A value trap in most cases is a truly undervalued stock but it lacks a catalyst to unlock the value quickly.
Investors do not like to tie up their capital in a stock for a long time with no performance to show for. There is an opportunity cost of the money and a long wait also may indicate that the company is not working to create shareholder wealth. Some investors may also be unsure of their investment thesis and therefore get anxious if the time to profit extends beyond a few months or years.
How to Avoid a Value Trap?
Value traps are very hard to figure out in advance. It is not easy or possible to predict the future of a stock. However, one can increase his or her chances of avoiding a value trap by any combination of the following:
- Insist on a catalyst: A catalyst such as resolution of a legal proceedings, replacement of the management, a new contract getting signed, FDA approval of their drug candidate, etc makes the investors take notice of the changed prospects of a company. This increased attention will force the value in the stock to surface, as majority of the time it lay dormant due to lack of investor attention.
- Look for industries undergoing structural changes: If there are structural changes in the industry such as a large number of new incumbents, mergers and acquisitions, market disruptions, product replacement cycles, a sector recession, etc. it becomes unlikely that an undervalued stock will remain undervalued for long. When there are large number of sophisticated buyers looking for cheap assets to buy for capital gain, or to improve their own market position, value traps cannot exist
- Avoid dual share class companies: Many times a company may have 2 different classes of stock, with the management owning a class of stock that gives them unduly large amount of voting rights. These companies are not very attractive to activist investors as it is unlikely for them to buy into a board seat or two to push their reform agenda. Stock of these companies may remain undervalued for a long time.
- Is there an activist on the board?: Activist investors can force a company to take actions that create and release trapped value in the stock. If there is one or more activist investors on the board or with a large ownership in the company, it is very likely they may force the company to act on the behalf of all the shareholders. This could also mean taking extreme actions such as liquidating a company and returning wealth to the shareholders, that an entrenched management may not want to do.
- Is this an evergreen sector?: Being a value trap in a fast changing industry or sector may mean that the company may not be able to keep up with the pace of the change and go out of business before the shareholders can receive any value for their investment. Most investors tend to avoid old school industries and sectors as they fear that an undervalued stock may stay that way for a long time in these industries. In reality, old school industries provide a long enough runway for the so called value traps to become value releasers.
There is no such thing as a permanent value trap
Bold statement, perhaps, but an undervalued stock will always become profitable given enough time, as long as the company does not destroy value during this time.
Industries change, technologies become obsolete, and businesses die all the time. A company that survives does so by adapting and innovating their way out of a changing market place. In some cases, this may take a long time, and in some other cases maybe not that long. Do you as a shareholder have the patience to wait for the value to come back to you?
The worse case scenario for most value investors is when they invest in a greatly undervalued stock – and then the company proceeds to destroy more shareholder value over time and the investors never really warm up to the company. An incompetent management team is often the culprit. If you have sufficient capital to buy a seat on the board of the company, you can force changes in the management and break out of this value destruction cycle. However, if you are an investor that is unable to or unwilling to go against the entrenched management, you should try and avoid undervalued companies with bad management.