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As a value-oriented investor ascribing to the principles of Benjamin Graham, Warren Buffett, and others, one must be careful to avoid “value traps”. This blog is intended for intermediate investors and students of finance. I will explain what a value trap is, how to identify one, and hopefully, help readers avoid getting caught in one.

Definition. A value trap is an investment that appears “cheap”, enticing an investor due to its low valuation, but it has a material weakness or risk. If the risk or weakness comes to fruition, the investment’s estimated “margin of safety” would disappear.

Identifying value. Value investors often run screens, searching for attractive investments. Common value investor stock screens search for attractive valuation metrics such as: low P/E (price / earnings), low P/B (price / book value), low P/CF (price / cash flow), or high dividend yields. The first step in ferreting out a value trap is verifying the calculations and valuation metrics.

Careless investors may not catch poor data or errors that create false positives. The following are examples I have seen in the past, even by Wall Street research analysts as they too can rely on third party data providers. Examples include: using incorrect shares outstanding (particularly if there are multiple classes of stock, or a recent capitalization event), using a “pro-forma” or GAAP earnings figure, which is not normalized, or incorrectly annualizing a figure such as a special dividend. Please verify the initial metric(s) that appeared attractive.

Next, gain a better numeric understanding of the company and valuation metric, which may explain the identified discount. The explanation could be a high level of debt, significantly changing earnings from period to period, or inflated asset values, which the market is discounting. For example, a company with a price to earnings for the last twelve months of say 7.5x may appear cheap, but upon comparing it to analyst consensus earnings estimates for the next twelve months when earnings are expected to be cut in half, that multiple would expand to 15x, hardly the bargain it first appeared to be. Another extreme example would have been a financial stock prior to the financial crisis of 2008. Some financial stocks appeared to trade at a discount to book value, however, that was due to the asset values of loans and other financial instruments not reflecting their risk and lower fair value. Investors who bought when the discount appeared without recognizing the likelihood of asset write-downs and related deleveraging efforts would have suffered significant losses.

After the initial metric has been validated, develop a complete financial picture of the company. Evaluate additional multiples and metrics compared to the company’s historical performance, projected performance, and against comparable companies. Trading at a discount to the comparables price to earnings multiple could be explained if instead the company is richly valued on a price to cash flow basis, due to the firm’s high capital expenditures. Develop analyses and evaluate ratios beyond valuation multiples such as operating metrics, efficiency ratios, or long-term models such as discounted cash flows, abnormal earnings, or a leveraged buyout scenario to further evaluate attractiveness.

Value traps often can go from cheap and attractive to very expensive and ugly, plummeting in value and leaving the investor feeling stuck or trapped. Not unlike a bear in the woods who comes across an enticing feast, and instead finds their foot between the sharp teeth of a steel trap, perplexed, thinking ‘how did I fall for this?’, and writhing in significant pain.

How to Possibly Avoid Getting Trapped. David Einhorn, head of the hedge fund Greenlight Capital wrote in his book, “Fooling Some People All of the Time”, “When we buy something, we generally do not know who is selling. It would be foolish to assume that our counterparty is uninformed or unsophisticated.” This added humility, should also raise the hurdle of conviction necessary to go against a market opinion. Numbers and valuation are often just the first part of a strong investment thesis. The analyst’s next responsibility is to understand all of the risks and opportunities, whether they are industry, economic, regulatory, strategy, capitalization, or operational that may cause the market to discount the value of the company. By reading company filings, analyst research, discussing with the company’s merits with other investors, and other news, one can begin to understand the expectations that the company will be measured against. Concerns may be justified and the investment should trade a large discount, or risks may be overblown, and the investment is truly a great opportunity. Understanding the perspective and expectations of others is imperative if the discount and margin of safety will hold and ultimately generate positive returns.

Mental and behavioral finance biases must also be kept under control when bargain hunting to avoid value traps. In particular, after identifying an investment that is trading at a steep discount or attractive valuation, further evidence and justification for that discount could be ignored and an investor instead only focuses on the cheap valuation. Furthermore, if the investment begins to decline due to operational missteps and underperformance, the investor must quickly adapt and decide if their initial valuation and analysis must be updated to reflect the new realities and performance.

An Example and Lesson Learned.

At this point I am going to offer an example of an investment mistake I made, and a value trap I fell for. The example is from a few years ago, and in hindsight, it is clear to see where I went wrong. The investment was Blackberry (at the time Research in Motion, NASDAQ: RIMM), the enterprise leader in smart phone and mobile devices.

I often screen for price to earnings multiples of 12x or less. At approximately $75 per share, and having earned $7.50, Blackberry was trading at approximately 10x trailing earnings, with a clean balance sheet. I saw the Company’s brand and enterprise leadership position as assets. The valuation appeared enticing.

What I did not appreciate or sufficiently factor into my analysis was a shift in consumer preferences and IT departments changing their policies. The trend of bring your own device (BYOD) emerged, as consumers preferred touch screen displays and universe of apps available through Apple and Google. As Apple and Google improved their security credentials, IT departments changed their policies for their workforce, allowing employees to just carry one device and access company email and servers through their personal iPhone or Android device rather than the company issued Blackberry. Apple, Samsung, HTC, Motorola, Nokia all had smart phones, but what in my experience and mind made Blackberry different, was its relationship with business customers. Blackberry also remained popular outside of the U.S. and Canada, even if U.S. consumers were switching to Apple and Android devices. Alas Blackberry’s enterprise stronghold and reputation as the best mobile device provider for business was no longer the moat it had been. Coupled with various strategic and operational missteps, Blackberry’s sales and profitability began to decline precipitously.

I was enticed by the low price to earnings multiple and surplus cash, and I did not fully understand the trends, risks, and financial impact of the rapid emergence of competition to Blackberry. By following Blackberry and this market, I gained a knowledge and understanding to go long Apple and lessened the impact of my loss from Blackberry. Making mistakes is inevitable in the investment business, but learning from those mistakes will allow you to improve your methodology and investment process to avoid making the same mistake again.

Disclosures and Disclaimers:

This article is for informational and educational purposes only. This article is not a solicitation, offer, or recommendation of any company or securities mentioned herein. CCM, its clients, and/or its principals may have an economic interest in investments mentioned.