By Datuk Eu Hong Chew
IF you have been following news about fundamentals-based investing, you would likely have come across the term ‘”value trap”.
A value trap happens when a stock appears inexpensive but it is actually cheap for a reason. The trap springs when the real reason for it to be cheap surfaces. What you thought was an investment opportunity turned out to be a dud.
“Value trap” is such a common phrase that you would have thought that there would be a general understanding of what the phrase meant. However, a survey of the top 100 websites ranked by Google for the phrase “value trap” showed that there are differences in interpretation.
The results showed that there are some who consider value trap as an investment that is cheap relative to its historical price. This could either be viewed from an individual stock perspective or from a fund or index perspective.
There are even some sites that confuse the picture further. These talk of value traps as being cheap based on historical prices as well as some multiples.
We can agree that comparing the historical prices is wrong. This is merely speculation, hence should not be thought of as a value trap. The “true” value trap should be comparing price with the value as determined by the fundamentals, commonly referred to as intrinsic value.
However, it is no surprise that not all agree on what is the best way to assess intrinsic value.
The survey showed that 61% of the top 100 sites use some form of market multiple to assess intrinsic value.
Avoiding value traps
How does the surveyed group think about avoiding a value trap? There are two groups when it comes to avoiding a value trap.
- Those that advice you to look at fundamentals either directly or using a set of factors
- Those that don’t mention fundamentals but advice some form of diversification
There are two interesting points:
- The group that viewed a value trap based on comparing it with historical prices. The majority here advised checking with fundamentals to avoid value traps.
- Those sites that used multiples to assess value traps. Of these, 80% of them said that investors need to consider other factors and fundamentals in order to be conclusive.
From a fundamental perspective, valuations are based on assumptions about the future. If your assumptions are not based on reality or if there is a black swan event that affects the prospects, then you could have a misleading valuation.
How do you avoid such cases? You need a good valuation approach. But more importantly, ensure that the assumptions are built up from detailed business analysis.
What is a value trap really?
If it is cheap relative to market prices, then it should not be called a value trap.
You are buying into the company because you think that the market has got it wrong based on price information alone. I would call this a “price trap”. If you have invested because it is cheap relative to some price benchmarks and the price dropped further – too bad as you were speculating.
But it is cheap relative to your assessment of its intrinsic value – and you are wrong about its intrinsic value – then it is a value trap. In other words, you were wrong about the “cheapness”.
But, if it is cheap relative to its intrinsic value which has been estimated correctly, it cannot be a value trap. It is a bargain.
Being wrong regarding “cheapness”
I can think of two scenarios when it comes to being wrong about the “cheapness.”
- Firstly, even though the price is significantly lower than the intrinsic value, the market continues to misprice it. There is no fundamental reason for the price to be lower than its intrinsic value. Any mispricing is because the market has not recognised the value. Now whether the market will recognise the mispricing is another story but market mispricing per se should not be the criterion for a “value trap”.
- Secondly, you could have made a mistake in assessing the intrinsic value. You could have used some inappropriate valuation methods. Or you could have assessed the fundamentals wrongly. In this case, it was not cheap in the first place. This is the real value trap.
Like most issues in investing, there are different interpretations of “value traps” as shown by the survey results. While there are a lot of challenges in investing, the least you should do is to get the correct picture of a value trap.
Value traps and bargains are two sides of the investing coin and as such, it is key to fundamentals-based investing. It should be assessed by comparing the current price to intrinsic value and not historical price. – Feb 2, 2021
Datuk Eu Hong Chew was on the board of I-Bhd from 1999 till 2020. As Group CEO, he led its transformation from a digital appliance manufacturer into the developer of i-City, the Selangor Golden Triangle.
This article was re-purposed from “An Effective Way to Screen for Value Traps” that was first published on i4value.asia. Refer to the article for more details of the list of websites covered in the survey and the method.
The views expressed are solely of the author and do not necessarily reflect those of Focus Malaysia.