Sunday, April 13, 2014

Value traps and how to avoid them

It seems that articles about value investing concepts are far more popular on IGValue than company analysis pieces so I am going to try to pickup the pace on the concept articles. Value traps are the number #1 reason for amateur value investors losing money. I have been a victim of several value traps and will attempt to categorize them into a checklist here so that we can all avoid them in the future.

A value trap is a stock that seems cheap relative to value but is fairly priced as the underlying business is doing worse than meets the eye. A simplistic example would be a company that drives up earnings in a year by selling some age old property and then claims that they will repeat it year on year.

In the company analysis articles I try to cover these points in the Soft factors sections.

1. Compromised honesty

Honesty has always come at a huge premium. Even a slight blemish on the honesty front by management, promoters or employees is almost always a value trap. A dishonest company almost always goes to zero before changing course and that too only happens when the dishonesty drivers are replace a 100%. Staying away from fraud is always a good thing. There is no formula for detecting fraud other than reading the fine print and doing some channel checking.

Example: Satyam Computers had fixed deposits on their balance sheets against which interest was not being earned. That was something suspicious that exposed the fraud. Once the old promoters were out and the Mahindra group took over is when the fraud ceased.


2. Too much Optimism

Running a business is not easy. Hubris or delusions of infallibility in a management create a set of unachievable expectations that never end well. It is always better to buy a company that promises little and over delivers. 

A subset of too much optimism is missed earnings estimates. Earnings estimates are created by analysts based on data and perceptions given by the company in public communications. They are typically a reflection of what the company is thinking.


3. Bad business

A bad business is defined as one where there is some factor that ensures low margins. Some of these factors could be:

  • Too much capital chasing a small opportunity
    • Example: E-commerce in India or specialty small scale healthcare in India has been chased by excessive capital
  • Inability of the company to increase prices (demand elasticity) 
    • Example: Auto Parts
  • Too much supplier control
    • Example: Lithium ion batteries
  • Bad payment terms - this is a trap that besets some industries when there is a slowdown
  • Too much capacity - look for a cost advantaged producer
  • Outdated products where the technological jump was too high - Examples are numerous but personal computer assembly businesses went out as they were unable to adapt to making laptops
  • High capital intensity where the company becomes "pot committed" - the company is forced to make sales at bad prices as it has no other choice
    • Many scrap melting plants go through this when ingot prices fall
    • Glass manufacturers go through this as glass plants cannot be stopped until end of life
  • Lack of consistent profits - companies that declare routine losses need to be kept away from.

4. Regulatory issues

Investing in highly regulated industries needs to be done very carefully. For example utilities, government driven oil companies, and others may be used to fund subsidies.

Other regulatory examples include things like FDA bans on Indian exporters of generic drugs. I had looked at Wockhardt pharma at the lows and one can say I passed on it and missed the 20% rally but the FDA ban is something I don't really understand.

5. Doctored financials

This is something on which several books, research papers, journal articles and other media is out there. I recommend reading all of it. Time to time I cover articles on doing this.
A few important ones are:
  • Cash flow not keeping pace with net income
  • Ballooning inventories & their valuation
  • Ballooning debtors

6. Errors on financial websites

Yes! This can be a value trap too. Several financial websites like Moneycontrol, Myiris, Bloomberg, Google finance and others can sometimes have errors. Purely relying on the website for information can lead to disaster. Also the financials as presented by the website and the company can many a times differ. For example Moneycontrol many times nets off the current assets and liabilities and shows it as a single line item on the assets side whereas the company might be reporting the same in greater detail.

7. Insider activity & significant stake buys/sells

The BSE and NSE clearly report insider transactions. Never ever buy a company stock where insiders are selling. On the contrary insider buying in small quantities could also be a value trap. Company buybacks in large quantities are a good thing but sometimes companies can use excess cash to buy back stock just to tell the markets that they believe in their stock.

8. Cyclical industries

Highly cyclical industries also have to be dealt with in a careful manner. Mostly cyclical industries tend to be bad businesses and over the long run don't create much value. Wrongly times large bets on capacity can weigh down heavily on companies.

9. Debt traps

If a company's debt continues to rise over a long time without a commensurate increase in profits or revenue it is most likely a value trap. One needs to be very careful as the company might be overly optimistic on non-existent business opportunities.

10. Government owned companies

PSUs as they are called in India can find themselves in situations where the business interests of the shareholders are put aside for other gains. For example the NPAs start to rise for PSU banks where their mandate shifts to inclusive lending. There are PSU banks who have been know to say that NPAs are not a crime. Overall one has to be aware of the downsides while investing in government owned companies.

11. Lack of focus or overly diversified companies

While investing in a company you want to be betting on a management that is trying to be number #1 in its industry. There are several companies out there that have their fingers in too many pies making it fairly unlikely for them to be the leader in any field. Please don't get me wrong - all conglomerates or diversified companies are not value traps. Just the ones where you cannot see leadership in any field are value traps.

If there are traps I have missed or if you have interesting anecdotes about please do comment on this post or please write to me at info at igvalue dot com - I would love to hear from you.