Unmasking The Value Trap

A value trap is a situation in which an investment appears to be undervalued based on traditional valuation metrics. They may be trading at low price to earnings ratio or price to book ratio or higher dividend yield but the stock price continues to decline or remains stagnant for an extended period. The article takes a closer look at how value trap works and how it can be avoided 

In the bustling city of Mumbai lived a young and ambitious investor named Ravi Raskar. Ravi had always been fascinated by the world of finance and had a keen interest in exploring various investment strategies. He had heard tales of great investors who had amassed tremendous wealth by following the principles of value investing. He was especially inspired by Warren Buffett, referred to as the ‘Oracle of Omaha’, whose investment approach is heavily influenced by value investing principles. Buffett’s story of buying See's Candies is often cited as an example of his value investing principles. He purchased the company in 1972. [EasyDNNnews:PaidContentStart]

Although See’s Candies was a relatively small acquisition, it became a highly profitable investment for Berkshire Hathaway over the years. Intrigued by the idea of identifying undervalued stocks with great potential, Ravi set out on his own investment journey. He analysed the current market and saw that value theme was greatly outperforming the Nifty 50. Since the start of 2020, Nifty Value 50 has moved up by 105 per cent till now. In the same period, Nifty 50 has gained 54 per cent. Armed with a strong belief in the power of value investing, Ravi plunged headfirst into the stock market. He meticulously researched companies, studying their financial statements and analysing their past performance. 

With a sense of enthusiasm and confidence, Ravi made his first few investments solely based on the principle of value investing. He focused primarily on finding stocks that appeared to be trading at a discount to their intrinsic value. He applied the most common metrics such as price to earnings (PE), price to book value and dividend yield to determine if a stock was undervalued or not. He found a couple of stocks such as Indian Oil Corporation and CESC having higher dividend yield and available at very low PE ratio and price to book value compared to the entire market. Ravi believed that sooner or later the market would recognise the true worth of these companies, and he would reap substantial profits. 

However, as Ravi soon discovered, the stock market is a complex and unpredictable beast. Some of his initial investments, which seemed like incredible opportunities, turned out to be ‘value traps’. The stocks he had purchased continued to languish, and their prices showed no signs of improvement and were not able to match even the market returns. Ravi watched helplessly as the value of his investments steadily declined or remained stable. For example, Indian Oil Corporation has been up by only 18 per cent since he purchased it in 2016 while Nifty 50 has more than doubled in the same period.
 

What are Value Traps?

A value trap is a situation in which an investment appears to be undervalued based on traditional valuation metrics. They may be trading at low price to earnings ratio or price to book ratio or higher dividend yield but the stock price continues to decline or remains stagnant for an extended period. In recent times many companies, particularly in the chemical sector, have seen their supply chains normalise abnormally. This led to them being saddled with high cost inventory. Their customers were also holding high cost inventory. Hence, they had to absorb this high cost inventory. Most astute investors following this sector closely recognised this and the situation got reflected in the companies’ share prices. 

When the share prices were compared to their trailing 12-months matrices, they still looked like compelling ‘value’ buys with lower PE and PBV and higher dividend yield. Many investors bought into this. In other words, investors get ‘trapped’ in a stock that appears to be cheap but fails to realise its perceived value. Value traps can occur when investors solely rely on quantitative metrics to identify undervalued stocks without considering other crucial factors that may affect the company’s prospects. These factors can include a deteriorating business condition as reflected in the example above or could be attributed to poor management, industry disruption, excessive debt or other fundamental issues that hinder a company’s ability to create value. 

It’s not only the retail investors that fall prey to such value traps. Even most of the shrewd and professional investors sometime get into value traps. Prashant Jain, the former Chief Investment Officer (CIO) of HDFC Mutual Fund, made an investment in Yes Bank, which later turned out to be a value trap. Yes Bank was once considered one of India’s leading private sector banks, but it faced significant challenges over the years. In early 2020, Yes Bank experienced a severe deterioration in its financial health due to issues related to bad loans, inadequate capital reserves and governance concerns. The bank’s stock price plummeted and it faced a crisis of confidence among investors and depositors. 

