Validea article on Value traps

[Spekulatius]

It is not often that I read articles in Interactive brokers traders insight newsletter, but this one is pretty good and caught my attention:

https://ibkrcampus.com/traders-insight/securities/stocks/the-value-trap-conundrum-and-six-criteria-to-help-deal-with-it/?src=tiPlus070723us&eid=10000017&blst=NL-TI_cps_artclBtn

 

If you  buy cheap or out of favor, like I try to do, then avoiding value traps should be front and center of your thoughts. I find it interesting that besides all the fundamentals screens they use a momentum screen at the end to catch what they may have missed with their fundamental screens.

Edited July 8, 2023 by Spekulatius

[Luca]

18 minutes ago, Spekulatius said:

If youngish buy cheap or out of favor, like I try to do, then avoiding value traps should be front and center of your thoughts. I find it interesting that besides all the fundamentals screens they use a momentum screen at the end to catch what they may have missed with their fundamental screens.

Isn't avoiding value traps the goal for anybody in investing? Difficult to find the sweetspot, quality and growth for a good price. But those plays do come around from time to time. 

[ValueArb]

One of the most critical aspects of value investing is avoiding value traps, but I mostly disagree with everything this guy wrote.

 

First, true value investing isn't taking on excess risk. Typically you are fishing where other fishermen are not, lower liquidity stocks aren't more risky but they are certainly less efficiently priced. I do agree with what he said about Behavorial investing explanation, but more broadly value investing is finding opportunities where market participants average expectation for a stock is incorrect. The market is efficient enough that this happens relatively rarely, but occasionally its very obvious.

 

Second is his first five criteria are just standard parts of any value analysis. They don't filter out value traps. And "relative strength" isn't a value investing concept at all, value investing means conceding you can't predict price movements. It makes me wonder if this guy understands value investing at all when he refers to it as a "factor" and never mentions margin of safety or intrinsic value.

 

The key to avoiding value traps is only buying an undervalued opportunity if it has a catalyst. The most obvious and common catalyst is strong earnings growth. Buying a company that is growing earnings at 20% a year at a low PE will work even if the PE never increases. As long as earnings continue to grow 20% a year you will end up making roughly 20% a year.

 

Other catalysts include stock buybacks, dividends, mergers/acquisitions, tender offers, even sometimes liquidations. If you own a business trading at a huge discount to its intrinsic value but management isn't investing its earnings intelligently to benefit shareholders, you probably own a value trap.

[crs223]

21 minutes ago, ValueArb said:

true value investing isn't taking on excess risk.

 

True value investing doesn't involve buying value traps.  Ergo this article is not useful to true value investors!

 

 

[crs223]

4 minutes ago, crs223 said:

True value investing doesn't involve buying value traps.  Ergo this article is not useful to true value investors!

 

On a more serious note, I thought I was a value investor when I bought companies that dropped in price (like Kohls just before COVID).  Then I thought I was a value investor by purchasing companies cheaper than the gurus paid (like BABA).  Now I'm almost entirely in BRK while I figure out how this whole thing works.  Lucky for me I got in cheaper than Greg Abel.

[ValueArb]

5 hours ago, crs223 said:

 

True value investing doesn't involve buying value traps.  Ergo this article is not useful to true value investors!

 

 

 

You are no true scotsman!

[HubbadaPow]

Ben Graham used a different approach to avoid sitting in value traps.  He just gave each position a certain amount of time to appreciate and then he would sell it no matter what.  I think a couple of years if memory serves.  Some things are cheap for ages whether it comes down to an analytical mistake, market madness, or being early.  The momentum overlay seems to work really well if you are doing statistical value. 

[Spekulatius]

22 minutes ago, HubbadaPow said:

Ben Graham used a different approach to avoid sitting in value traps.  He just gave each position a certain amount of time to appreciate and then he would sell it no matter what.  I think a couple of years if memory serves.  Some things are cheap for ages whether it comes down to an analytical mistake, market madness, or being early.  The momentum overlay seems to work really well if you are doing statistical value. 

Yes, he recommended a 2-3 year holding period for value stock buys:

 

[HubbadaPow]

32 minutes ago, Spekulatius said:

Yes, he recommended a 2-3 year holding period for value stock buys:

 

Thanks for finding the reference Spekulatious.  It takes a lot of confidence to make an individual stock selection and a lot of humility to put guardrails on that decision, but those two things together dramatically improve the chances of getting satisfactory results. 

