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
