High-profile proponents of value investing, including Berkshire Hathaway chairman Warren Buffett, have argued that the essence of value investing is buying stocks at less than their intrinsic value. The discount of the market price to the intrinsic value is what Benjamin Graham called the "margin of safety".
Now one of the most important and difficult aspects of stock selection is determining whether the stock you have selected is really a value investment or a value trap.
The price of an actual value investment is low because of temporary factors. Its price is a bargain because it trades below the real or intrinsic value. For example Infosys declined substantially when Mr Sikka quit as MD& CEO, but business dynamics did not changed & in due course someone else took over his position. Thus it was a good value buy. Tata Motors is a good company with a temporary slump in sales & sales are expected to recover in due course. Thus it could be a good value buy at current levels. My experience is a lot of times value investing is synonymous to taking a contra-bet. As Warren Buffet says 'Be fearful when others are greedy and greedy when others are fearful'. SBI was trading at multi year lows ~Rs.150 18 months back as if the bank will close down. We must remember that every business has ups & downs and the best bet would be a buy a good business in bad times. One final example which comes to my mind was when Motherson Sumi Systems crashed due to the Volkswagen fiasco. If you were confident on the business of Motherson Sumi & it turning around. That was the best time to find value in the stock.
A real value investment stock will have consistent or growing cash flow, a business plan for products that have strategic advantages and strong financial statements. The price must be low enough that it provides a margin of safety; therefore the purchase price you are willing to pay should be substantially less that its real worth.
The price of a value trap on the other hand is low because of long term or more permanent factors. Its price appears to be a bargain but in fact is not selling at a price below its intrinsic value. This is usually because something is different, or is going to change, that negatively affects the earnings or cash flow of the company. It appears to be a bargain compared to its previous price, but in reality something has changed and the lower price is discounting or warning of deterioration or change ahead. As the saying goes- never try to catch a falling knife. For example in case of cyclical/agri stocks like sugar/rubber last year was a bumper year for the companies but the cycle might have turned & the coming year profits may be significantly lower. Thus the stocks will look really cheap going by trailing 12 month valuations but may be expensive based on forward earnings. Same with industries with crude derivative raw materials like plastics/airlines. With crude at $30/bbl they made bumper profits but with crude at $70/bbl the situation may be different. Another classic example coming to my mind is investors inquiring about Reliance Communication at Rs, 50/40/30 and the stock finally declining to Rs.10/sh. A similar thing was seen in infrastructure/real estate stocks few years back like IVRCL, GMR Infra, JP Associates, Unitech etc as these stocks declined by 80-90% from their peak.
It is difficult to determine the difference between a real value investment and a value trap. Even the best value investors buy value traps. Making mistakes is a part of investing risk. But keeping in mind aspects like earnings/cash flows, management quality, liquidity/debt-equity ratio and business model/product profile help in distinguishing between a value investment & value trap to some extent and reduce mistakes. The goal is to maximize your probability of purchasing a real value investment, and minimize buying value traps.
Sabyasachi Paul has been associated with equity research and advisory on equity markets in India for over 9 years & currently heads the equity research desk of Eastern Financiers Ltd, Kolkata. He also manages a portfolio on the online platform Kristal. Find link to the strategy named ‘The Tortoise’