VALUE TRAPS CAN SUCK THE LIFE OUT OF YOUR PORTFOLIO
Here’s how to differentiate duds and how to avoid them, Martin Pelletier writes.
With both domestic and international equity markets in correction mode this year, investors may be tempted to step into many of the value opportunities that are currently developing. While we are contrarians by nature and try and seek out such opportunities ourselves, one of the golden rules when taking the opposite side of the consensus view is to be very aware of the so-called value trap.
A value trap begins when an investor is enticed by a large discount multiple a company is receiving in the market, only to discover that the discount is there for a reason. For example, a management team might have a history of eroding value, such as through a misaligned acquisition or poor deployment of capital, and will continue to make poor decisions, driving the share price down further, awaiting the next unsuspecting investor.
For those already sucked into the trap, pulling the trigger on an exit can be very difficult as it’s much easier to believe management’s promises that things will get better than it is to realize you made a bad decision and lock in a large loss.
A value trap isn’t something that catches only inexperienced investors either: I’ve encountered it myself and witnessed it among many fund managers in Canada. However, the differentiating factor is the top managers will quickly acknowledge they’ve made a mistake and exit the trap before the damage gets any worse.
Fortunately, there are a couple of things an investor can look for to determine if an investment is a trap or not.
1)
Problem? What Problem?
One sign that you have stumbled into a value trap is when the market reacts quite negatively to an announcement and yet management refuses to recognize there is a problem, or adopts a “the market is wrong and we’re right” mentality. Smart management teams will quickly acknowledge when they’ve erred and take immediate action to correct it. This means proactively reverse engineering potential outcomes by researching other similar situations to come up with a plan to quickly get them back on course.
2)
Strategy drift
We’ve seen this situation — divergence from a core strategy — most often when a company does an acquisition that is too large and disruptive to their core operations while not having the appropriate capital structure in place to onboard the target properly. The share price gets hammered during the implementation period and the company has no choice but to undertake actions that will further erode shareholder value, such as substantial asset sales or a large dividend cut.
Instead, the better management teams know their own limitations and will often pass on those larger deals in favour of more “tuck-in” acquisitions that will be easier for their company and themselves to digest and unlock incremental value.
3)
Management track record
If management has a history of making poor capital allocation decisions, then it is best to stay away. Imagine that you are giving them your own money to invest directly in their operations — you would want to ask, what have they done with previous investor’s capital?
While the assets of the company may look attractively valued, having the wrong management team can turn a good asset into a bad one in short order.
A high turnover or departures of key members of the senior management team such as the COO or CFO is another sure sign of trouble. Trying to get a pulse of employee morale can be quite useful — there are some interesting online tools such as Glassdoor that can help.
Finally, look at management compensation and ownership and tie it back to their performance. If there isn’t a link then there is the chance that they will take on extra risk, since it’s your capital at stake instead of theirs.
Of course, sometimes the market does get it wrong and true value opportunities arise. While you should always be on the lookout for them, remember that it is much easier and a lot less painful to avoid a value trap than it is to exit one. Martin Pelletier, CFA, is a portfolio manager and OCIO at TriVest Wealth Counsel Ltd, a Calgarybased private client and institutional investment firm specializing in discretionary risk-managed portfolios as well as investment audit and oversight services.