Value Trap

Over time, the most common measure of a stock's value or cheapness has been a low price-to-earnings ratio (P/E). But many investors who follow this trail often find themselves falling into the "value trap." To quote an old Japanese saying, "Yasukarou, warukarou—what is cheap may also be bad."

In an excellent article, (here) Amit Dugar explores the potential pitfalls of value investing and offers some practical guidance on avoiding the value trap.

An excerpt from the article :

The theory goes, with the cheaper share, investors are buying protection and lowering their risk. While investors expect a lot of future growth from a stock with a high double digit or triple-digit P/E, the market will often trash it at the slightest hint of trouble. On the other hand, the market is signaling it has low expectations for a stock trading at a single-digit P/E. Bad news is likely to have nowhere near the same impact on the low-P/E stock that it would have on the high-P/E one. The theory is that since the market has lower expectations, these stocks are more likely to show positive surprises in the future—with a greater likelihood of above-average returns.

In reality - some cheap stocks are dogs. That's where the value trap comes in. There are lots of examples of former high-flying growth stocks now selling for much lower P/E multiples than in the past. This does not necessarily mean that these stocks are now a good value. They may continue to fall, and may never recover. Without knowing their intrinsic values or possible catalysts for turnaround, you can't know whether they offer good value or not.

Notice the author talks of two important things here - 1. intrinsic value and 2. catalyst. I would like to talk a bit more about the catalyst.

A catalyst refers to an internal or external event (foreseeable or non-foreseeable) which dramatically moves the stock upwards or downwards. While we had explore a similar event like Siemen's one-time provision (post), the essence of a constructed catalyst (i.e. internal) is captured in the following items -

1. LBO (leverage buyouts) : When PE groups buy out publicly-traded companies and subsequently own them privately. The catalyst here is that speculation that certain publicly-traded companies might be ripe for picking by these private investors may increase the market price of their stock. An Indian example of LBO : KKR's acquisition of 85% in Flextronics (article in IHT)

2. Leveraged recapitalizations : are similar to LBO's in that such recapitalizations usually retire sizable amounts of the common stock of the publicly-traded companies involved, by buying it in the in the open market and replacing it with newly-issued debt. Unlike companies involved in LBO's, these companies' stock remains publicly-traded--but, again, speculation that XYZ Co. is going to do such a recapitalization will tend to increase the market price of its stock. My favourite case study on leveraged recap is the one on 'Sealed Air Case' (here)

3. Corporate split-ups : When companies divest part of their structure by giving such parts outright to the original companies' shareholders or selling the parts to other parties. Again, speculation of such deals will tend to drive up the stock price of those companies. There have been many split-ups in recent years with Reliance being the prominent example.

4. Huge stock buybacks : Many companies have been for years buying back their own publicly-traded shares on the open market. Of course, this buy-back activity tends to increase the market value of the stock by increasing the demand of the companies themselves for it. However, the investment community has grown a bit skeptic of buy-back announcement. Enclosed is a news article where UBS didnt term Dell's $10 bn buyback announcement as a catalyst (here)

5. Spin offs : The spin-off of a segment of the company that was not a good match with the rest of the company--is actually promoting future organic growth of the company. A recent Indian announcement was the proposed spin off of it's tower by Tata Teleservices (here).

These catalyst are instrumental in hiking or shunning the price of a share and value picks are no different. For any value stock to come out of a value trap, a catalyst is a must.