Value traps come in many shades. Typically, the stock has recently under performed and now looks inexpensive, hence making them attractive to the hungry value investor.

A classic value trap in recent years was BILLABONG. Keep it in mind when reading the rest of this article.

Value traps arise when the attractive price valuation turns out to be an illusion and the share continues to fall and ends up as a nightmare for the value investor and a gain for short sellers. The result is that the value investor ended up overpaying for the true earnings potential of the company.

A different and much more sinister and serious value trap is when the drop in earnings is structural and driven by fundamental changes where the company’s competitive position is being eroded as industrials rivals quietly, but steadily, eat into the company’s market share. It may be that the company’s products are out-dated and being substituted by new and better products from the competitors, or the company may no longer have a competitive cost structure. If the company does not manage to fight back and regain its edge, this could well lead to a permanent reduction in earnings and in the worst case make the company’s services/products completely obsolete.

There are several key characteristics that should set off warning lights and help us to detect a potential value trap.

1. Unclear business model
2. Poor management and strategy
3. Aggressive accounting principles
4. Erosion of competitive edge
5. Capital structure – high leverage
6. Technological obsolescence
7. Valuation – no margin of safety

1) Unclear business model
It is the business model that differentiates the good company from the bad and if the business model is unclear and complex, it is a warning that you should not ignore. If you cannot understand the business model, it is unlikely you get an understanding of how the company creates revenue and value.

2) Poor management and strategy
The strategy and the quality of a company’s management is an important point, best assessed from the historical track record. If the company’s management lacks a clear strategy and communicates expectations that time and time again turn out to be too optimistic this could indicate a lack of knowledge of the industry. It may also be that management does not prioritize long term interests, such as investments in research and development, in order to achieve higher earnings in the short term. The risk is that the lack of investments will weaken the company’s competitive position in the longer term.

3) Aggressive accounting
Warning lights should also start flashing when management is using aggressive accounting methods in an attempt to boost revenue, possibly with the help of frequent acquisitions, and thereby hiding mediocre performance in the underlying core activities. Many of the value traps seen over time have been characterised by dodgy and unclear accounts. When there is the slightest sign of fraud or when a company is in the media suspected of fraud, it is hardly a good idea to buy the stock, no matter how much the stock price has fallen.

4) Erosion of competitive edge
Companies with a well-defined competitive edge can maintain a strong growth and high return on the invested capital. The strategy and the competitive edge are the fundamental elements in value creation of a company. If there are signs that the competitive position is under threat and that the company has difficulty in differentiating itself from its competitors, then this is a warning that future earnings will come under pressure and the rate of return on the invested capital will go down.

There are four circumstances that determine whether or not the company has a sustainable competitive advantage. The first relates to size. If the company has a large and dominant market share, it is often a sign of successfully keeping the competitors at bay.

Most likely this is a result of the company having lower costs (scale benefit) and offering lower prices to the customers compared to the smaller competitors. The network effect is another very important factor that improves in strength concurrently with growth. The so-called positive ‘feedback loop’ is created when the value for the customers grows concurrently with the growth of penetration of the service/product.

Switching costs is the third circumstance; high costs or inconvenience linked to a change to a different product or service is also a source of high profitability as the price of the product or service can be set relatively high.

The fourth and final significant way to differentiate from the competitors is to protect the earnings source with, for example, knowhow which is hard to attain or with rights and patents.

5) Capital structure – high leverage
Large debt load can kill even great companies. Debt is a double-edged sword. In good times it can enhance earnings and return on equity, but in bad times the opposite is the case, with the risk that banks might call the loans, increasing the company’s vulnerability.

A relatively low debt load will mean that the company is better equipped to survive catastrophes and other unforeseen circumstances that can put the business model under stress. Low debt increases the chances of survival in the long term and gives the company the option to invest in the future and thereby increase the life span of the company. The more fluctuating the earnings; the lower the debt load of the company should be.

6) Technological obsolescence
The technological evolution is harsh and ruthless and has a large number of value traps on its conscience. Mortality is particularly high in the technology sector due to relatively short product cycles and frequent technological breakthroughs. Out-dated technology is the victim of creative destruction, whereby innovative products are developed for the benefit of the consumer and society as a whole. In worst case scenario, this could lead to a total wipe-out of a whole industry,and it could mean the end to those companies that did not face up to reality.

It is crucial to remain humble and accept the fact that the future is uncertain and therefore one should never compromise margin of safety. The margin of safety ensures that we will still have an upside and that we will not be squeezed out of attractive long term investment. Besides,the margin of safety also compensates fort he fact that we are not insiders, and there is information we do not have access to.

Furthermore,there is the uncertainty of how quickly the stock will approach Fair Value;hence the time value of money should betaken into account. A well thought out investment process and focus on quality make a difference.

A logical and well thought out fundamental ‘bottom-up’ investment process will offer the best protection against the many pitfalls in the stock market. Since the investment process is the engine that generate the future returns, warning lights should be flashing if the process is too complex, difficult to repeat, or lacks a logical connection to the historical returns.