How to spot a value trap - and 2 sectors where they are prevalent

Spotting a cheap stock is something most investors could do with their eyes shut. Spotting a cheap stock that presents good value and can grow over time is not always so easy. Value traps, as they are so called, often appear to be cheap on the surface but don't end up delivering strong capital returns. They may pay great dividends too but their fundamentals end up disappointing investors in the long run. 

For value-aligned investors like Hugh Selby-Smith and the team at Talaria Asset Management, it's especially important to avoid these. And while Selby-Smith is keen to point out that growth traps are far more painful than value traps, the latter still sting hard.

Recently, Selby-Smith shared the Talaria team's thoughts on the macro landscape, some of their top conviction calls, and how they avoid value traps. 

The big-picture view

Talaria's overarching macro view is that equity markets are still priced for perfection. They expect corporate earnings to de-rate over the next 12 months.

"Our view is that the lagged impact of monetary policy is going to continue to see economies slow," Selby-Smith said. "In aggregate, we would expect corporate profits to decline going forward," he added.

There has also been a serious bifurcation between stocks and bonds. This question came up when the team started to notice that benchmark bond yields were sitting stubbornly in the 3-4% range even though the equity market continued to power higher. So how do they reconcile the difference between the two?

"Maybe it's because fiscal profligacy (wastefulness) has started to seep into the bond market," he said with reference to the idea that government spending became reckless during the COVID-19 pandemic. "The market is obsessed with monetary policy but if you have a look at actually what's contributing to GDP growth and liquidity, it's really this dramatic change of the fiscal outlook."

"The bond market's starting to sniff that out and that's why bond yields haven't come down even though inflation's effectively halved," he added.

To back up this bearish view of the markets, Talaria is holding nearly 20% cash in its portfolios while arguing that the mix of equity winners over the next 10 years will likely be drastically different from the last 10. 

On America and Japan

The S&P 500 has surged nearly 20% so far this year despite the key set of leading economic indicators continuing to trend downwards. Talaria's house view is that the divergence is a signal of a major disconnect between market participants and the real economy.

The fund owns no IT stocks but its two biggest positions are US-domiciled healthcare names Gilead (NASDAQ: GILD) and Johnson & Johnson (NYSE: JNJ). 

"The American market is expensive in aggregate at the index level," he said before adding:

But that doesn't mean we haven't been able to uncover areas that are continuing to be relatively cheap and that are seeing some structural change," Selby-Smith noted.

That was a natural segue to the Fund's winning positions in Japan. The country now makes up 13% of the Fund's regional allocation.

"Japan has been an extremely good performer over the last six months to the end of June. That was an area of the market that we were getting exposure to and significantly increasing over the last 24 to 36 months," he said. Nikkei-listed Nippon Telegraph & Telephone Corp (TYO: 9432) is the fund's 10th-largest position. 

Value traps and how Talaria avoids them

A quick recap of what value traps are. These are investments that are trading at such low levels and present as buying opportunities for investors but are actually misleading. Often, a stock's low price is accompanied by extended periods of low multiples as well. 

Other signs of a value trap include consistent share price underperformance, high debt-to-equity ratios, and inefficient capital allocation. For most Australian investors, the best value trap example that comes to mind is Telstra (ASX: TLS) which has never risen above $10/share as a public company (and fell to just $2 at multiple points).

So how does Talaria avoid value traps in its investment process? Primarily by establishing an anti-mortem. To illustrate this, Selby-Smith uses an example involving McKesson (NYSE: MCK), an American pharmaceutical distribution company.

"What we don't want to do is say this [stock] is only ever going to be this and it's earning 10 times P/E today and [that] it'll be 10 times P/E in five years time," he said.

"We're looking for where people have extrapolated and haven't looked and actually underestimate their earnings capability to the company as well," he added.

Two sectors with value traps

As bottom-up stock pickers, Talaria doesn't go out of its way to establish investment ideas in sectors where there are depressed values (or for that matter, avoid entire sectors with extreme growth traps). But the team has noticed certain sectors tend to have a greater range of outcomes than others.

For one, retail. 

"We've done very well in retail but equally, there are several retail stocks that we put through that anti-mortem process and saying this is progressing in a way that we don't like, that have continued to go down a lot since we cut them," he said. 

"You're talking about fashion risk, you're talking about the quality of a retailer, you're talking about operational gearing because of leases," he added. "When you get store rollout and positive commerce, it's a very, very virtuous circle. But when it goes the other way, the market says every incremental dollar you're spending is at a lower and lower return."

Put another way:

"There will be a Roche (SWX: ROG) business in 20 years now but there's plenty of retailers that won't be with us in 10 years."

Another sector laden with traps in their experience has been technology.

"There's a lot of fantastic companies in technology but many of them don't come through the screen because of their valuation. And [for] the ones that come through, the range of outcomes is very, very wide.

"Say a security software company would be one that we recently talked about. It appears to be growing quite a bit slower than some of the peers. Why is that? Oh, that's a mixed issue between exposure to small business rather than enterprise or larger customers. So how do we validate that? It's actually very hard to validate that."

Even a company as large as Apple (NASDAQ: AAPL) makes Talaria's team pause for thought. Sure, it wants to get into the AI trend while it's hot. But Talaria has some questions.

"Is that growth CAPEX or is that maintenance CAPEX because they don't do it? Where's Apple's business in 10 years? Do you put a growth multiple on that or do you think about that as growth, etc?"

Talaria favour strong balance sheets and the ability to generate high levels of free cash flow relative to valuation. With this in mind, Selby-Smith pointed to healthcare as a significant winner in recent years.

The fund currently holds French pharma giant Sanofi (EPA: SAN) and Swiss counterpart Roche. It also holds Novartis (NASDAQ: NVS).

"Healthcare has been an extremely absolute dollar generator of return for our investors," he added.