Posted on June 11, 2012 // 25 Comments

“Who would join a Facebook chat around investing on a bright Saturday morning?” I asked myself while preparing for the latest session of Safal Niveshak’s Facebook Jam on June 9.

I opened the session for questions at 9 AM, but the first question came only at 9.16 AM. So my fears were coming true. But then, the speed at which people came in and the intensity at which the discussions progressed, it was an amazing feeling by the time the jam ended at 11 AM.

Click here to read the transcript of the jam. The next session will be held on coming Saturday, 16th June, between 9-11 AM.

Anyways, the reason I’m talking about the Facebook Jam is that this is one platform where I’ve encountered the best questions around investing over the past four weeks since it all started.

Like in the last session, one of the avid readers of The Safal Niveshak Post asked, “What are the risks involved in value investing?”

“Wow!” I exclaimed as this is one topic that I’ve never discussed on Safal Niveshak in the past, despite the importance it holds for all value investors out there.

You see, in our love for something, we often tend to ignore the pitfalls…the dangers that this love life might lead us to. This is also true of value investing .

Value investors, so much consumed in finding ‘value’ in the stock market generally overlook some big risks that might lead them to incorrect judgments.

So, what are those risks that value investors face day in and day out…and might easily ignore in their pursuit of value?

Here are three that I have personally encountered over the past five years of being a value freak (and many value investors out there might vouch for the same, plus add to the list):

1. Falling into ‘value traps’
2. Mis-assessing cash flows and margin of safety
3. Acting on frustration at not finding ‘value’

In this post, I’ll discuss the first of these risks, keeping the other two for the next two posts.

Falling into ‘value traps’

The most widespread saying in stock investing is “buy low, sell high. But this is easier said than done.

There are times when stocks that are beaten down unfairly can create some of the best opportunities if you have patience.

But then, there are times that a stock, even after a drastic fall in its price, continues to slide despite cheap valuations.

This kind of stock is what is known as a value trap, whereby the stock appears to be cheap because of low multiples of price-to-earnings (P/E), price-to-book value (P/BV), or even cash flow. Investors looking for a bargain buy into such a company only to never see the stock price improve again.

Just because value investors are so focused on the ‘cheapness’ of the stock’s price, they ignore the ‘cheapness’ of the underlying business…

• Rising competition that’s eating into profits due to reducing entry barriers for new players.
• Declining overall sector growth that’s putting a cap on the future growth.
• Volatile earnings that is set to hurt future growth and expansion.
• Rising debt on the balance sheet that can create problems in case of a slowdown.
• Poor management that’s destroying capital.
• Management aggressively pursuing acquisitions that can put the entire business at risk of going down.

All these factors that value investors might ignore in their intoxication of having found a “great stock at a great price”, can set the bait for the perfect value trap.

A classical argument before falling into a value trap is – “The stock has already fallen by 90%. How much more can it fall?”

Well, a stock that fell from Rs 100 to Rs 5, first fell 90%and then another 50%. As simple as that!

Take a look at banking stocks as of now. When you are investing in a bank, you are actually investing in a leveraged, blind investment portfolio (of loans, advances, and treasury investments) and the investment portfolio is invested by bankers.

Its just very hard to have an accurate value because they hold so many assets, and the assets they hold are not always clear.

In case of PSU banking stocks specifically, while most of them appear “cheap” as of now (in fact, they have been cheap for quite some time now), I have a lurking doubt that most of these are value traps given that they are sitting on huge potential NPAs (property and agriculture loans) that may create havoc anytime in the future.

P/E and value traps

Most investors I’ve seen falling into a value trap have been those who believe that a stock with a low P/E (price-to-earnings) presents ‘great value’.

You see, P/E’s aren’t a perfect measure of value. A company that is small and growing fast may have a very high P/E, because it may earn little but has a high stock price. If the company can maintain a strong growth rate and rapidly increase its earnings, a stock that looks expensive on a P/E basis can quickly seem like a bargain.

Conversely, a company may have a low P/E because the business is going downhill and there are signs of greater trouble in the future.

In such a case, what looks like a “cheap” stock may be cheap because most people have decided that it’s a bad investment.

Such a temptingly low P/E related to a bad company is called a “value trap.”

Take a look at this P/E chart of Suzlon Energy (during the volatile phase of January 2008 and March 2009), and you’ll understand the concept better.

Data Source: Ace Equity

Avoiding value traps

The simple way to avoid a value trap is to not concentrate on its stock price or valuations much but do a strong due diligence…not just into financial metrics, but also in the operational aspects of the business…like its competition, management quality, and competitive moat.

Here are a few key questions you must ask yourself before attempting to catch a falling knife (a falling stock that appears cheap):

1. What are the odds that this company will not be around ten years from today?
2. What is the company’s sustainable competitive advantage that no competition can take away from it?
3. Is the management overly optimistic about the future?
4. Are the company’s products getting out-dated?
5. Is the company’s balance sheet getting messy (with rising debt and working capital)
6. Will I be happy to see the stock fall 50%? (This is the ultimate test for an investment. If you will be happy to buy a stock at half of today’s price regardless of the short-term noise, simply because you know that the company is intrinsically strong, that’s a good sign…and usually not a value trap.)

If getting answers to these questions worry you, don’t worry!

You will get the answers to all these questions when you study the company – its quarterly reports, the annual reports, and the management’s vision for the future.

Always remember, the (stock) price is what you pay, but it is the “value” that you get. So be clear of the value you are getting. Avoid falling into a trap.

I would love to hear your opinions on whether you have encountered any value traps in the past, and the lessons you’ve learned from falling in such traps.

P.E. If you havent already, sign up for my free 20-lesson course in value investing on the essential pillars of becoming a successful investor, Safal Niveshak-style. In this course, I talk about simple investing strategies that will work for you, and make you a smarter and successful investor.