jim Chanos who made his reputation shorting the shares of overvalued businesses.
According to Chanos, he often finds himself shorting companies that appear cheap and often does so while 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.
As such, 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 stockmarket 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 valuation, leading to a significant share price fall.
* 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.
While we would argue this is the right strategy overall, it can lead to a failure to recognise where a company’s earnings power has permanently deteriorated. Historic profits can potentially provide a false sense of security and, while they are often a good guide to future profits, investors should not 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 therefore be less than they appear.
* Appearance of cheapness on management’s metrics:
This is where a business’s management, sell-side analysts or others stop focusing on traditional metrics, such as earnings, and come up with their own.
One 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.
Another is the use of metrics such as ‘price per eyeball’ to justify the valuations of internet-focused companies and divert attention from the fact that, on traditional valuation metrics, these companies can look very expensive.
* Accounting issues:
In one sense, this takes the fourth point to an extreme, arguing the market’s valuation of a business is flawed – not because it is 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, 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 ends up looking much less attractive.