Invest
Value Traps
By Musicwhiz  •  May 22, 2009
[caption id="attachment_2517" align="alignright" width="173" caption="Photo by brendan.lally"]Photo by brendan.lally[/caption] The title looks simplistic and deceptively simple, doesn't it ? However, do not be taken in - value traps are defined as companies which appear to have "value" and margin of safety but in reality are far from being investment-grade. As an aspiring value investor, value traps are one of the most insidious things to look out for, as they can confound and confuse for years before you finally realize them for what they are. By then, you would have lost not just a substantial and significant portion of your capital, but also suffered from opportunity costs of deploying your capital in companies which truly qualify as "investment-grade". So what constitutes a value trap ? I could probably give some examples in real-life context (coupled with mistakes I had made before when I first started investing); but the underlying theme is that such traps consist of companies which seemingly have an edge or competitive edge over other competitors and are able to generate a high ROE/ROA, but the problem is that this is fleeting and temporary or it may be at the "peak" of its earnings cycle. Therein lies the danger - companies whose businesses are cyclical are likely to suffer from poor revenue growth and earnings deterioration once the cycle is over; while those which did not adhere to a business model which works over time may likely get surprised when economic conditions deteriorate (as they have done now). Other examples are companies which seemingly have a value proposition and some competitive edge, but which cannot make use of this edge or hold on to it to generate high returns on capital. Lest the reader thinks that the companies I currently own are NOT value traps, let me first state that some of them MIGHT BE. This is the difficult aspect of value investing - the fact that it may be difficult to spot a value trap till it is too late, or I may be myopic in my business assessment of the companies I own; or something could go drastically wrong with the business to render all prior analysis and study irrelevant. The idea is to pick companies with a business moat and few competitors, or are at least large enough in their own right to be able to command superior margins and a competitive edge, coupled with good and honest Management. There have been cases where an investment into (supposedly) such companies failed to yield positive results, due to the fact that my analysis was flawed or incomplete; or business conditions evolved to such an extent as to render the previous analysis obsolete. One recent example is Trek 2000, which manufactures and has patents for their Thumb Drives. Although much of its revenue is earned from licensing agreements with major technology players, its revenue base and gross margins have been declining of late as the technology sector ran into problems and they were unable to come up with innovative new products to sustain revenues. A similar case in point would be Creative Technology, which was unable to replicate the success of its SoundBlaster in the 1990s. Creative has now had the misfortune of falling into the red and are frantically scrambling to cut costs amid a severe slump as well as losing market share to Apple Computer (the i-Pod and i-Tunes). Read more...
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By Musicwhiz
Musicwhiz who is in his 30s is educated in accounting and works in the investment line (but not in a bank, financial institution, brokerage or fund house). He has a have a full-time job and investing is his side-line as well as passion. Musicwhiz is a value investor and his technique is derived from the teachings of Warren Buffett, Benjamin Graham and Phil Fisher. He incorporate all aspects of their investing style, and modify his value investing style to the Singapore market.
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