Value Traps: How to avoid bargain stocks that might never recover

When Warren Buffett raised his stake in Tesco in 2012, little did he know that he was breaking one of his own investment rules. He’d initially taken a position in the UK retail giant some years earlier. After a profit warning and news of increasingly fierce competition, Buffett chose to buy more shares as price started to slide. It was an error that eventually forced him to take a £287m loss on what had turned out to be a classic Value Trap.

With Tesco, Buffett showed that Value Traps can open up in front of even the smartest investors. Yet these disappointments are a particular risk for investors looking for a bargain. The bargain hunter’s favoured territory is the deepest, darkest corner of the market. It’s here that unloved, broken and misunderstood companies languish. In amongst them lie the turnarounds and contrarian plays that can deliver stellar returns if they rehabilitate. But also lurking are the value traps - stricken stocks that may either never bounce back or make you bear too much opportunity cost to make it worth the wait.

Deep value - the domain of the value trap

‘Deep value’ is an investing approach that was born in the writing of Benjamin Graham. Chastened by the losses of the 1929 stock market crash, Graham hatched a completely new brand of security analysis. He shunned the expensive ‘glamour’ stocks of the day in favour of unpopular shares that sold below their 'intrinsic value'. Importantly, he insisted that these potential dogs were priced so cheaply that there was a healthy ‘margin of safety’ in the price. With a well diversified portfolio, he reasoned that he could absorb a number of inevitable losers but ride out profitably on a wave of winners.

Graham’s value strategies have earned him a great deal of respect. But one of the risks of taking his approach is becoming overexposed to stocks that are risky and perhaps on the brink of bankruptcy.

Seth Klarman is one of the best known modern day investors to have modelled an approach on Ben Graham’s ethos. He’s become a billionaire through his stewardship of Baupost Group and even wrote a book called Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor.

In his 2012 letter to investors, Klarman pinpointed the subtle risk of falling into a Value Trap. He wrote that a bargain price is necessary but not sufficient for making an investment because sometimes securities that are superficially cheap turn out not to be:

‘Value traps’ are cheap for a reason - perhaps an inept and entrenched management, a poor history of capital allocation, or assets whose value is in inexorable decline.

These hallmarks and others have long been the driver of academic and industry endeavour to find a way of weeding out Value Traps. Professors and professionals alike have looked for ways of stacking the odds in favour of finding value shares that are more likely to recover.

Joseph Piotroski, an American finance academic, did just this in 2000 with the development of his F-Score of corporate financial health. Crucially, the impetus for his work was a finding that less than 44% of a basket of the cheapest stocks in the market go on to deliver a positive return over the next two years. Essentially, Piotroski was saying that if you’re blindly picking stocks at the cheapest end of the market, your chance of picking one that will recover is well below 50/50.

How to step over a Value Trap

Of course not all deep value stocks are going to end in business failure. But statistically, this is one of the most dangerous places to be in the market - the domain of broken business models and sectors in cyclical or secular decline. Some companies will fail, while many others will simply languish for prolonged periods. The key lesson is to give loss making, out of favour, cheap shares a wide berth unless they start to show confirming factors. The two most powerful indicators of recovery are Momentum and Quality.

Improving share price momentum has earned a reputation as the first sign of a recovery in risky value shares. Josef Lakonishok spent decades researching and then putting into practice a strategy of using Relative Price Strength as a signal that a bargain stock was on the mend. Similarly, Joseph Piotroski’s F-Score of fundamental momentum specifically looks for an improving financial health trend.

When it comes to quality, one of the most famous Quality + Value approaches is Joel Greenblatt’s Magic Formula. Ranking the market using two metrics: Earnings Yield and Return on Capital offers a way of finding cheap stocks with strong operational efficiency and profitability (see the Magic Formula screen here). Even Buffett offers a lesson on introducing quality to a value strategy by using ROE, ROCE and margins, and examining the consistency of the financial history.

Don’t make the same mistakes as Buffett

Warren Buffett spent a good part of his 1989 letter to Berkshire Hathaway shareholders reflecting on his past investing mistakes. His message carried a warning against the folly of excessive bargain hunting - something he called the ‘cigar butt’ approach to investing:

A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit. Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original “bargain” price probably will not turn out to be such a steal after all… Second, any initial advantage you secure will be quickly eroded by the low return that the business earns.

Twenty-five years later, he was owning up to his mistakes again - this time with Tesco. While it may not be a classic cigar-butt share, is is another example of how an apparently cheap stock can be a distraction from the signs that a business is facing challenges on many fronts.

Everyone loves a bargain, but the lesson here is that too much focus on buying ‘cheap’ without a consideration of company quality can risk underperformance. At best it can lead to the prolonged agony of waiting for value to ‘out’ - if it ever does. A preferable approach is to avoid this corner of the market and turn instead to classes of value shares that have the profiles of Turnarounds and Contrarian plays. Next up we’ll take a closer look at the strategies that can be employed to find them.