Jain, known for his long-term value investing approach, decided to invest in Yes Bank through his fund during this tumultuous period. He believed that the bank’s problems were temporary and that it had the potential to recover and create value for shareholders. Jain saw an opportunity to buy the stock at a deeply discounted price, considering it an attractive investment based on value investing principles. However, despite Jain’s optimism, Yes Bank continued to face numerous challenges. The bank required substantial capital infusion and had to undergo a significant restructuring process under the guidance of regulatory authorities. 

Shareholders of Yes Bank, including Prashant Jain and HDFC Mutual Fund, suffered significant losses as the stock price has remained depressed till now. Since the start of FY20 the shares of Yes Bank have been down by 94 per cent till now. The investment in Yes Bank serves as another example of the risks associated with value traps. Even experienced and successful investors can misjudge the potential for recovery in troubled companies. The case of Yes Bank underscores the importance of conducting thorough analysis and considering not only apparent value but also other crucial factors such as the financial health and corporate governance of the company.
 

Does Value Investment Work?

To assess the effectiveness of the value investing approach, we conducted a comprehensive historical analysis. We focused on three commonly used criteria—price to earnings ratio (PE), price to book value ratio (PBV) and dividend yield—for determining whether a company qualifies as a value investment. Our analysis encompassed the BSE 500 companies starting from FY16. At the beginning of each year, we obtained the PE, PBV and dividend yield values for every company in the BSE 500. Using these ratios, we ranked each company according to their value criteria scores. To ensure equal weightage for each criterion, we assigned identical weights to PE, PBV and dividend yield. This resulted in a final weighted ranking for each company on an annual basis. 

Based on the final rankings, we divided the companies into deciles. This classification placed them into 10 groups, each representing one-tenth of the total companies. Subsequently, we calculated the returns of each company for the following year. For each decile, we computed the median, maximum and average returns. By analysing the median, maximum and average returns across deciles each year, we aimed to gain insights into the performance of companies based on their value rankings. The following paragraphs indicate our result analysis.

Over the course of the last seven years, the performance of stocks across different deciles based on valuation has exhibited diverse outcomes. Starting with the top deciles, D1 companies forming part of this decile have an impressive average return of 39 per cent. Nonetheless, the following two decile stocks performed even better than D1, D2 and D3 also displayed strong performances, achieving average returns of 42 per cent and 44 per cent, respectively. The lower deciles, D9 and D10, experienced comparatively lower returns with averages of 15 per cent and almost no returns respectively. 

This analysis of decile-based performance does not give any clear idea as to whether value theme works. Since we are taking average returns, there may be a case where few exceptional returns would pull the average returns and hence we went one step ahead and calculated median returns of each decline each year and calculated the average returns of these median returns. The table shows the average median returns of stocks in different deciles over the past seven years. Decile 1, which represents the top 10 per cent of stocks by value defined earlier, had an average median return of 26 per cent. Decile 2, which represents the next 10 per cent of stocks by average valuation, had an average median return of 25 per cent. 

This trend continues until Decile 10 which represents the bottom 10 per cent of stocks by performance with an average median return of negative 3 per cent. This data suggests that there is a positive correlation between stock performance and decile rank. In other words, stocks that rank higher in deciles tend to perform better than stocks that rank lower in deciles. This suggests that there is a great deal of variation in the performance of stocks that are cheap and dear in terms of value.
 

Why Value Investment Works

The reason why the value theme of investment continues to yield superior returns despite conventional expectations is an anomaly. In theory, once investors realise that undervalued stocks tend to outperform their overpriced counterparts, they quickly drive up the prices of undervalued stocks, eroding the performance advantage. However, the persistence of the value premium suggests otherwise. The enduring existence of this anomaly can be explained by deeply ingrained aspects of human behaviour that have been extensively explored in the field of cognitive psychology, notably by Daniel Kahneman and Amos Tversky. 