[scorpioncapital]

just cut out the word 'value' and the key is to avoid traps , in all investing. The traps that I find most challenging are the slowly deflating kind. They waste your time and just show up as 'sub-benchmark' return over time...How to spot them? it's an art and a science. Don't forget the art part. That comes from synthesizing 1. past experiences 2. past patterns where you saw this before 3. thinking outside the box and 4. reverse engineering this and other situations. I can't say there is an algorithm but generally watch out for egregious management actions, the nature of a business (recently hard asset stocks tend to have done worse than asset-light or software/tech stocks, but this trend could continue indefinitely), and perhaps even sometimes just bad luck. You sometimes need scuttlebutt to know if a company is doing worse than another and why.

[Spekulatius]

I agree with @scorpioncapital here - most value traps I have encountered are asset heavy with asset not generating much or any cash flow. I rarely have value traps that had high cash flow yield to owners with the exception of debt heavy companies with shrinking cash flows (which are probably the most risky investments one can make).

 

that's why my twitter handle has "I look at the cash flow statement first" in my profile. I still do sometimes break this rule....

Edited July 13, 2023 by Spekulatius

[HubbadaPow]

 Great points.  I remember Bruce Greenwald saying that if you have a lot of asset value and small or negative cash flow, immediately go to the proxy statement to see how you can replace management.  If you can't, just move on to something else.  That seems about right to me.

[Spekulatius]

15 minutes ago, HubbadaPow said:

 Great points.  I remember Bruce Greenwald saying that if you have a lot of asset value and small or negative cash flow, immediately go to the proxy statement to see how you can replace management.  If you can't, just move on to something else.  That seems about right to me.

As retail investor, I consider the chance that I can change management as fairly slim.

[HubbadaPow]

23 hours ago, Spekulatius said:

As retail investor, I consider the chance that I can change management as fairly slim.

I'm no activist either, but if the management CAN and SHOULD be changed, then someone might get involved and do the work for me.  If management CANNOT be changed and they're doing a poor job, then I'm probably hosed as a retail investor. 

[scorpioncapital]

On 7/13/2023 at 11:50 AM, HubbadaPow said:

 Great points.  I remember Bruce Greenwald saying that if you have a lot of asset value and small or negative cash flow, immediately go to the proxy statement to see how you can replace management.  If you can't, just move on to something else.  That seems about right to me.

 

I'm glad you mentioned Bruce Greenwald. I've watched his youtube interviews and he is quite astute. I remember him saying over and over - that advantages get competed away. He said this happened in agricultural stocks and now is happening in manufacturing stocks (the 'hard asset' stuff). He gives a warning that in the years and decades ahead it can happen to software stocks too but he still thinks this is a fruitful place to be so far. Another guy I like is Viktor Shvets at Macquire who believes the same thing from the angle of the marginal cost of capital approaching zero with technological advancement. I am not sure if or when we get to some pure communist phase but he says the banks are toast if there will be no cost to capital and a cbdc. I also like The Death of Money, a fascinating book I am sure Gates and Buffett have read as it talks of farmland as an inflation hedge and seems to mesh with Buffett's ideas on inflation. He even predicted UBI in 1973 but like Gates has said that we are not yet there, lots of work still to be done. The cost of capital being zero is probably premature but abundance or commoditization in some industries may make investing challenging.

[Saluki]

The early Ben Graham type of thinking was heavily focused on asset value instead of income. The thinking was that income can go away a lot faster than the assets that support it.  So in an asset heavy industrial world, a company with no income but valuable assets could be liquidated.  The problem, which Munger identified, is that in terrible businesses it's not fun to sit around hoping that someone will buy out this company before it goes bankrupt. In the information age, the best companies (META, GOOG, MSFT, CRM) don't require a lot of assets, but they do spin off lots of cash. Margin of safety has to mean something different there (network effects, switching costs, patents, better products). And if margin of safety means something different with these types of companies, than value traps has to have a different meaning too.  I don't know how to identify it though.  

 

There are asset heavy companies that the METAs and GOOGLes are built on, the fiber providers.  But they exhibit commodity like tendencies.  You care about bandwith and speed, not the brand name of the provider. So how much do those assets give you a margin of safety if the tech has to be upgraded constantly and the legacy facilities have environmental risks? And what about things like banking? If the government will bail out all depositers, regardless of the FDIC limit, then why does it matter where you put your money? You will deposit where they pay you the most, and borrow where they charge the least, which will race to the bottom and erode margins. 

