June 23, 2011

The anatomy of value traps

The number one problem faced by value investors is not a big permanent loss of capital, due to overpayment for growth, but the weak and anemic return from an average business bought at a cheap price.

Let me explain further –

A typical value investor (who are far and few anyway) generally tend to be conservative in paying up for a business. The deep value types go for the really cheap stocks (as measured by low PE or P/B ratios), whereas the others would pay up a bit for the quality of the stock and growth, but not too much.

A deep value investor typically looks for a company which is selling in low single digit PE ratios and in some cases if you back out the cash or other assets on the balance sheet, the core business could be available for almost nothing.

What is a value trap?
The problem with most of these investments is that the underlying business is stagnant with a comatose management who is not interested in either growing the business or ready to return the excess cash to the shareholder. In such cases, the market discounts this cash heavily and refuses to bid up the stock price.

Let me a give a personal example – Kothari products. You can read my earlier posts on this company here and here

Let’s look at the price history for the company below



As you can see, that the stock has gone nowhere in the last 5 years. If one includes dividends then, the return comes to around 15% for the entire 5 year duration. The index during this period has more than doubled.

Even a savings account would have done better!!

What are the key causes?
There are several causes for such value traps. The primary cause is a stagnant or declining business with a management which keeps pouring capital into the sinkhole. If on the other hand, the business is generating excess cash, the management keeps hoarding it and refuses to return it to the shareholder.

The second reason is that the underlying economics of the business has deteriorated and the market realizes it with a lag. Case in point – the telecom industry. The economics of this industry has gone into a tailspin for the last few years, with almost everyone bleeding money (except probably bharti airtel). In such cases, if you keep looking at the past data and do not understand how the economics of the industry has changed, you can get stuck in a no-win situation

The last category of value traps are the low return, second and third tier commodity players. These companies have a low return on capital over the entire business cycle, and unless you can dance in and out of the stock in time, you can get stuck with very low returns.

How to indentify value traps before hand ?
That’s the tough bit.

For starters, investors like me need to get out of the low PE, cheap stock mindset. A really cheap stock is often cheap for a reason. It makes sense to dig deep and understand the business in detail to figure out why the market is valuing the company at such low valuations ?

If a company has been cheap for the last 5 years, why should it suddenly get re-rated just because smart lil me bought the stock?

One needs to understand the economics of the business in depth and also confirm that the management is creating value for the shareholder and not just twiddling their thumbs. Only if you have a strong belief that that business is doing well and will continue to do so and the management is also good, then should you think of making a commitment to the stock

What if you are caught in value trap?
There are no easy answers. For starters, swallow your pride and sell the stock. That’s easier said than done – ask me!. The unfortunate bit is that people like me take 10 years to realize it :). Luckily for me these mistakes have not been big enough to damage my long term returns.

The risk of holding onto such investments is that although you do not lose money on paper, in reality you are losing the benefits of compounding by not investing the same money in other opportunities. It would be silly to compound your money at 10% in a value trap, when the index itself can give you 15% without any effort.

If you have invested in one of those low return commodity stocks, hope that the commodity cycle turns and market in its temporary fits of insanity, re-prices the stocks. As soon as this happens, sell the stock and never look back !

It is always a constant struggle to avoid value traps, as they come in various shapes and forms. One has to be vigilant and learn to exit them, once you have realized that you are stuck in one

31 comments:

Anand said...

totally agree... as Warren Buffet rightly says, better get an excellent company at a fair price than get a fair company at an excellent price...

SV said...

i guess your link to your posts on kothari products are not actually linked..

Pradeep said...

Review: Noting down the reasons why it is a buy at first place and doing an annual review to check whether they still hold true and if they have changed then re-evaluate.

Discipline: Instilling intelligent investor psychology and not fall for behavioral psychological traps.
(agree, it's easier said then done but extremely important to analyze yourself and must overcome by practice)

Anonymous said...

Well said Rohit. I had my value traps in the form of Tata Investment Corporation, India Nippon Electricals etc.. From my understanding on all these value traps, the key thing to look at is how much are the earning likely to grow in the next 5 or 10 yrs. If we assume that the low pe remains low pe or high pe remains high pe then your return is nothing but the earning growth rate. if the company returns back all money to share holder and invest nothing the growth could be stagnant and so do the price. If a company holds cash but its ROCE keeps going down then we have the same problem (bad value traps). If the company holds cash and maintains roce then growth would be equal to roce. Based on pe expansion (highly likely with low pe companies) or pe compression (highly likely with high pe companies) the actual returns vary. Best strategy is to buy companies at low pe that have very decent ROCE (prefer 15% and above) which reinvest a big portion of the profit generated back into the business. Also the growth that happened should have high probability of happening in the future. I failed a bit here with Balmer lawrie. It had a great run in ROCE and margins in the past 4 years due to logistics business which I thought could continue for sometime but looks like it has hit a peak. As you said its a difficult exercise wherein you thought process becomes clear only in hindsight.
Regards
Ravi

Anonymous said...

