Premium Value Investing NewsletterDownload Free Issue

3 Big Risks in Value Investing – Part 1

“Who would join a Facebook chat around investing on a bright Saturday morning?” I asked myself while preparing for the latest session of Safal Niveshak’s Facebook Jam on June 9.

I opened the session for questions at 9 AM, but the first question came only at 9.16 AM. So my fears were coming true. But then, the speed at which people came in and the intensity at which the discussions progressed, it was an amazing feeling by the time the jam ended at 11 AM.

Click here to read the transcript of the jam. The next session will be held on coming Saturday, 16th June, between 9-11 AM.

Anyways, the reason I’m talking about the Facebook Jam is that this is one platform where I’ve encountered the best questions around investing over the past four weeks since it all started.

Like in the last session, one of the avid readers of The Safal Niveshak Post asked, “What are the risks involved in value investing?”

“Wow!” I exclaimed as this is one topic that I’ve never discussed on Safal Niveshak in the past, despite the importance it holds for all value investors out there.

You see, in our love for something, we often tend to ignore the pitfalls…the dangers that this love life might lead us to. This is also true of value investing.

Value investors, so much consumed in finding ‘value’ in the stock market generally overlook some big risks that might lead them to incorrect judgments.

So, what are those risks that value investors face day in and day out…and might easily ignore in their pursuit of value?

Here are three that I have personally encountered over the past five years of being a value freak (and many value investors out there might vouch for the same, plus add to the list):

  1. Falling into ‘value traps’
  2. Mis-assessing cash flows and margin of safety
  3. Acting on frustration at not finding ‘value’

In this post, I’ll discuss the first of these risks, keeping the other two for the next two posts.

Falling into ‘value traps’
The most widespread saying in stock investing is – “buy low, sell high”. But this is easier said than done.

There are times when stocks that are beaten down unfairly can create some of the best opportunities if you have patience.

But then, there are times that a stock, even after a drastic fall in its price, continues to slide despite cheap valuations.

This kind of stock is what is known as a “value trap”, whereby the stock appears to be cheap because of low multiples of price-to-earnings (P/E), price-to-book value (P/BV), or even cash flow. Investors looking for a bargain buy into such a company only to never see the stock price improve again.

Just because value investors are so focused on the ‘cheapness’ of the stock’s price, they ignore the ‘cheapness’ of the underlying business…

  • Rising competition that’s eating into profits due to reducing entry barriers for new players.
  • Declining overall sector growth that’s putting a cap on the future growth.
  • Volatile earnings that is set to hurt future growth and expansion.
  • Rising debt on the balance sheet that can create problems in case of a slowdown.
  • Poor management that’s destroying capital.
  • Management aggressively pursuing acquisitions that can put the entire business at risk of going down.

All these factors that value investors might ignore in their intoxication of having found a “great stock at a great price”, can set the bait for the perfect value trap.

A classical argument before falling into a value trap is – “The stock has already fallen by 90%. How much more can it fall?”

Well, a stock that fell from Rs 100 to Rs 5, first fell 90%…and then another 50%. As simple as that!

Take a look at banking stocks as of now. When you are investing in a bank, you are actually investing in a leveraged, blind investment portfolio (of loans, advances, and treasury investments) and the investment portfolio is invested by bankers.

It’s just very hard to have an accurate value because they hold so many assets, and the assets they hold are not always clear.

In case of PSU banking stocks specifically, while most of them appear “cheap” as of now (in fact, they have been cheap for quite some time now), I have a lurking doubt that most of these are value traps given that they are sitting on huge potential NPAs (property and agriculture loans) that may create havoc anytime in the future.

P/E and value traps
Most investors I’ve seen falling into a value trap have been those who believe that a stock with a low P/E (price-to-earnings) presents ‘great value’.

You see, P/E’s aren’t a perfect measure of value. A company that is small and growing fast may have a very high P/E, because it may earn little but has a high stock price. If the company can maintain a strong growth rate and rapidly increase its earnings, a stock that looks expensive on a P/E basis can quickly seem like a bargain.

Conversely, a company may have a low P/E because the business is going downhill and there are signs of greater trouble in the future.

