A friend recently forwarded me an article written by Edward Chancellor called The Value Trap.
It's an excellent article, and one that would have saved me plenty of money on previous occasions. In a nut-shell: value investing works, but money can be lost through being seduced into value traps. What's a value trap? A superficially cheap stock (such as a low price to book) but where the underlying assets have already experienced a high level of growth and are now in deep oversupply.
The common value trap is buying a mining company when it looks cheap. BHP looked cheap on simplistic valuation ratios at $40. But there was a lot of money spent on expanding production during the boom creating future oversupply. The maxim of buying mining companies when they are expensive and sell them when they look cheap seems to hold fairly true. Dare I say it, avoiding BHP was fairly obvious as the mining boom faded, however, value traps are often far more subtle and and far more ubiquitous than thought.
Boom Logistics (BOL) has been a first-class value trap. Too many cranes. Not enough demand. BOL does have other issues, but perfectly fits the bill of a group of assets (crane) in oversupply. BOL has been 'cheap' for a long time but still the share price just keeps going down as the glut continues.
Conversely, my mentors have taught me to look through the cycle of a company - look beyond current valuation measures to future supply and demand. The real trick comes from finding undiscovered companies that are experiencing more demand than supply in whatever they do - not just now, but in the future. Often this means buying a company that actually looks expensive based on current year financials but is going through a sustainable uptick in demand, industry rationalisation - whatever. I noted in the Feedback Loop post that cheap stocks can be very dangerous and also it is a mistake to write off stocks because they look expensive. Of my three biggest winners over the last 12 months, one was a deep discount, another had an infinite PE (no E) and the other on a PE of 31 (small E). My three biggest losers have all been of the value-trap variety.
Asset growth is slightly harder to quantify in service businesses, and is probably easier to re-deploy should an oversupply develop. It takes a long time to soak up excess housing and mining infrastructure (you can't just make it go away) but a bank can quickly reduce headcount. However I think the concept still holds true - be careful where a lot of resource has been allocated to something, regardless of price. The first cafe in a suburb probably makes great money, but after the tenth the profitability has been whittled down. The guys first to market typically make great money and then more resources (competition) follows and the industry matures and delivers more pedestrian ROEs.
Asset growth is slightly harder to quantify in service businesses, and is probably easier to re-deploy should an oversupply develop. It takes a long time to soak up excess housing and mining infrastructure (you can't just make it go away) but a bank can quickly reduce headcount. However I think the concept still holds true - be careful where a lot of resource has been allocated to something, regardless of price. The first cafe in a suburb probably makes great money, but after the tenth the profitability has been whittled down. The guys first to market typically make great money and then more resources (competition) follows and the industry matures and delivers more pedestrian ROEs.
Perhaps this is why software businesses can provide outsize returns (for reasons over and above the obvious scale effects they can achieve). Because they can roll-out so quickly, it is difficult for competition to catch-up and therefore they achieve monopoly status and enjoy the outsize ROE). I look at Pro Medicus (PME) and shake my head in wonder at fast it is capturing market share and the profits it will earn. Google has left its competitors for dust and I'm not aware of significant investment outside of a few obvious names allocating cash to catch them. The mining boom was different - massive amounts of capital were spent trying to capture the returns from higher commodity prices.
Kristian
The term Value Trap intrigues me. I think it says more about the investor than the stock. Many investors give up on a situation and call it a value trap. BOL is a good example. The thesis behind this investment is simple. The company trades at a considerable discount to NTA. The company is selling its cranes and repaying its debt while waiting for the cycle to turn. The risk here is that the company won't be able to realise book value for its cranes and hence the massive discount to NTA. As the cranes are sold and the debt diminishes the market will wake up to the fact that the gap to NTA needs to close. The company may start some kind of capital management or the company may be taken out by a competitor. One way or the other, the market will recognise the value and price the stock appropriately. As impatient investors sell the stock calling it a value trap, the value on offer increases - the margin of safety becomes larger. The trap, in my view is impatience not the value on offer.
ReplyDeleteFair point. However that argument could have been made at 10c, 20c, 30c etc. BOL is cyclical and if they continue to pay down debt it will probably be a great trade at some point. So yes on a long enough time horizon it is probably good. But in the meantime there have been better ways to invest money.