Good post
Were do you find value in india ? Which sectors ? Which companies. .
Some indications at least please.

Regards
Subu

Zero Point SomeOne said...

Hi Rohit,

What are you views abt Piramal Healthcare? Its quoting at PE of 0.48.

Karun

VISHNU said...

Hi Rohit

First Value Trap can be for a individual investment but it’s not for the whole portfolio if you diversify enough (again there is no guarantee ex: Lot of people diversified among Junk Bonds / CDOs)

If you are concentrating your investments, you are NOT only betting on the discrepancy between price and intrinsic value, you are also betting capital allocation ability of management team and their integrity. (Even then they can make mistakes Ex: Buffet buying Textile Companies or Ajay Piramal buying NBFC companies)

The mistake is either your Capital Allocation ability (Decision to buy & concentrate this stock) or Management ability to allocate capital.

I will not too harsh on your capital allocation ability if you bought this as basket bet instead of concentrated bet given the Interest Rate and Inflation Rate between 2006 and 2011

Regards
Vishnu

Anonymous said...

dear rohit, i am invested in two companies- bimetal bearings and voith paper fabrics.
do u think , looking at the reserve cash at hand and share price r they value traps
otherwise valuations look good
thankx

sachin8778 said...

Rohit,
Great post as usual.

I would love to read your views on Piramal Health Care. Someone commented on Ajay Piramal buying NBFC itself as example of failed strategy, I don't agree yet. He has demonstrated excellent record on capital allocation over the years. Please share your thoughts, assuming you must have analyzed the company. Prof Bakshi has detailed post about it on his blog.

Sachin

Rohit Chauhan said...

hi anand
true ...especially in a rapidly growing economy makes sense to go for quality

rgds
rohit

Rohit Chauhan said...

Hi sv
done ..fixed the links

hi pradeep
thats the antidote ..being intellectually honest. and ofcourse not easy..but then good investing cannot be too easy

rgds
rohit

Rohit Chauhan said...

hi ravi
i have had some of the same value traps. the key was to exit when i realised i was stuck in one.

the other thing i noticed that i subsconciously did not create a large position as i was not too convinced.

on the other points ...i would go with a moderately growing company with high ROE. in such case if the management keeps raising the dividend then one will get reasonable returns - equal to the ROCE ...even if the PE remains the same.

I think balmer lawrie falls in that bucket and is not really a value trap.

on the other hand if the earnings are growing and management just sits or wastes the cash, then the stock will stagnate

i think we are saying roughly the same thing

rgds
rohit

Rohit Chauhan said...

hi subu

i really dont go by sectors ..but financials and infra are attractive

rgds
rohit

Rohit Chauhan said...

Hi karun/ sachin
I have read on piramal healthcare from the post by prof bakshi.

I read through it and found the logic convincing. at the same time its a bet on an individual - ajay piramal. i have invested in situations where the mcap was less than the cash and got stuck as the management just sat on the cash ...and the market does not like that - for ex: kothari products itself (though the business keeps making money)

so in case of piramal - we are betting on ajay piramal. i am not yet as comfortable to do that ...maybe later

i would not go by PE in such cases

rgds
rohit

Pravin said...

Hi Rohit,
really Good post, After burning my hands in stock market on speculative trading I am a new student to Value investing, I have started my journey of reading security analysis. Would you like me to suggest me few more books? .. many thanks for your reply in advance..

Anonymous said...

Rohit,
What you think of SRF and UniChem labs at these levels? Thanks
Gian

Anonymous said...

Hi Rohit,

Thanks for the detailed response. Well I have couple of followup comments. I brought out the example of Balmer Lawrie to talk about the growth in earnings. I agree it is not a value trap yet but likely to be one if the management does not deploy/distribute fast growing cash soon. Previously they deployed the cash in logistics which was high return business which helped. Now the management looks to slow to move and being a PSU that is expected. Tea and other loss making would continue to drag (as they cannot just get rid of it due to unions). Purely from market perspective and to some extent from value investor perspective it would be beneficial if there is big special dividend and they reduce their cash. I have never a PSU do share buyback so looks like a low probability event.
With regards to your comment on Piramal Healthcare I completely agree that it is a bet on an individual. Just like Berkshire holders bet only one Mr Buffet, its a bet on Mr. Piramal. While the market may be concerned about him sitting on cash for long time, I am not concerned as long as he has some plans for it (hope he does). Given his past track record, he is likely to invest only if he has a bargain and I like that compared to overpaying just because you have lot of cash. In my opinion, Piramal is a highly uncertain (low risk) and high return bet. Only time will tell if we have bet on the right horse. Well Ajay Piramal is the Jockey now who has sold his best performing horse and hoping to find another one which is young and can run fast. God knows if he will find a horse or a donkey. Track record suggests he would find a decent horse and hence the bet.