 

I think Graham's idea of giving your stocks a timeframe to play out is a great idea, which I should incorporate. In a month it will be 3 years since I bought ATEX.  I haven't sold a share since I think the licenses are much more valuable than the stock is trading at, but at some point they should be able to deliver the revenue that they were promising.  When I bought SWBI, I didn't have a deadline in place, but I believed that within a year of the new factory opening, would be a good time for it look much better and sell.  And with VTS I assumed that one year and a day would be a good time to sell the shares in my taxable account.  Other companies I just bought because they were really cheap (TV) or the growth prospects look good, but I couldn't figure an end destination (FFH, JOE, GOOG). So if I have a timeframe for some stocks, why not others? Why not just set a date in my notes when I buy so that I don't talk myself into holding "until it comes back"?  It seems to me that if many of my investing mistakes have been emotional/tempermental and not mathematical, then whatever safety rails I can incorporate with regard to process should improve the outcome. 

[LC]

Quote

So if I have a timeframe for some stocks, why not others? 

To me it makes sense to have a timeframe for Ben Graham type stocks (net nets, cigar butts, etc.). Stuff you are buying low and selling at something looking like fair(er) value.

 

Other stuff with long term compounding opportunities, that I am a little more flexible. These are the great company/good prices Buffett-esque stocks.

 

TV, like you, I bought because it looks cheap. But, I don't want to own the main business long term. Maybe if they spin Univision or the futbol team & stadium, I would consider holding those. But to me, this is cigar butt I am looking to get a puff on. 

[Luca]

17 hours ago, scorpioncapital said:

 

I'm glad you mentioned Bruce Greenwald. I've watched his youtube interviews and he is quite astute. I remember him saying over and over - that advantages get competed away. He said this happened in agricultural stocks and now is happening in manufacturing stocks (the 'hard asset' stuff). He gives a warning that in the years and decades ahead it can happen to software stocks too but he still thinks this is a fruitful place to be so far. Another guy I like is Viktor Shvets at Macquire who believes the same thing from the angle of the marginal cost of capital approaching zero with technological advancement. I am not sure if or when we get to some pure communist phase but he says the banks are toast if there will be no cost to capital and a cbdc. I also like The Death of Money, a fascinating book I am sure Gates and Buffett have read as it talks of farmland as an inflation hedge and seems to mesh with Buffett's ideas on inflation. He even predicted UBI in 1973 but like Gates has said that we are not yet there, lots of work still to be done. The cost of capital being zero is probably premature but abundance or commoditization in some industries may make investing challenging.

Why would the cost of capital decrease with technological advancement? Could you link the book "Death of Money". 

 

Thanks!!

[Intelligent_Investor]

As Munger has said before the best time to sell is when your thesis has changed/no longer is likely to be true. For a net-net that will likely be in a few years, but for a compounder like Coke that might be decades.

[scorpioncapital]

10 hours ago, Luca said:

Why would the cost of capital decrease with technological advancement? Could you link the book "Death of Money". 

 

Thanks!!

 

https://recision.files.wordpress.com/2010/12/jens-parsson-dying-of-money-24.pdf

 

Fascinating book. I would have never thought as a hardcore capitalist about the risks of and to democracy and change my view to actually desire higher capital and inheritance/wealth taxes. This guy was very persuasive. I started to see that while the world has many types of systems what protects gains in capitalism is some types of a fair, just and altruistic society, even if it is painful to the individual hyper-capitalist. The only criticism I have is that humans are not perfect and repeat errors and this works only for advanced developed economies that do not regress back to developing status. He also seems to acknowledge the errors and failures that led to inflationary disasters. He seems to balance theory and reality of human nature and is a pragmatist. Still, unless people get along and don't get ultra polarized, you will tend to get sub-optimal economics in any state or society.

Edited July 19, 2023 by scorpioncapital

[Luca]

6 hours ago, scorpioncapital said:

 

https://recision.files.wordpress.com/2010/12/jens-parsson-dying-of-money-24.pdf

 

Fascinating book. I would have never thought as a hardcore capitalist about the risks of and to democracy and change my view to actually desire higher capital and inheritance/wealth taxes. This guy was very persuasive. I started to see that while the world has many types of systems what protects gains in capitalism is some types of a fair, just and altruistic society, even if it is painful to the individual hyper-capitalist. The only criticism I have is that humans are not perfect and repeat errors and this works only for advanced developed economies that do not regress back to developing status. He also seems to acknowledge the errors and failures that led to inflationary disasters. He seems to balance theory and reality of human nature and is a pragmatist. Still, unless people get along and don't get ultra polarized, you will tend to get sub-optimal economics in any state or society.

Thanks for sharing, strongly agree!