In such a case, what looks like a “cheap” stock may be cheap because most people have decided that it’s a bad investment.

Such a temptingly low P/E related to a bad company is called a “value trap.”

Take a look at this P/E chart of Suzlon Energy (during the volatile phase of January 2008 and March 2009), and you’ll understand the concept better.


Data Source: Ace Equity

Avoiding value traps
The simple way to avoid a value trap is to not concentrate on its stock price or valuations much but do a strong due diligence…not just into financial metrics, but also in the operational aspects of the business…like its competition, management quality, and competitive moat.

Here are a few key questions you must ask yourself before attempting to catch a falling knife (a falling stock that appears cheap):

  1. What are the odds that this company will not be around ten years from today?
  2. What is the company’s sustainable competitive advantage that no competition can take away from it?
  3. Is the management overly optimistic about the future?
  4. Are the company’s products getting out-dated?
  5. Is the company’s balance sheet getting messy (with rising debt and working capital)
  6. Will I be happy to see the stock fall 50%? (This is the ultimate test for an investment. If you will be happy to buy a stock at half of today’s price regardless of the short-term noise, simply because you know that the company is intrinsically strong, that’s a good sign…and usually not a value trap.)

If getting answers to these questions worry you, don’t worry!

You will get the answers to all these questions when you study the company – its quarterly reports, the annual reports, and the management’s vision for the future.

Always remember, the (stock) price is what you pay, but it is the “value” that you get. So be clear of the value you are getting. Avoid falling into a trap.

I would love to hear your opinions on whether you have encountered any value traps in the past, and the lessons you’ve learned from falling in such traps.

P.E. If you haven’t already, sign up for my free 20-lesson course in value investing on the essential pillars of becoming a successful investor, Safal Niveshak-style. In this course, I talk about simple investing strategies that will work for you, and make you a smarter and successful investor.

Print Friendly, PDF & Email

About the Author

Vishal Khandelwal is the founder of Safal Niveshak. He works with small investors to help them become smart and independent in their stock market investing decisions. He is a SEBI registered Research Analyst. Connect with Vishal on Twitter.

Comments

  1. Investment Questionnaire says:

    Thanks for sharing the investment risks. I totally agree with your points. We must take care of “Falling into ‘value traps’”…. Most companies do value traps.

  2. Mansoor says:

    Anyone who knows the price of everything and value of nothing is moving towards value trap. Good article Vishal.
    Yes, if it’s a mistake, I have done it, not proud though. Orient Abrasives was one such investment. You look at the financials for the past 8-9 years, great. Growth has been great year after year. Dividends were great. D/E was in control. Out of the blue, the sales dropped, profits dropped and stocks although available at a bargain, totally not worth the investment.

    • Thanks for your comment Mansoor…and thanks also for sharing your case of Orient Abrasives. Falling in a value trap serves as a great lesson for any investor to avoid similar (and bigger) mistakes of commission in the future.

  3. karthik says:

    vishal…

    Value traps.. especially in the space of smaller PSU banks…
    ex: central bank,Punjab and sind bank,united bank

    Dont know. but all these seems are from eastern region and branches are highly concentrated.. these are value buys.. but i feel more in the trading perspective..

  4. vishal,

    as usual one more fantastic article…
    just to present different view on banking stocks..believe many of the annual reports of banks carry elaborate report on risk management outlining risks involved in every type of asset class, risk models used to quantify the risk factor and related value at risk reports etc….so it is not really bad …may be knowledge or time deficit of individual investor stops in taking calculated risks…

    • Thanks for your feedback, Sri! Indeed you are right. Banks have to present extensive disclosures in their annual reports, which they do. But comprehending the risks on their unending (and varied) investments is what worries me.

      Plus, given my experience in interacting with the treasury teams of some banks (mostly PSUs), most of them bet a large amount of their allocation to stock markets on risky, speculative, momentum stocks…because most of them are chasing “instant” returns).

  5. @karthik
    central bank of India is having headquarters at Mumbai and not small PSU bank.
    Punjab & Sind Bank is headquartered at New Delhi and recent entrant in equity market.
    Only Bank from eastern region is United Bank which is headquartered at Kolkatta.

