As value investors, our main goal is to find a company trading at a discount to its intrinsic value. Outperformance and a sufficient margin of safety can only be established through this search of value. It’s basic buy low, sell high.
However, looking for an opportunity such as this tends to attract stocks that are trading at a discount for a good reason. The presence of a value trap can ensnare investors, and lead otherwise profitable strategies into turbulent waters.
Risk management is an often overlooked aspect of the investing world, and it entails more than just a simple diversification solution. Every investor must face the same simple fact. An individual position that records a loss must often gain a much higher percentage return in order to break even.
For example, a 10% loss on a stock requires a subsequent 11% gain in order to break even. The discrepancy raises as the losses become bigger. A much larger 50% loss requires a full 100% gain to break even, and a 75% loss requires 300% returns to break even.
As we can see, the presence of substantial losses, or drawdowns, in our portfolio greatly hinders our ability to create an outperforming portfolio. The simple principles of mathematics thus make losses more substantial than gains, and force an investor to focus more on limiting losses than maximizing gains. At least an intelligent investor would do such a thing. It turns out, this reverse focus mindset fares very well in other competitive fields.
One of the great chessmasters recently shared that his secret to success lies in a reverse focus mindset. While most other chess players focus their energy on the opening strategy, this chessmaster studied the end game instead.
He soon discovered that no matter which ending scenario the game turned to, he was able to adapt and dominate his opponent through his sheer mastery of the end game. He went on to become one of the greatest chess players of his time.
Investors can also study the “end game” of an investment, as it pertains to a value trap or value opportunity. At the end of the day, a stock has two possibilities. One is that it continues to be traded on the exchange and life goes on.
The second possibility is that a stock goes bankrupt. It is this second possibility that disturbs me the most, and is most detrimental to a successful value investing strategy. The gain required on a 100% loss is infinite. That’s money that is lost forever. As you might already know, some of the best looking opportunities are actually value traps, and it’s a value trap that turns into a bankruptcy that causes the most damage.
Looking back at some of the most shocking bankruptcies of the past, I was able to quickly comprehend just how deceiving a value trap can be. In late 2008, Lehman Brothers seemed to be a fine value play through many income statement valuations, with a P/E below 15 and a P/B below 2. In the same token, a company like Borders looked like a strong value play to some narrow minded investors, who saw the consecutive dividend increases and low price to book valuations as signs of a strong opportunity for profits.
Instead, both companies went bankrupt. An investor who faced these losses also had to face the prospect that this kind of a scenario could happen again, without warning or insight.
Yet a prudent investor would look at these situations as opportunity for learning. While these companies looked attractive on the basis of a few select valuations, a bigger picture analysis would uncover that Lehman Brothers also carried a debt to equity of 29, and Borders had recorded negative earnings for over four years.
If we were to look at other value trap bankruptcies, we’d hope to find predictable symptoms that show that these deceitful traps are actually easily avoidable if you know where to look.
Value Trap Research Results
Turns out, this is exactly what I’ve found. Knowing that the value investor’s greatest threat is a value trap, I took a backwards approach and tried to study the worst case scenario of any investment: the bankruptcy. By examining the 30 biggest bankruptcies of the 21st century, I was able to discover that not only are value traps quite predictable, but many of the bankruptcies had the same symptoms. If we know the symptoms of bankruptcy, we can greatly reduce exposure to them.
With this valuable information, I took the most common symptoms and formulated a number based indicator to decipher value situations. By looking at all three financial statements, the income statement, balance sheet, and cash flow statement, I pulled the most important valuations from each and incorporated them into the indicator. This had the net effect of flagging any company that had even one poor valuation metric. This might seem like a strict condition, but consider how just one valuation tipped investors off to Lehman Brothers’ perilous situation.
With a solid foundation of seven categories, and a wide coverage of the most important and bankruptcy predictive valuations, the Value Trap Indicator would’ve avoided 29 of the 30 bankruptcies examined, a full 96% accuracy rate.
The information from the bankruptcy research clearly identified the two biggest possibilities of a value trap turning insolvent. These were the presence of negative earnings (annual), and a high debt to equity relative to the average.
The average debt to equity of any stock on the major exchanges is usually around 1. Any company with a much higher debt to equity ratio was increasingly at risk to bankruptcy, as was a company with a combination of negative earnings and higher debt to equity.
So by avoiding these situations, a value investor can greatly increase overall return and limit major drawdowns. This has the double effect of keeping an investor in the companies that are profitable and successful, thus increasing probability for out-performance by principle as well.
If I can just leave you with one great idea as a result of this blog post, it’s to not underestimate the destructive power of a value trap. Learn how to avoid exposure to them. Research and personal experience help, but a reverse focus mindset and an outside-of-the-box approach fares much better.