How do we know if we are buying a company that is a value trap or at a bargain?
One of the biggest misconception of determining if a company is a value trap would be on the stock price. A stock that is trading at the same cheap price for years does not necessarily mean it is a value trap. Rather, the two key criteria that one should be assessing would be the company’s historical intrinsic value and financial performance.
- The slow erosion of the company’s intrinsic value. More often than not in such scenarios, we would have mistaken the past for the future. This is where we believe that the financial performance of the company would revert back upwards. However, it could just be that the future of the company is not going to be as rosy as before due to some structural change within the industry. Hence, with the intrinsic value of the company going down, it would just ultimately mean we are left with a company that is not worth as much as what it was originally worth.
- Mistaking the value of the company. While this could occur by using overinflated growth rates in a DCF model, I am not referring to such a scenario. The scenario I am referring to would be in the case of accounting frauds. Many a times, we may use extremely conservative estimates, however, we did not question ourselves if the cash is truly within the company.
With bargains, we would observe that intrinsic value is either constant or trending upwards over the years. With such companies, it is likened to a ‘coiled spring’.
- Catalyst. While a stock may be a bargain, many investors would prefer it to have a catalyst, where they can see management unlocking the value of the company. Personally, I would say that identifying such catalyst is unimportant. This is because if the catalyst is that easily identifiable, it would probably mean that the stock price would have already priced it in. In a way, some may view that the value is a catalyst in itself.
- Time Frame. Some may argue on how long one has to wait for the bargain stock to ‘bounce’ back up. Assuming a total return of 50% over a 10-year period translating to a 5% annualised return, such a bargain stock does not seem that much of a bargain anymore. That is indeed true. However, I believe that as investors our main concern should solely be about capital preservation, ensuring that our downside is protected and not be too bothered about any upside potential. Furthermore, research has shown that usually such bargains would revert back within 3-4 years. If readers are interested on such research, I have written quite a few articles on it.
With determining a value trap or bargain, we should not be focusing on what has the price of the stock been but rather on the intrinsic value and financial performance of the company.