Value Traps

The title looks simplistic and deceptively simple, doesn't it ? However, do not be taken in - value traps are defined as companies which appear to have "value" and margin of safety but in reality are far from being investment-grade. As an aspiring value investor, value traps are one of the most insidious things to look out for, as they can confound and confuse for years before you finally realize them for what they are. By then, you would have lost not just a substantial and significant portion of your capital, but also suffered from opportunity costs of deploying your capital in companies which truly qualify as "investment-grade".

So what constitutes a value trap ? I could probably give some examples in real-life context (coupled with mistakes I had made before when I first started investing); but the underlying theme is that such traps consist of companies which seemingly have an edge or competitive edge over other competitors and are able to generate a high ROE/ROA, but the problem is that this is fleeting and temporary or it may be at the "peak" of its earnings cycle. Therein lies the danger - companies whose businesses are cyclical are likely to suffer from poor revenue growth and earnings deterioration once the cycle is over; while those which did not adhere to a business model which works over time may likely get surprised when economic conditions deteriorate (as they have done now). Other examples are companies which seemingly have a value proposition and some competitive edge, but which cannot make use of this edge or hold on to it to generate high returns on capital.

Lest the reader thinks that the companies I currently own are NOT value traps, let me first state that some of them MIGHT BE. This is the difficult aspect of value investing - the fact that it may be difficult to spot a value trap till it is too late, or I may be myopic in my business assessment of the companies I own; or something could go drastically wrong with the business to render all prior analysis and study irrelevant. The idea is to pick companies with a business moat and few competitors, or are at least large enough in their own right to be able to command superior margins and a competitive edge, coupled with good and honest Management. There have been cases where an investment into (supposedly) such companies failed to yield positive results, due to the fact that my analysis was flawed or incomplete; or business conditions evolved to such an extent as to render the previous analysis obsolete. One recent example is Trek 2000, which manufactures and has patents for their Thumb Drives. Although much of its revenue is earned from licensing agreements with major technology players, its revenue base and gross margins have been declining of late as the technology sector ran into problems and they were unable to come up with innovative new products to sustain revenues. A similar case in point would be Creative Technology, which was unable to replicate the success of its SoundBlaster in the 1990s. Creative has now had the misfortune of falling into the red and are frantically scrambling to cut costs amid a severe slump as well as losing market share to Apple Computer (the i-Pod and i-Tunes).

Other cases of value traps would be companies which trade at very low price-earnings ratios like the current batch of S-Chips listed on SGX-ST. Some of them are valued at a mere 2-3x PER while peers listed in Hong Kong are trading at valuations of at least 10-12x PER. So why is there a valuation "gap" and can this be exploited ? Again, the issue of size, competitive strength and market share come into play. Listed footwear makers in Hong Kong like Anta, for example, are much larger in terms of size and scale and distribution network as compared to smaller players like China Hongxing, China Sports and Hongguo. Similar examples include comparing Synear Foods and Youcan with larger players like Mengniu and Yili. Such cases show that the market will value a company based on future growth prospects, and the reasons for trading at low multiples could represent a value trap for investors who do not understand the nature of the business or the expansion potential of the Company. The recent results from the fibre companies like China Sky and Li Heng also illustrate that growth may be slowing or margins severely crimped, thus also "crimping" valuations. Hence, low valuations may represent more of a value trap than a value proposition - the key is in analyzing the qualitative aspects of the business and not just the quantitative aspects and being able to conclude on what constitutes a good "buy" and what represents a good "bye" !

One final category I can think of in terms of value traps are companies which trade below their Net Asset Value (NAV), of which there are quite a handful in this bear market and sharp economic recession. There are those who argue that such companies represent good value because an investor is able to obtain at least the NAV upon liquidation, which is stated as a value higher than the currently traded market price. However, one should be mindful that such businesses are unlikely to be liquidated anytime soon, and the liquidation value is based on the historical cost of assets on the Balance Sheet, NOT market value of their assets. This can be very misleading as a forced liquidation of current and fixed assets may not fetch more than 60 cents on the dollar, for example, as compared to an orderly liquidation. Firesales of assets for companies which are burning cash and struggling to survive will not yield much returns for assets stated at cost on the Balance Sheet; therefore the NAV number may be deceiving at best, and totally misleading at worst. Thus, I have classified companies with poor business prospects, high cash burn, very low margins and poor revenue visibility under "value traps" even though they may be trading at a huge discount to NAV.

The value investor's job is to avoid value traps; however it is unavoidable that some will be encountered during the course of his investment journey due to either inexperience or flawed analysis. It is thus important to be able to identify such cases quickly (so as to cut losses and not repeat the mistake) or to avoid such cases altogether (through dilligent study into the cases where value traps exist as pointed above). My knowledge on this area is still expanding and I endeavour to continue to learn of value traps and to identify true good value in companies.