Several key behavioural traits play a significant role in understanding the value premium. Firstly, humans have a tendency to overpay for the allure of quick wealth, exemplified by their propensity to invest in lotteries despite the consistently poor returns associated with them. This inclination towards seeking instant riches is one facet that contributes to the value anomaly. Conversely, another important behavioural feature contributing to the value anomaly is the aversion to situations that appear unattractive, troublesome or carry a perceived high probability of loss. Known as loss aversion, this trait leads investors to avoid scenarios that might lead to losses, both in investing and in other aspects of life. 

Furthermore, a deeply ingrained psychological factor that underlies the value anomaly is the inherent human tendency towards overconfidence. People are inclined to embrace certainty and disregard alternative possibilities, exhibiting a bias that can have a substantial impact on investment decisions. Collectively, these deeply rooted behavioural tendencies shed light on the persistence of the value premium in investment. Understanding these aspects of human behaviour helps explain why undervalued stocks continue to offer superior returns and why the value investing approach can be an effective strategy in the face of market dynamics.

Avoiding the Value Trap

Investors may be enticed by the low valuation multiples and believe that the market will eventually recognise the stock’s intrinsic value, leading to a price recovery. However, value traps can persist, and investors may experience substantial losses if the underlying issues within the company remain unresolved or worsen over time. To avoid falling into a value trap, investors should adopt a comprehensive approach to investment analysis. This approach involves considering not only quantitative factors but also qualitative aspects. 

There are many examples of value traps in the Indian equity market. Some of the most common include: 

◼ Companies with declining businesses. These companies may once have been great businesses, but they are now facing headwinds that are causing their profits to decline. As a result, their stock prices may be trading at low valuations, but this is not necessarily a good sign. It is important to understand why the business is declining. This will give you a sense about the company’s future that will help you to make a better investment decision. 

◼ Companies with poor management. The management of company is in the driver’s seat and determine the fate of the company. A company with poor management is unlikely to be able to turn things around, which might lead to company’s share to trade at low valuation. It is important to look at the company’s management team and track their performance over time before investing in a company like this. 

◼ Companies with high leverage. Companies with high debt levels based on their industry average are more likely to default on their loans, which could lead to their lower valuation. It is important to look at a company’s debt levels and debt-to-equity ratio before investing in a company like this. 

◼ Companies in cyclical industries. Companies in cyclical industries are more likely to experience periods of high and low profitability. As a result, their stock prices may be volatile and prone to sharp declines. It is important to understand the cyclicality of a company’s industry before investing in a company like this. One such example is commodity companies that saw cyclicality in their performance and hence when they are in a trough of the cycle they may look like perfect value buying. 
 

Unmasking the Value Trap  

This experience shook Ravi to his core. He realised that value investing based on those value matrices alone was not enough to guarantee success in the market. He needed to broaden his perspective and consider other crucial factors such as understanding of the business, management and cycle among others before making investment decisions. Ravi decided to embark on a new approach, one that involved a comprehensive evaluation of a company’s overall business model and future prospects. With renewed determination, Ravi began studying additional valuation parameters, and keeping them in context to make sense of them. He delved deeper into a company’s financial health, examining its debt levels, cash flow and growth potential. Ravi also paid close attention to the company’s competitive position, market trends, and management team. 

Armed with this newfound knowledge, Ravi started making more informed investment decisions. He looked beyond the superficial numbers and took a holistic view of a company’s potential. Ravi sought businesses with sustainable competitive advantages, strong growth prospects and sound management strategies. By considering these additional factors alongside value investing principles, Ravi aimed to avoid falling into the value trap again. Over time, Ravi’s careful analysis and diligence paid off. His portfolio began to recover from the losses incurred during his earlier value trap experiences. 

Ravi’s new approach allowed him to identify promising companies that were not only undervalued but also had solid fundamentals and a clear path to growth. Ravi’s story serves as a valuable reminder that success in investing is not easy. While value investing can be a powerful tool, it is essential to consider multiple valuation parameters, as well as a company’s business model and future plans. By taking a holistic approach, investors can increase their chances of making sound investment decisions and navigating the ever-changing landscape of the stock market.

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