WHAT ARE “VALUE TRAPS”?

“Is Microsoft stock a value trap?”
“PaperlinX is trading at 0.1x P/B. It must be cheap!”

“Value trap” is a term used in the investment management industry. It describes stocks that appear cheap, but the gap between price and potential value does not close, or, worse, widens. With this Elevation Capital Insights paper we have sought to explain the concept of value traps, and how Elevation Capital tries to avoid being “trapped”.

Case Study #1 – Business in secular decline1 (e.g., Newspaper, VCR, CD, Hard Disk Manufacturers)

In Y1, an investor might believe the stock is cheap and purchase it (P/E = 10x, P/B = 0.5x). However, as the company is in an industry in secular decline (newspapers, etc.), the value of earnings and assets are declining each year, therefore so is the stock price (Chart 1).

From a valuation perspective, the stock appears cheap, as it continues to trade at a low P/E or P/B. However, there is little hope that the company will be able to improve its earnings as its industry is in secular decline. Eventually, the investor is going to suffer permanent capital loss.

Lesson #1: Research the industry which the Company is operating in. Consider industrial trends, potential/new technologies, competitors, and barriers to entry that could affect the competitive landscape.

1 A secular decline trend is a long-term downward trend

Case Study #2 – Cyclical business (e.g., Steel and Housing industries)

For cyclical businesses such as steel mills and builders, the typically useful valuation metrics such as P/E ratio’s are likely to be misleading. It can be observed in the above table that the stock is trading at its lowest P/E in Year 4 (peak of the business cycle). If an investor purchases the stock at this time because it is trading at a multiple of only 5x P/E, he/she is going to regret his/ her decision. As the economy slows down, the company’s earnings suddenly disappear, along with the dividend yield!

Lesson #2: Elevation Capital utilises Price to Book and 7yr average Price to Earnings ratios to value cyclical stocks. We calculate the 7yr average earnings to provide ourselves with an estimate of the Company’s average earnings throughout a business cycle. We then calculate the P/E ratio based on the average earnings to provide ourselves with a guide as to whether the stock is undervalued or not.

Case Study #3 – High Debt Level + Recession

A business with a high level of debt can typically operate comfortably when the broader economy is growing. However, as soon as the broader economy slows down, interest payments can become a significant burden on the Company. Earnings are reduced, and the stock price will likely decline as investors realise that the company might have problems servicing its debt, with the increasing prospect of insolvency (Chart 3).

Lesson #3: Avoid companies with high debt levels. At Elevation Capital, we primarily invest in stocks that have Shareholders Equity to Total Assets > 50% to avoid this potential risk. This means the shareholders own more of the company’s assets than the bond/debt holders. We take this one step further by typically writing off goodwill & intangible assets, as these can quickly disappear from a balance sheet if a company has overpaid for past acquisitions.

Case Study #4 – Is this a value trap? (e.g., Microsoft)

In the above table, we see a Company that has grown its earnings and book value significantly over time. However, the market seems to not recognise the Company’s success. The stock price has remained the same over this time period. This is what happened to Microsoft. The stock traded at $27.35 on 28/6/2002, and nine years later, it traded at $26.59 on 30/6/2011, a decline of 2%. During the same period, Earnings Per Share (EPS) has increased by 284%.

Lesson #4: Was Microsoft stock a value trap for the investor who invested nine years ago? no - they just didn’t listen to the Dean of Value Investing, Benjamin Graham’s timeless advice on not buying a stock with a P/E above 16x*.

Conclusion:

In this paper, we have tabled general situations where an investor might become “trapped” when making investment decisions solely on valuation metrics such as P/E and P/B ratios, without considering other factors such as industry landscape and company-specific issues.

At Elevation Capital, we use P/E and P/B ratios to screen potential investment opportunities that are undervalued. We also spend a considerable amount of time and effort in analysing other important qualitative and quantitative factors before we make investment decisions. We believe that this approach has the highest probability to both protect investors’ capital and offer superior returns over the long-term.

John Tsai

john.tsai@elevationcapital.co.nz Research Analyst
Elevation Capital Value Fund

Disclaimer:
Elevation Capital Management Limited, its directors, employees and agents believe that the information herein is correct at the time of compilation; however they do not warrant the accuracy of the information. Save for any statutory liability which cannot be excluded, Elevation Capital Management Limited further disclaims all responsibility or liability for any loss or damage which may be suffered by any person relying on any information or any opinions, conclusions or recommendations contained herein whether that loss or damage is caused by any fault or negligence on the part of Elevation Capital Management Limited, or otherwise.

* According to Benjamin Graham, P/E of 16x should be “the maximum one should be willing to pay for an investment”. on 28/6/2002, the MSFT stock traded at a P/E of 30x (2003 earnings). on 30/6/2011, it traded at a P/E of 9.7x (2012 earnings).

Disclaimer: 

Elevation Capital Management Limited, its directors, employees and agents believe that the information herein is correct at the time of compilation; however they do not warrant the accuracy of the information. Save for any statutory liability which cannot be excluded, Elevation Capital Management Limited further disclaims all responsibility or liability for any loss or damage which may be suffered by any person relying on any information or any opinions, conclusions or recommendations contained herein whether that loss or damage is caused by any fault or negligence on the part of Elevation Capital Management Limited, or otherwise