With regards to sitting on cash, I may sound biased with contrary arguments for Balmer and Piramal. But my rationale (or may be I am rationalizing) is that Balmer scores very low being a PSU with little known/unknown directors compared to Pirmal having a well accomplished director team (Independent directors may not really add value but its only hope) and Ajay Piramal with excellent track record.
I hold both positions and currently plan to add more of Piramal.
I really appreciate the time you take responding to every comment with sincerity. Just shows how much you enjoy this as it is not possible to do it if there is no passion.

Regards
Ravi

Anonymous said...

Hi Rohit,

What about companies having average or below average companies, not incurring losses but available at a considerable discount to valuation (lets say book value). Can they not be one time value opportunity? Definitely one would not have a very long investment horizon for such companies without above avg business prospect, but they can give decent returns in the intermediate term...

Regards,

Raj

Anonymous said...

About Piramal Healthcare - Both Graham and Buffett advice that the company should be a going concern with minimum 10 years of operating history and then a bunch of tests should be done to establish -
1. Company's past performance..including normalization.
2. For financial stability
3. For valuation reasons...
The other situation would be if one is looking at an arbitrage situation. I am a bit surprised that Prof. Bakshi is advocating investing in Piramal based on past record of Ajay Piramal. Its almost like he is saying trust Ajay, he has done good in the past and he will (might?) do good in the future??!!

NBFC's are headed southward and so I do not get the strategy of Piramal...if anyone has any ideas pls. clarify.

Regards,
Vidyanshu

jagadish said...

any views on these probable value traps 1.mangalam cement 2.avon corporation 3.veer energy 4.kriti industries. 5.birla precesion tech 6.kriti industries 7.ptl enterprises ltd.
Thx,
jagadish

Neeraj Marathe said...

Very well said Rohit,
I have been thinking on similar lines recently and me and Ninad have had quite some discussions on it..
Even very experienced investors i know have been trapped in stocks like ultramarine pigments..one needs to be extra careful indeed..
cheers!
Neeraj

kudva said...

The biggest value trap I've known is that house you purchase when you are 25. It just gives you a "wealth effect", grows at just about the rate of inflation and has a huge opportunity cost.

Rohit Chauhan said...

hi pravin
you can look at following classics of value investing to start with

- intelligent investor by benjamin graham
- common stocks and uncommon profits by phil fischer.

and finally go the the website of berkshire hathaway and read the letter to shareholders by warren buffett.


rgds
rohit

Rohit Chauhan said...

Hi gian
SRF ..if i remember its a bearing company ? good company but not cheap valuations

have not looked at unichem, but will do so

rgds
rohit

Rohit Chauhan said...

Hi ravi
great comment. on balmer lawrie i think the management is doing a decent job with hand which has been dealth to them ...they are allocating capital well and growing the company too ...it has gone from a 15% ROC to a 50% ROC company with decent growth. they are making money selling lubes, barrels and travel services which is not easy. so all in all it is a decent business

on piramal, its a bet on the person. i personally dont have the confidence or the insight to do that. once they make a move into a business i will re-look at the company. the downside is that i will lose some of the returns...but then i am reducing the risk of my ignorance

rgds
rohit

Rohit Chauhan said...

Hi raj
true ...such companies do have a place in the portfolio ..but one has to identify the trigger which will unlock the value otherwise, it could be a long wait

rgds
rohit

Rohit Chauhan said...

Hi vidyanshu
Prof bakshi is betting on the manager and as he has met him personally and it is possible he can judge a person well.

I have no personal access and really dont have good skills in judging management...so due to my limitations i have given the company a pass

rgds
rohit

Rohit Chauhan said...

jagadish
i have analysed only mangalam cement. the key to buying mangalam would be to buy at the bottom of the cycle ..otherwise the returns may not be very high. timing the sale and purchase would be critical here

rgds
rohit

Rohit Chauhan said...

Hi neeraj
same here ..my discussions with ninad has pushed me in that direction too. in addition i ran a personal experiment of a graham syle portfolio on the side along with a main portfolio and saw that the main portfolio of high quality picks beat the so 'called' cheap stocks.

one of those cheap ones was ultramarine :) ..only saving grace was i swallowed my pride and sold it

rgds
rohit

Rohit Chauhan said...

Hi kudva
well you and me are in the same boat on that and in a minority :)
first home is a necessity and after that it has a lot of cost, but then that is not a widely held view. everyone thinks real estate is the best investment option

rgds
rohit

Pradeep said...

I am doing some reading and found this link.

Thought of sharing:
http://moneymorning.com/2008/12/10/value-investing/

I will add point #11 to that list is to evaluate the future market. If the existing market is getting obsolete.