DeleteThanks for the response Kristian. It's an interesting conversation and challenges my investment philosophy. The difference I see at the various prices that you quote for BOL is that when BOL was 30 cents (2012) the stock (only!) traded at a 42% discount to NTA. When it traded at 20 cents (2013) the discount to NTA became 61%. At 10 cents (2015) the discount widened to 76% and now at 7 cents the discount is at 81%. On top of this, the company's debt burden has decreased considerably. The margin of safety has actually increased. It reminds me of a piece by Howard Marks that I read recently, where he said when everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it's not risky at all. Broad negative opinion can make it the least risky thing since all optimism has been driven out of the price.
DeleteJust started listening to an audio of Howard Marks book. What a great book. One of the very, very best investment books I've read (though I haven't finished it yet). Every value investor should read it. Thanks for the prompt Mr/Ms anonymous!
DeleteHi Kristian. Good post, and good article from Edward Chancellor. Thanks.
ReplyDeleteI think, for what it's worth, that superficial measures of value (low price to book, low PE, or whatever) should only be used as very blunt indicators. I think one should never lose sight of the fact that ultimately what you're paying for is future cashflows. So, in a low price to book ratio, for instance, one really needs to think about how those assets will ultimately put cash in ones pocket.
With respect to BOL, I suspect the fat lady has far from sung. In my opinion, BOL is demonstrating that it is very effectively monetising its assets to pay down its debt. One needs to be cautious, of ccourse. For instance, it has generally been claiming a "profit" on assets sales. However, these have been on assets that were previously written down. It's hard to determine exactly how written down these were, as BOL write down assets at the time of tranfer to the "assets held for sale" account, which may already have been previously impaired.
Nevertheless, conservative guesstimates can be made, and even if we assume debt is ultimately eliminated via continued asset sales at a 40% loss to book, there will still be substantial value left on the table.
On top of this, operating costs now appear to be reducing at a sufficient pace that EBITDA may be stabilising. This is key, and I acknowledge that I am making a wager here after digesting the last report. Without a stabilisation of EBITDA, I felt there was a real risk of BOL leaving nothing for shareholders after satisfying its bankers. It is for this reason that I only started investing fairly recently.
If we combine these two factors, and make very conservative assumptions about what returns the business may make on remaining capital in the future (even if not for a number of years), BOL appears to be a worthy gambit at current prices.
Of course it's far from certain, but to me it looks like a sensible opportunity.
I think a mistake made by many, in the mining services sector, is to ignore lessons from the prior boom (ending in the year 2000, I think). The unwinding of that boom resulted in a drop in mining capex (in Australia) of about 40% from its peak. In this latest unwinding, we have no where near yet dropped by a similar amount, despite the fact that this latest boom was far more buoyant (in duration and magnitude). So people should have allowed for the very high probability that demand would keep falling a long way further, and indeed that it will keep falling.
If we wait until demand is clearly turning, won't the market already have turned?
Cheers, Mars
Hi Mars, my second best investment this year has been a mining services business. This is a business not in the supply of equipment (e.g. BOL) but labour. See my comment to the previous reply on BOL. It's definitely not over, but it is fact it has been a value trap for years now. I could see myself buying BOL in the future when we think things are stabilising and some other changes are made.
DeleteBuying BOL, when I did, was on the basis that my expectation of future cashflows would provide an attractive return. With a low quality business like this, in the industry in which it exists, under the circumstances in which the industry finds itself, I think it would be foolhardy to assume that that cashflow will be coming to me any time soon. I think it would also be foolish not to allow for the probability of some pretty negative things completely negating once cashflow thesis.
DeleteWhat I am saying is that my probability weighted present value was the basis of my investment. If the market comes to the party, so that I don't purely have to rely on my assesssment of intrinsic value, all the better. If management expedite a market re-rating via a buy-back (once debt is a little more under control, which won't be long now) better still.
My point is, the market did not factor into my decision (apart from providing my entry price).
If it takes 3 years for me to get my return (via a market re-rating, or via dividend returns), which wouldn't surprise me, then at which point along that journey should I decide whether or not I have been seduced by a "value trap"?
Of course, my assessed intrinsic value may be completely wrong. But until I feel some conviction that the likely value of the business is less than my assessment at the time of purchase, then I don't see why the market should decide whether or not I've stepped into a trap.
Good to talk, Mars