A Fool deconstructs what a 'value trap' really is.
My title this week is deliberately a little misleading because I don't mean by it what superficially it appears to mean. I'm not saying that you should try to avoid value traps -- I'm saying that I'm not convinced value traps exist. Consequently, you should not necessarily accept this description of a share as used as a criticism by some investors of a particular share they don't like and suggesting thereby that it should be avoided.
Okay, the first step to my destroying the credibility of the value trap is to define it. What people mean by this is that a value share, which they acknowledge genuinely is such, will turn out to be a perpetual value share because it will never out. The share looks attractive on the usual numbers but those numbers will remain that way. Thus, an investor will become trapped in the holding, which despite showing clear value features, simply remains in that state and thus the anticipated profit never materialises.
Value investing relies on the expectation that a share is in an unsustainable situation. The theory is that it's too cheap as judged by common investment measures, and sooner or later the market will have to do something about that. When it does, the value player cashes in. Genuine cheapness just isn't permitted to remain that way indefinitely. Sometimes this goes wrong and the value is outed on the downside. For example, the asset value is sharply reduced, dividends cut, net cash balances turns into net debt, earnings fall and so on.
Either way, though, whether a profit or loss ensues, it is when value has evaporated sufficiently that the investor will sell and on balance over a many trades I would expect this to be at a profit. The value trap criticism, though, is employed when it is believed that the value never will evaporate but it will more or less remain the same. Cheap stays cheap. Value stays value.
Give it time
One difficulty with value investing is the time scale required. I've written repeatedly that the patience of a fossil is required to follow this strategy because there is just no knowing when a share will out. So the investor has to be prepared to wait for a considerable period, possibly many years. It's not an approach for those who lack the necessary perseverance.
But I don't see how anyone can know if a share is a value trap as an investment for the future, unless they are judging this by its past. And as the fund ads say, the past is no guide to the future.
Suppose you come across a decent-looking value play. Then you look back and find that it has stood on a similar value rating for some years. Some might conclude that it is a value trap because if you had bought it back then, the crucial outing required to score would have eluded you and you would have made nothing, maybe just some dividends. Does this mean that you can extrapolate that lack of outing into future years? Not in my view.
It could out tomorrow or not for many years. You don't know, just as you don't know with any value share, but I don't see that the share in question is any less of a value investment due purely to having remained on a low value rating for a considerable past period. I don't think that value investing is made more profitable by adding the filter of the length of time that a share has stood at value, giving a higher merit to those that have more recently acquired this status.
What's it to you?
To follow the strategy, in my view you have got to believe that all value shares will out, while accepting that some will inevitably out on the downside. No trading strategy wins on every trade. But what you don't have to take any notice of are those value shares described by some as traps. There are no value traps, there are just value shares that haven't outed yet.
All this assumes you have found the fundamental value criteria and ways of assessing a play that you have proven to work for you. If a share then meets your requirements, go for it and don't be distracted by anyone describing it as a value trap because it hasn't yet outed over a long past period. If it had outed, it wouldn't be a value share in the first place.
Simply by investing in value shares, you have already taken the decision to exercise extreme patience. But what do you do if a long time later, a share hasn't outed so you've made nothing? Well, you could eventually run out of even the patience required of a value investor, call it a value trap in exasperation and sell, especially if you see a better opportunity elsewhere and need the money to reinvest. That doesn't mean it really was a value trap, just that you ran out of patience. The next guy may well be another value investor to whom it's a new holding. Or, you could go on holding it forever because even after several years, you still cannot know when it might out.
I can understand the situation of selling a value play after years of frustrated holding. But that's after the fact, you've given it what you regard as a fair run and it has done nothing. However, those using the term 'value trap' usually do so when making a prediction, a warning against investing in a share now, and it is that usage which I don't really accept. I don't think there are any value traps at the stage of investing in a share. There are just unouted plays waiting to be outed.
http://www.fool.co.uk/news/investing/2012/08/30/dont-fall-into-the-value-trap.aspx