  6. vishal ji,
    //Plus, given my experience in interacting with the treasury teams of some banks (mostly PSUs), most of them bet a large amount of their allocation to stock markets on risky, speculative, momentum stocks…because most of them are chasing “instant” returns).//

    we will discuss this whenever we meet in mumbai.
    banks do have clear cut laid down investment policy
    besides i think there is rule that equity allocation cannot exceed 5% of incremental deposits…though in absolute terms, money may be bigger but when compared to their whole asset size, it may not pose such great risk.
    anyway, we will surely take this up later.

    • Hi Sri…surely we can discuss this when we meet. I am planning to organize a workshop in the city…will keep you updated. As for the investment policy of banks, yes that’s clearly laid out. But I was talking about their allocation to stock markets, which is more in the lines of speculation than investment. Of course, as you mentioned, the allocation is not big enough to cause any major trouble when things go wrong…but the speculative instincts just show where the treasury guys are coming from 🙂

  7. vikrant says:

    Vishal,

    my question is how to you find the answer’s of the questions. These questions would not be answered in the balance sheet so what do we need to know to do to find the answers apart from the 6th one? because that is something that would change for everyone.

    • Vikrant, when you work towards understanding a company well, the answers to all these questions follow through. The answer to the 6th question will depend on your conviction about the company and about the depth of your research on it.

  8. Avadhut says:

    Hi Vishal,

    Very well written article and thanks for the Suzlon example.

    My question is – What happened to the company’s financials or operations that affected PE in period Aug 08-Oct08?

    Secondly, if this was a good “value” buy between Aug08-Oct08, it should be a good buy for the next 10 years also as per this article. Do you still think Suzlon is a good “Value” buy?

    Regards,
    Avadhut

    • Hi Avadhut, the company started facing several pressures starting that period – its windmills started falling :-), plus its financial performance also took a hit led by its over-stretched balance sheet.

      As for the term “value buy” I’ve used in the chart above, it was to suggest that people thought that the stock got cheap during that period…and I know a lot of people who thought it was a “value buy”. But in fact, Suzlon was a “value trap” because despite the stock’s cheap valuations, the stock was still risky because the business itself was going downhill.

      I’ve never liked Suzlon as a company and a stock, and maintain my view. 🙂

      Regards,
      Vishal

  9. Hi Vishal,

    Have you written the the next articles in this series?

  10. I dont think all the points mentioned above are related to risks value investing.Points 1,2,3 & 4 are irrelevant when buying cheap value stocks.You need to price in these 4 points into the risk you are taking by buying cheap stocks.

    The biggest risk, as far as I see, is the lack of trigger for unlocking the value for a very long time.Say for example if you buy a stock at 50% intrinsic value, if it moves to 90% in 2-3 years its a good bet.But if it takes 5-6 years for this to happen you loose a lot of money in terms of opportunity cost.

    • Rakesh, here I’m reminded of what Charlie Munger says – “Investing is where you find a few great companies and then sit on your ass.” The 6 points I mentioned will help you find those few great companies 🙂

  11. My first Value-Trap : –
    1) Voltamp Transformer:
    I entered this stock in 2009 when the PE was around 6 and EPS was 100+, RoCE – 63% (2009) had an impressive rise in its sales, profit and RoCE from 2003 to 2009. But from late 2009 onwards PE has jumped from 6 to current 16 and EPS from 100+ to current 26 (drastic performance). It’s a debt free company, pays a good dividend.
    The stock price has come down nearly by 40% of my investment price.

    • Keyur,

      I am in the same boat with Voltamp, Not sure what needs to be done with this stock now. I have very small portion of my folio in it.

  12. Hi Vishal, Have you written the next article in the series? Thanks.

Trackbacks

  1. […] Investors have to know that everything that’s cheap is not necessarily a sound investment. There are value traps to watch out for. […]

  2. […] Led by higher advertising costs, the company’s profitability is on a consistent decline. This – declining margins – is one of the key factors to identify a potential value trap. […]

Speak Your Mind

*