Sometimes stocks are cheap for a reason

There's nothing better than a discount, and nothing better than beating the crowd. Well folks, welcome to value investing - where everything is on sale! But as with shopping, sometimes stocks are on sale for a reason, but it takes research and a process to decipher whether you're getting a good deal. 

Take AMP - an Australian darling turned horror story. For the last two years, investors have been topping up their allocation to this company, hoping for a turnaround story. A bit of research would have told you that AMP in fact had many underlying issues and was in fact, cheap for a reason. 

So how do you tell a good deal apart from a trap? In part 2 of this three-part collection, I asked two value investors about how they define and identify a value trap. 

Responses come from: 

• Justin Koonin, Allan Gray Australia Equity Fund 
• Michael Goldberg, Collins St Value Fund 

To get the reward, you need to do the research 

Justin Koonin, Allan Gray Australia Equity Fund 

A value trap is a stock that looks to be a bargain at face value, but does not go on to perform well. Often, these stocks trade on a low multiple – relative to the market, or to history – of valuation metrics such as price to earnings, price to book, or price to cash flow.

These metrics can be useful guides, but they come with limitations. First, these are often ‘point-in-time’ metrics, which do not always give useful information about future performance. Second, everyone else in the market has access to more or less the same tools and screens. There is little competitive advantage in simply following the herd; we believe that you can’t invest in the same way as everyone else and expect to outperform.

From a contrarian perspective, it can be dangerous to allocate capital purely on the basis of the results of a screen. For us, there is no substitute for detailed internal analysis of a company. Our analysis looks at a range of potential future outcomes for the company and tries to get a sense of the probabilities of different possible future paths.

There is no use in opposing consensus merely for the sake of it. To outperform the market, not only do you need to do something differently to the market – you also need to be right! At least, you need to be right more often than you are wrong (after all, none of us can predict the future with any certainty) – and/or the size of your wins needs to be greater than the size of your losses.

It is constantly humbling to invest in a contrarian manner. You need to be willing to look wrong, and foolish, while the market disagrees with your decision. But if your analysis of a stock is correct you can be rewarded over the long term.

You're not buying last year's income at today's price 

Michael Goldberg, Collins St Value Fund 

A ‘value trap’ is where a stock has been sold off extensively for good reason. Yet, based on historical earnings and historical outcomes (which are all that are reported on a lot of retail broking platforms) the stock may appear to be trading on very attractive price to earnings multiples and nose bleed dividend yields, but the reality is you aren’t buying last year’s income at today’s price.

For large cap stocks there is always the opportunity to back out of the trap (albeit after taking a bit of a hit) given the liquidity, but at the smaller end of town the trap can become a lot more dangerous with delistings, prolonged periods of suspension from trading and questionable capital management initiatives.

Value traps are often characterised by broken business models, weak balance sheets with limited or reluctant shareholder support for new capital raisings, systemically challenged operating environments underpinned by onerous legislative changes and worse.

A classic example of this is AMP. This is a company that has been on a steady decline for 2 years now and which really has proven itself to be little more than a falling knife…..one that unfortunately many contrarian investors cut their hands on.

For these reasons research is absolutely essential for any value investor. Afterall, as the old saying goes, when someone with money meets someone with experience, the person with the experience gets the money and the person with the money gets the experience!

Stay tuned for more