If defined by the popular media value investing is considered the practice of buying turnarounds and companies that have entered a state of perpetual decline with the hope they eventually recover. In many circles value investing itself is seen as a bit of a trap. Buying cheap companies with no growth doesn't seem like a way to grow a portfolio.
If one were to look at the investing universe from a cold and calculating seat in an ivory tower it might resemble a giant system that continually reverts to a mean. Stocks that go up too much eventually fall back down. Stocks that fall too much eventually rise back up. But why do companies do this?
Behind the bid/ask, constant stream of quotes, and ad-naseum discussions about abstract financial figures are businesses trying to sell products that solve customer problems. These businesses are run by people who are worried about keeping their jobs and keeping their customers. If margins slip some mythical shareholder might be angry, but if a key customer isn't given a deal an employee might hear about it at t-ball practice all week. In situations like this who do you think employees will favor, the faceless shareholders behind computer monitors, or those they interact with daily?
These real companies ebb and flow with the business cycle. Maybe a company creates a fantastic product that customers love and they're rewarded with sizable profits for a few years. Or maybe a once successful business decides to rest on their laurels for a decade too long and slips behind the competition. Either way the company's results are driven by their operations, whatever they are doing to satisfy their customers needs.
Investors are an emotional bunch. They get excited at the announcement of a new product and drive a stock senselessly higher. Or they panic because a company hasn't issued a press release in a few days and wonder if they are even still in business, or worse yet a fraud. The supply and demand dynamics of the market, along with fickle investor interest drive stock prices higher and lower than business fundamentals.
Eventually stock prices do tend to settle around a businesses fundamentals. This is mean reversion, the concept that eventually the price of a stock will trade close to the fundamental value of a business. If an investor buys at a point of pessimism and holds long enough they will be rewarded with a gain. If an investor buys into hype and holds long enough they will probably lose money.
A value trap is what happens when a company never reverts to the mean. The company never reverts because there is no mean to revert to, the company's business fundamentals have changed for the worse and the market is quick to reflecting it.
I think that retail provides the easiest examples of value traps. This is because popular opinion changes quickly in retail and what was hot one summer can be cold the next. Retail also exhibits significant operating leverage. There are certain fixed cost that needs to be covered at each store. The marginal sales above fixed cost fall almost straight to the bottom line. More sales equals more profits and better margins. Retail is a volume business.
Near us there is a plan to redevelop an old shopping center into a new Wal-Mart. Residents are against it claiming that Wal-Mart will drive all of our local companies out of business leaving us with chain stores and generic suburbs. I could argue that these residents don't realize that this generic utopia is exactly what Americans seem to want. Every exurb in the US looks the same, from the fake town square down to the same Costco, Chipotle, and Whole Foods. And the exurbs are growing fast as Americans trade their small character-laden residences for large faceless McMansions in McSuburbs that are all one of the 10 Best Places to Raise a Family.
The fact that Americans are enamored with cookie cutter living spaces isn't my point, it's that I have no sympathy for a business that Wal-mart closes. The argument against Wal-mart is that they shut down small companies who can't compete. Rephrased it's that Wal-Mart's prices are lower, and customers only care about price. It's true that most local businesses can't compete with Wal-Mart on price, but if a business is small and their competitive advantage (in their eyes) is low cost they have a problem. A company that has a niche, or offers something of value to customers beyond price alone will retain customers. People know the quality of goods that Wal-Mart sells. If I am looking to purchase something more or less disposable I don't mind buying it cheaply at Wal-Mart, but that's my expectation, it's cheap and will break.
What does this discussion of a local Wal-Mart have to do with value traps? Everything. The local Wal-Mart changes the local market business dynamics. Small companies who had a price advantage no longer hold one. The dynamic has changed forever. A local store that was a price leader will need to either change their business, or go out of business. There is no reversion to the mean for them, the dynamics have changed.
The residential outcry against the Wal-Mart has filled the news here with town hall meetings. My wife pointed out something that I thought was interesting. She noticed that almost everyone at the town hall meetings is in their 50s, 60s or older. Now this could be because residents in their 20s and 30s don't care about local issues, or it could be something else.
She followed this observation with the point that younger generations don't care about Wal-Mart because Amazon.com lives in our pockets. Why even go to a Wal-Mart when you can buy from anyone anywhere in the world with a simple click? For most items you can have them two days later. If a person is able to plan ahead slightly there aren't many regular purchases one needs faster than two days in the future.
While local residents are worried that the local Wal-Mart is going to put small companies out of business the younger generation is using a tool that has Wal-Mart worried. The life cycle in retail is short, who knows what might happen to Amazon. Maybe one day I'll be watching the news as they discuss what to do with the empty shell of an abandoned Wal-Mart.
A value trap is when a company begins to trade lower due to these structural shifts. Many investors ignore the shift, or discount it and claim shares are cheap. The structural shifts are important because most businesses have significant operating leverage. This means slight decreases in sales can translate into large losses. A business that's built to sell $5b worth of parts a year will struggle to slim down to a $500m a year business. Operational infrastructure in business is built with one thing in mind, growth. No one building a company thinks "if my sales were to drop 50% from a new invention how would I react, how do I build an organization to handle that?"
If a structural change is what causes a value trap then it seems like it should be easy to avoid them. Just avoid companies in the midst of an industry upheaval. That's easier said than done, companies with perfect earnings and great growth don't usually trade for low valuations. But companies in struggling industries do trade for low valuations.
One approach to investing in tumultuous industries is to follow the methodology set out by Benjamin Graham in Security Analysis. He recommended buying the leading company in a depressed industry. The rationale was that the industry leader almost always came through a crisis intact, and while they might not trade as low as other companies they would still be low enough that investors could make money. This is a very safe and sane approach.
What does one do when the situation isn't as clear cut? I think the best way to avoid a value trap is to ask yourself the question "under what condition would this company never revert to the mean?" The perfect investment is one where the company is fundamentally sound, but investors have a negative impression. All that needs to happen is investor psychology needs to change, and investors are fickle and quick to change, so it won't be long. If the answer to the question is long and involved it's possible you're dealing with a value trap. Q:"What needs to happen for RadioShack to revert to the mean?" A:"Ham radio, flip phones, Tandy computers and remote control cars need to become popular again." The likelihood of any of those things happening, or a completely company transformation happening are long shots.
You've probably noticed I haven't spent any time discussing financials up to this point. That's because I don't believe you can identify a value trap from a company's financials alone. One needs to look at the industry and the structural shifts first. Then secondly look at the company's financials. If a company is caught in the midst of an industry shift the best margins and best balance sheet won't mean anything except that the company will endure the misery longer than their competitors.