“The Value Trap”

When we start get­ting inter­est­ed in val­ue invest­ing, one of the first things well-mean­ing friends warn you about are “val­ue traps.”

A val­ue trap is an invest­ment that looks cheap based on met­rics but stays cheap (or gets cheap­er) for good rea­son, usu­al­ly because of under­ly­ing weak­ness­es in the busi­ness or its indus­try that aren’t imme­di­ate­ly obvi­ous.

Peo­ple who believe in the Effi­cient Mar­ket Hypoth­e­sis (EMH) think val­ue stocks are basi­cal­ly too good to be true, like a politi­cian who does what they promised before the elec­tion, or a Niger­ian prince who just needs your bank details to release $47 mil­lion. Accord­ing to EMH, there are no gen­uine mis­pric­ings. If a stock looks cheap, it’s cheap for a rea­son, and the mar­ket already knows some­thing you don’t.

It’s easy to see why this sticks. It sounds sci­en­tif­ic. It has Nobel prizes behind it (Eugene Fama won in 2013), and it con­ve­nient­ly excus­es doing noth­ing.

We side firm­ly with the behav­iour­al finance peo­ple, Kah­ne­man and Thaler, who blew a mas­sive hole in EMH by show­ing that prices are sys­tem­at­i­cal­ly dis­tort­ed by human psy­chol­o­gy: pan­ic, herd­ing, recen­cy bias. The mar­ket prices fear effi­cient­ly. Val­ue is anoth­er mat­ter entire­ly.

Here’s the thing: we aren’t experts in any par­tic­u­lar busi­ness, sec­tor, or indus­try. We don’t claim to be. Some peo­ple, like Buf­fett and Munger, are hap­py to spend their days study­ing the intri­ca­cies of var­i­ous mar­kets, and if you want to do that (and have the time and ener­gy), best of luck to you. That’s not what we do. Tony would rather play golf. Cameron would rather do kung fu.

Our approach is to trust the algo­rithm to find val­ue stocks, and then use our sell­ing rules to exit if some­thing goes wrong. We assume we’re going to get some wrong. That’s built into the sys­tem. Even Buf­fett has always claimed a win rate of around 60%, and that’s what we aim for too.

Our U.S. pulled porks are a per­fect exam­ple. We know very lit­tle about the Amer­i­can mar­ket. The major­i­ty of com­pa­nies we’ve cov­ered on QAV Amer­i­ca were com­plete­ly new to me, and prob­a­bly to most Amer­i­cans too. Have you heard of Mam­moth Ener­gy Ser­vices (TUSK)? Pre­ci­sion Drilling Cor­po­ra­tion (PDS)? Korea Elec­tric Pow­er Cor­po­ra­tion (KEP)?

Over the past year or so, we’ve done pulled porks on 45 Amer­i­can com­pa­nies that were high on our buy list at the time. As of the day I’m writ­ing this, 31 of them (68.9%) are up since we cov­ered them. Of the remain­der, our sell trig­gers would have had us out and into some­thing else on the buy list before the dam­age got seri­ous.

So I don’t lose sleep over val­ue traps. I buy what the check­list tells me to buy, and I let my sell trig­gers tell me when to leave. The algo­rithm wor­ries so I don’t have to.

I do still steer clear of Niger­ian princes, though.

QAV Myth Killers is a week­ly col­umn in the QAV newslet­ter, tak­ing apart a piece of
invest­ing con­ven­tion­al wis­dom. Read the series, or
get it by email every Fri­day.

Gen­er­al advice only. Space­craft Pub­lish­ing Pty Ltd
trad­ing as QAV is a Cor­po­rate Autho­rised Rep­re­sen­ta­tive (CAR 001292718) of MF & Co.
Asset Man­age­ment Pty Ltd (AFSL 520442). This is gen­er­al infor­ma­tion and does not take your
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