Value Traps and How to Avoid Them

Well that was cool!  My last post got a little personal, and all the positive reader feedback was simply amazing!  You peeps are truly awesome!  Truly!

Before I get too misty-eyed and start giving out tentacle laden hugs, let’s change the subject to something a little bit more clinical: Value Traps.

When the markets are down, value traps abound! 

That’s the saying anyway.  With markets down significantly from their 52 week highs, I thought today might be a good opportunity to discuss value traps.

What’s a value trap?  Well, I’m glad you asked! 😀

[Note:  For the purposes of this post, I’m going to be discussing value traps as they apply to common stocks.  The term ‘value trap’ can also be broadly applied to any kind of asset.]

Value Stocks & Value Traps

A very popular stock investing strategy is to invest in “bargain priced” stocks  — these are commonly called “value stocks”.  Value-priced stocks typically trade at lower price multiples when compared to other stock categories (such as growth stocks, or tech stocks).

Value stocks tend to look attractive to investors because the cheap valuations make it appear the investor is getting a bargain price (or a bargain priced stream of future earnings).

Famous last words, right?

In the past, value stock investing was a very successful strategy, espoused by none other than the likes of Warren Buffett himself.   But in recent years this strategy has underperformed.  Performance of value stocks has been poor compared to growth stocks.

Sometimes this happens because all that ‘value’ isn’t much of a value at all.  Sometimes value stocks are actually something called a “value trap”.  These stocks are cheap for a  reason.

Value traps (as opposed to value stocks) are investments that appear to be selling at steep discount to traditional valuation metrics (PE, price/cashflow, book value,etc), but will crush the hopes and dreams of any investor.  By all accounts, the investment looks good — They appear to be a good value, but value traps are there to capture unwary investors.

Let’s say an investor puts $10,000 of his or her money into a value stock thinking it would be a good investment.  Hoping for a big win, the investor watches diligently for the impending value to be realized.

Except it doesn’t happen. After the purchase, the value stock continues to fall in price.  Business continues to get worse and worse.  That $10,000 turns into $5,000 — a serious loss for the investor.  This is the trap — By all accounts, a value trap looks like a solid investment, but it isn’t.

They frequently pull-in even very savvy investors looking for a bargain, yet the investment continues to tank…

The GE Example

General Electric is an example of a recent value trap that did exactly this.  This iconic industrial giant was once America’s most valuable company, and is now sadly a shadow of its former self.

On the surface, GE looked like a very good value buy  — A strong global company poised to rebound… and this particular value trap pulled-in many smart value investors over the last couple of years… and then burned them all.

In 2016 GE shares traded at $30/share.  Today it’s priced at around $8/share.  Yikes!!  Will we see a GE bankruptcy?  It’s very possible!

Before you hard-core indexers scoff at the incredible folly of stock pickers, please remember that GE is part of the S&P 500 — which means most index fund investors also suffered losses from investing in this value trap.  This titan of industry completely fell apart.  Over $500 billion in value was destroyed.  It’s been a giant disaster for everyone!

I know, I know… I’m being negative!  Instead of focusing on all the negatives of this debacle, let’s try to turn that frown upside down — Let’s learn how to avoid these messes in the first place!

A great place to start is by dissecting the most common kinds of value traps…

Value Trap: The Iceberg Of Information

If you’ve ever operated a boat in Arctic waters, one of the first things you learn is to steer clear of icebergs.  Why?  They’re friggin dangerous.  90% of an iceberg is underwater and completely hidden from view.  Icebergs are liable to shift and roll at any moment. I had it happen to me once with a fairly small iceberg, and it was still scary!  It could have crushed the boat we were in!

Thankfully, Mrs. Tako and I survived to tell the tale of the rolling iceberg.

The lesson learned here can also be applied to investing in large conglomerates.  While a company like GE posts regular earnings reports and annual reports, how much of the really important information needed to understand that investment gets published in those investor reports?

Not nearly enough.  Only about 10% of what an investor in GE would truly need.  Conglomerates (like GE) are comprised of dozens of businesses in a huge variety of industries.  It’s impossible for any one person to be an expert in them all.  There’s no way a complex business like that could be summed up in one slick annual report!

This is why I believe 90% of the information an investor really needs to invest in a company like GE is not visible to the public.  Like an iceberg.

