With stock markets in Asia and around the world down sharply from recent highs, a lot of stocks are trading at what might look like bargain prices. But in many of those stocks lurks a return-killing demon: The value trap.
History has proven that buying cheap stocks gives you better returns over the long term than buying expensive stocks. But in order to get those returns, you have to be sure that cheap really is cheap. If not, you won’t be getting the return you expect. And you might not get any return at all.
As you probably know… just because a stock trades at a low dollar value doesn’t mean it’s “cheap.” Whether a stock is cheap or expensive depends on its valuation. A stock that trades for only $1 can be expensive if it trades at a high valuation. And a $100 stock can be cheap if it trades at a low valuation.
In the same way, a run-down house in a bad part of town that costs $100,000 might seem “cheap” – but it’s actually a lot more “expensive” than a nice house in a good part of town that costs twice as much. A value trap is when a stock (or a sector, or a market) looks cheap (that is, its valuations are lower than long-term averages, or lower than its peers) but in reality, it isn’t cheap at all.
In other words, as Warren Buffett said, “Price is what you pay, value is what you get.”
There are a number of ways to measure a stock’s valuation. We’ve previously discussed two of the more popular methods to value a stock – the price-to-earnings ratio (P/E) and the price-to-book-value ratio (P/BV). These involve looking at the fundamentals of a company – things like how much they earn, how much they sell and how much debt they have – and measuring them against the market price of the stock.
Of course, there are a lot of ingredients to a stock’s valuation – and reasons why a cheap stock might not be as cheap as its valuation suggests.
Seth Klarman, one of the most successful value investors, points to a few reasons why value traps appear to be cheap: “Perhaps an inept and entrenched management, a poor history of capital allocation, or assets whose value is in inexorable decline.”
In other words, the stock prices of value traps are cheap because they’re no longer well-run companies. Companies that lose a competitive edge within their industry can also become value traps.
An earnings-driven value trap happens when a stock seems cheap because it has a low P/E ratio (calculated as the price of the stock divided by the amount of earnings per share). But if earnings keep falling, the P/E ratio will climb. For example, a stock trading at $5 per share, with earnings of 50 cents per share, will have a P/E ratio of 10. But if the share price stays the same, and earnings drop to 35 cents per share, the P/E ratio would climb to over 14. That’s a lot less cheap.
Investors fall into this trap when a stock price falls slightly, and the stock looks cheap. But then earnings drop, and what was cheap is now less cheap – even though the stock price hasn’t moved up. Then earnings decline again, and what once looked cheap is now downright expensive because earnings have fallen so much.
This often happens in the commodities sector when the economic cycle turns. Coal mining companies looked cheap four years ago, based on their stock prices at the time. But the coal industry is in decline as a whole. As earnings have collapsed, it’s turned out that “cheap” coal mining companies aren’t cheap at all – even though their share prices are now a fraction of what they were before. When earnings drop (or vanish), a stock will very quickly stop looking cheap.
Similarly, the stock price of Petrobras, Brazil’s state oil company, has fallen more than 70 percent since last May. By some valuation measures, it looks cheap. But, the company has US$100 billion worth of junk-rated debt, is mired in a corruption scandal and has a high cost structure. And the price of oil has fallen by 70 percent from recent highs. Even if oil prices recover, the underlying value of Petrobras won’t go up because of the other issues it faces. It’s a classic value trap.
Entire markets, like the Russian stock market, can also be value traps. New investors looking at Russian stocks are sometimes drawn in by the market’s low valuations, like a low P/E ratio. Russian shares have for years traded at a much lower valuation than other emerging markets. But this discount has been there for years, as shown below.
A value trap can stop being a value trap – and become an attractive, under-valued investment – if there’s a trigger for change. A change in management, a big change in the industry, higher commodity prices, a regulatory change – all of these things can turn a value trap into a great investment. There hasn’t been a catalyst for change in Russia (or for coal, or Petrobras), yet. Until there is, they’ll continue to be value traps.
How can you avoid value traps? Don’t invest based only on valuations that seem low, because they might have been low for a long time – and might continue to be low for a long time. Look carefully at a company’s debt profile. Also look for revenue growth – a company that isn’t generating more in sales every year will have a difficult time earning more money every year.
Is the industry or sector as a whole growing? If not, that’s another reason why a company might have a difficult time increasing revenues and earnings. Does the company operate in a cyclical industry (like commodities, for example)? If so, you’ll need to time your purchase so that you don’t get sucked into a value trap. And if the company is in what’s called a “structural” decline, it means that demand for the business, and sometimes the industry, will never recover.
Cheap is usually good. But not always. Value traps can punish your portfolio even more than buying a stock that’s too expensive in the first place.
