Recognizing and avoiding value traps

One of my favorite sayings from Charlie Munger, which he borrowed from the mathematician Carl Jacobi, is 'Invert, always invert.' My reversed questioning: In what way can I quickly ruin my investment portfolio? I only want to focus on value investing in individual stocks. If I were to broaden it to investing in general, I also come up with some points, such as:

• taking too much risk

• investing with borrowed money

• trading in products made by the counterparty, for example, CFDs

• chasing after prices

• following trends

• ....

In our small world of investing in individual stocks, value traps are the stocks that can significantly harm your portfolio. These are stocks that, at first glance, seem cheap, but rightfully so. Stocks that, for example, trade at a low price-to-earnings or price-to-book ratio but gradually destroy value. This can happen because they may be losing market share, experiencing declining profit margins, or hiding some skeletons in the closet. It can also simply be poor management with abysmal capital allocation skills.

Instead of the desired goal in value investing, where the stock price rises to the intrinsic value, the intrinsic value falls to the stock price.

These value traps are also the reason why investing in quality stocks is often the best form of value investing for most investors. I admit that I also seek most of my stocks at the intersection of quality and value, as Joel Greenblatt taught us in his little book. However, I won't pass up a deep-value stock or a special situation if it's clear enough.

How to recognize a value trap

There is only one true way to recognize a value trap, and that is by analyzing the company, its balance sheet, and the sector to which this company belongs. You should also be prepared for the occasional oversight.

For the ordinary investor, who often has to research investments before and after working hours or on weekends, this is often easier said than done. While managing money within the family is important, the partner, children, and family are even more crucial. The goal is to find a way to quickly separate the wheat from the chaff so that more time is left to enjoy what is truly important.

As the first method to quickly recognize a value trap, I think of the Piotroski F-score. Professor Joseph Piotroski developed a score based on three measures: profitability, solvency, and efficiency. The score is determined based on nine tests, each earning a point. I won't go into detail, but a score of 0 is poor and 9 is excellent. In practice, everything below 2 or 3 is especially to be avoided.

A similar score is the Altman Z-score. This score is developed to identify companies that may face financial difficulties and could potentially go bankrupt in the long run.

The problem with both scores is that you need the right tools to know them without having to calculate them yourself. Fortunately, these are now included in many software and screeners. For those looking for interesting screeners, Stratosphere.io, Chartmill, and Gurufocus are worth checking out.

Here are a few tips to recognize a value trap:

• Avoid stocks that involve fraud or inaccuracies in accounting.

• Be cautious with companies led by overly optimistic management.

• Exercise caution with companies in highly regulated sectors.

• Avoid stocks that have reduced or eliminated their dividends.

• Steer clear of stocks with a high level of debt.

• Exercise caution with companies in highly competitive sectors.

• Avoid stocks that have declined in price due to outdated products or services.

• Consider only profitable companies.

• Be cautious with cyclical companies; their valuation may appear cheapest when they are most expensive relative to their earnings, and they may seem most expensive when they appear cheapest relative to their earnings.

• Examine the behavior of insiders: are they buying or selling?

• Despite the price decline, is the underlying strategy of the company still intact?

What else can we do to avoid a value trap?

And here are some tips based on financial figures. This information can be found on the companies' websites, and in their annual reports, or you can use software and screeners for initial analysis, such as Chartmill, Gurufocus, or Quant-Investing.

1. Check if the company is profitable: Net Income should be positive.

2. Assess the level of debt using metrics like Current Ratio, Long-Term Debt to Assets, Total Debt to Assets, and Long term Debt to Equity and Total Debt to Equity. I prefer Total Debt to Assets or Total Debt to Equity, depending on whether it's a capital-intensive company or not. I prefer ratios below 65%.

3. For a company with a high dividend yield, also look at the payout ratio. This should remain below 70%.

As mentioned earlier, I caution against cyclical stocks because they may seem cheap when they are often expensive and vice versa. These are not value traps if they simply do their job and continue to grow on a normalized basis. It's important to learn to deal with this cyclicality and recognize these companies. You can even find interesting investment opportunities in them, but it requires a contrarian approach.

Not every Value Trap can be recognized (in time)

Not every value trap is recognizable, and sometimes changing market conditions can turn what initially seemed like a solid company into a value trap.

An example of a value trap where I suffered significant losses is Noble Corp. Noble Corp an operator of deep-sea oil drilling rigs. When I bought Noble in 2015, the sector was in a severe crisis.

In my opinion, there would still be demand for oil for a long time, and due to limited reserves, we would be reliant on offshore oil. At that time, Noble was one of the strongest companies in its sector, if not the strongest.

However, the crisis struck mercilessly; day rates were ridiculously low, causing all companies to bleed money. One by one, Noble's competitors fell. You might think this was favorable because Noble, as one of the few remaining, could set its prices, and that was also my idea. What I hadn't anticipated, though, was that due to the central banks' easy money policy, all the creditors of the collapsed companies chose, instead of liquidating, to let the companies go through Chapter 11. Existing shareholders were thus wiped out, and the creditors became the new owners. Anything was better than the alternative.

In this way, new companies emerged that didn't carry the heavy debts of their predecessors, while Noble bore that burden. They could outcompete Noble, who went from being one of the best in the class to the worst, as the last survivor of the old guard. I sold before Noble went bankrupt and recovered some, but it still hurt.

The difference between a value trap and a value stock is that the latter will ultimately return to higher prices. There is a catalyst that motivates people to buy shares, such as insider buying, the introduction of new products, or positive corporate results. A value trap exhibits none of these characteristics and is likely to face cash flow problems.

It's called a value trap because it's a trap. If everyone could recognize it beforehand, it wouldn't be a trap. However, the interesting aspect of investing is that you don't always have to be right. Our 'margin of safety' already covers us, but additionally, you can make money even if you are right only 6 or 7 times out of 10. As long as you pay attention to your companies, study the balance sheet, and stay informed about the news, you can avoid losing (a lot of) money.