Investors suffer from a dearth of information, and the larger more complex the investment the worse this problem gets.  Know your limitations before you invest.  Don’t discover them later.

Investors often head into investments with far less information than they really need to know in order to understand a business.  This is why I usually take a ‘hard pass’ on investing in big conglomerates like GE (outside of index funds).  They’re too complicated and I’m way too dumb to understand all the different businesses and economics that apply to them.

Wherever possible, I prefer to keep my individual investments in much simpler situations and avoid getting crushed by giant icebergs.

Value Trap: Declining Industries

Another area where value traps are commonly found is in declining industries.  Today, the most prominent declining industry found in the news has to be physical retail.

Sears just went bankrupt, Toys ‘R’ Us folded in 2017, and many other physical retailers have closed their doors in recent years.  It’s all over the news.  As a result, shares of troubled physical retailers are cheap.

It’s tempting to dive into these investments due to the value they represent, but danger abounds!  I’ve even written about several retailers that might represent potential investments — like Gamestop and several auto parts retailers.  But I haven’t invested.  Frankly, I’m too chickenshit to invest.

The problem is in extracting value from investments like this.  Like an elevator, most investors prefer to ride the investments that are going ‘up’, but they’ll break ranks once that elevator shows signs of going down.

When everyone exits the elevator, this will absolutely punish the shares.  It also means investors won’t be realizing profits from capital appreciation any time soon.  You’ll be limited to dividends and share buybacks until the company turns things around (if ever).

But did the market dive out of the elevator too quickly? Is there value to be harvested?

These are answerable questions, but extracting that value is the really tricky part for small investors.  Large hedge funds often take control of the value extraction (as was the case with Sears), but rarely do small investors do well in these situations.

My rule of thumb is that it’s best to avoid industries in decline… unless you have a very clear path to value extraction (and a fair understanding of the pace at which the investment will decline).

Value Trap: The Dividend Carrot & The Debt Trap

Despite warnings to the contrary, many newbie investors often get attracted to investments with large dividend yields and equally large debt piles.  This is frequently a value trap.

The investor focuses on the dividend carrot and fails to see the frightening bear trap of debt ready to spring shut at a moments notice.

GE was a perfect example of this — For years the company paid out nearly 100% of free cash flow as dividends, and financed everything else with debt…  Including some very questionable acquisitions that had no hope of ever covering their debt load with free cash flow.

This put a greater and greater burden of debt servicing onto the good businesses in GE’s portfolio.  Eventually that debt was going to need refinancing at higher rates too…

In hindsight this equation looks like a clear disaster in the making, and investors should NOT have been surprised when the dividend was cut a couple of weeks ago.

Here’s my rule of thumb to avoid this kind of value trap: Under most situations, dividends should not exceed 50% of free cash flow.  Debt to equity levels should stay under 1.  Debt interest payments should be easily serviceable out of free cash flow after paying out dividends.

There are certainly exceptions to this rule (such as when investing in REITs), but these numbers should wave a red warning flag of caution for the most common investments.

Turnarounds

Turnarounds are another form of value trap that “catches” unwary investors.

For one reason or another, a stock’s business can decline… Maybe it’s due to poor management, lack of focus on the customer, or any number of other reasons.  The stock falls in response to the problems, creating a potential value…

What traps investors here, is a little song that management likes to sing called a ‘turnaround’.  The CEO promises that “things are going to change” and “business is going to come back soon”.

“The turnaround is just around the corner!” the fearless CEO exclaims.

That siren song tends to draws-in investors, but the promised changes frequently fail to materialize in time.  My advice about turnarounds:  They often fail to turn as expected.  Avoid them when possible.

The bigger the ship, the harder it is to turn.

Sears was once sold as a turnaround.  It never happened, and we all know how that story ended.  IBM is being sold as a turnaround right now.  Will IBM be able to transform itself and fix its problems?

Hard to say.  That would require a crystal ball in order to tell, and I’m fresh out of crystal balls.

Final Thoughts

I hope you enjoyed today’s look at the most common value traps that entice and capture unwary investors.  While certain stock prices might look beaten-down and cheap today, smart investors know that the value traps are lurking out there in the wild!

Keep on your toes and be warned!  There’s more to investing than looking for perfect valuation metrics and large dividends!

[Image Credit:  Bear Trap, Elevator, Iceberg]