How To Build A Value Trap Free Deep Value Portfolio

This guest post on how to build a value trap free deep value portfolio was written by Net Net Hunter member Jonas Åström. Jonas is a private investor from Stockholm, Sweden. Article image (creative commons) by Skitterphoto, edited by Broken Leg Investing.

Have you ever heard of an activist investor getting involved in a company only to lose money for shareholders? I hadn’t either until I watched a large chunk of cash I invested in Solitron go up in smoke.

I couldn’t believe it. An activist entered the company I had been considering and won a proxy fight, pushing out the CEO. It was everything I could wish for. It was the event that would revive Solitron and unlock the true shareholder value.

My initial euphoria slowly evaporated when I learned that the cost to sack the CEO was very high, and my net net wasn’t a net net anymore thanks to the CEO’s greed. I told myself that this incident was only a minor blip in my journey with Solitron, and that from now, it would turn into the great investment it was destined to be. I mean, the rest of the stocks in my net net portfolio were huge successes; this one had to become one, too. Right? So, I stuck with it and didn’t review my analysis.

I knew that I had bought a company that was burning its assets, but I hoped that the activist would manage a turnaround of the company within my two-year investment horizon. I was DEAD wrong: the company burned assets quicker than expected and the NCAV dropped below the stock price. I eventually did exit the position, but how could I have been so wrong in my analysis?

I now realize that I had stumbled upon a value trap.

A value trap is a stock that trades cheaply on typical value multiples (P/B, NCAV, PE, cash flow, etc.) and looks like a bargain, but it becomes a value trap when the price of the stock stays low for a very long time or even keeps falling from the initial purchase price.

If we can avoid, or at least reduce, the number of value traps in our portfolio, we can boost its performance a lot. Before I start listing the typical value traps, I want to point out that your investment time horizon is a very important parameter. For example, if you employ a strategy that sells a stock after two years no matter the outcome, you need to judge all the below criteria against that holding period. A value trap is normally not perpetual but time bound, and timing matters.

Value Trap? Understand The Real Issue

Obviously, there are many reasons why a stock becomes a value trap, and the below list is not exhaustive but a starting point for the most common reasons. Investors are often looking for catalysts that will make the market re-evaluate the situation and trade up the stock price, but when we are talking about how to analyze deep value stocks, the price is its own catalyst.

There are many reasons why a stock gets so cheap that it becomes so undervalued that we call it a deep value stock. The primary reason is normally a big problem, and you need to make sure that this problem can be fixed within your investment period.

For example, if the reason is worries about a company’s ability to refinance its debt, you’d better be sure that the company will be able to refinance and that it will happen within your holding period. Therefore, our first rule is:

Understand why the stock got cheap in the first place and make sure it can get resolved within your investment horizon.

Net Net Never Traded Above NCAV? Possible Value Trap

If your deep value stock is a net net you bought at 50 cents on the dollar, you’d better verify the history of the stock price and compare it to its historic NCAV values to see if it has traded above NCAV in recent years. There is evidence that there are “semi-permanent” net nets, and we’d better avoid them.

Assure that the net net’s stock price has traded above its previous NCAV values sometime in the last three years.

Management-Controlled Company? High Risk Of Being A Value Trap

If a company is controlled by management (more than 50% of voting shares), it is a warning sign and needs to be investigated. There are multiple examples of CEOs who happily keep running the company as it always has been run without any intention of making changes to improve the operating or financial situation. They are fat and happy, and they keep on collecting their (often very high) salaries. It is unlikely that there will be a change in management, and you’d better invest your money somewhere else. Under those circumstances, it is unlikely to see a correction of the stock price.

Avoid management-controlled companies.

Deteriorating Assets Lead To Value Traps

If you base your stock appraisal on the company’s assets (e.g. NCAV), it is crucial that the value of those assets doesn’t get reduced. The value of the assets can decrease either by write-downs of inventories or fixed assets — that’s why we love cash and receivables over everything else — or by the company consuming the assets due to bad operation. Therefore, we love increasing assets — cash in particular — but we avoid deteriorating assets.

One-time events that cause a reduction in assets are fine, but we shouldn’t invest in a company that burns through its assets too rapidly because we will lose our margin of safety very quickly. How to analyze deep value stocks is best done by considering:

Maximum allowed asset burn rate is 20%.

Activist Investor? Low Risk Of Being A Value Trap

Management often is the pure and sole reason that a stock becomes undervalued in the first place thanks to their lack of strategy and execution. Then, your best friend becomes an activist or a group of investors that takes a large stake in the company. They get one or more seats on the board, and they start to force changes. Those changes can be splitting up a company to unlock value, shuffling management, forcing stock buybacks, increasing dividends — or maybe even shutting down the company. They are your friends to unlock true underlying value.

An activist investor with a large share of the company is a strong buy signal.

Insider Buying? Buy Alongside The Insiders

In investing, you always want management’s incentives to be aligned with yours. Therefore, you want management with skin in the game — you want them to own lots of stock. To be significant, the stock holding should be at least three times their total yearly compensation package.

Owning stock is an important signal, but an even more important signal is when the company is going through tough times and they add to their holdings. Nothing is better than insiders buying lots of stock with their own cash. Options as part of their compensation package are not as valuable — in addition, they are also diluting shareholders. If management thinks as owners and not as management, you know that they will do everything possible to sort out the issues. You also want to make sure that there is no selling, only net buying of stocks.

Management should hold three times their annual compensation package in stock and add to their holdings.

Debt Level Is Critically Important For Avoiding Value Traps

Low debt is not an indicator of better returns, but high debt level is a very good indicator of bankruptcy. If a company’s debt level is high, then Mr. Market will be very cautious to pay a high price — particularly if it is a lousy business. We’d best stay away from deep value companies with high levels of debt.

There are several important debt ratios you can use when deciding how to analyze deep value stocks to limit potential value traps. The most important one is interest coverage ratio. It is defined as EBIT/(Interest expense), and a ratio of 1.5 and lower is when lenders really start to think that the risk of default is too high.

Interest coverage ratio higher than 1.5 times.

So, Is It Possible To Completely Avoid Value Traps?

No, but if I had employed the above checklist, I would have been able to avoid Solitron in the first place. There were so many warning signs, but I was desperate to add more net nets to my portfolio, so I gave in on quality and that cost me lots of money. Don’t repeat my mistake — use the above checklist and really learn more about value traps. Net Net hunter and Broken Leg Investing are great resources and can help you as well to improve your deep value portfolio’s performance.

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