The Value Trap Fallacy

A Deep Value Investor's Rational Behind Being Relaxed About Supposed Value Traps

“It is cheap for a reason, a value trap”, I mostly hear when presenting my investment thesis to fellow investors. I usually take such opinions with a pinch of salt. And for good reason.

A genuine “Value Trap” is no laughing matter and a nightmare for any deep value investor, including myself, But in contrast to conventional definitions, I see it as a situation where a cheaply valued company has some kind of structural issue, cannot make any positive returns on invested capital over time, burns its cash and will eventually fail. 

Seeing Value Traps Where Are None 

Investing in “Value Traps” is detrimental because of the permanent loss of capital. Genuine “Value Traps” are the genesis of Warren Buffett’s two rules to stock market investing: 

1. Never lose Money 

2. Never forget rule Nr.1 

I would add another rule. 

3. Be aware of the “Value trap misconception trap”

Because permanently seeing “Value Traps” that are nonexistent is no less expensive. The cost of over and over missing out on outstanding opportunities will compound significantly over the long- run. 

"Bargain stocks do not exist in a vacuum. They are always surrounded by high doubt and great fear. It is the inflicting pain of the relentless stock price decline in combination with temporary operational issues that creates them." (Stephen Penman)

Seeing "Value Traps" that do not exist is a common error among value investors. In a strange habit they call out "Value Traps" in bargain stocks with temporary, albeit often prolonged, operational and stock price weakness, unable to envision that the underlying profit potentials are often largely unimpaired. 
 
Therefore, it is paramount for a deep value investor to invert, always invert. Recalling that bargains do not exist in isolation. That they are always surrounded by high doubt and great fear and a myriad of reasonings uttered by fellow investors not to buy into them. And that these opinions find their expression in a ruthless downtrend of the company’s stock price.  

Real "Value Traps" Are Rare 

There is no doubt that a true "Value Trap" is a genuine risk in deep value investing. Given the regularity investors proclaim “Value Traps” makes one believe they are a highly frequent phenomenon. That is not the case!  

"Value traps are rare events for individual stocks. And for entire asset classes they are almost nonexistent." 

If a “Value Trap” is defined as a 90% stock price decline in three years or less, with no recovery in the next three years than, at any given time, less than 7% of all stocks in the broad U.S. market may be deemed "Value Traps". Thus, they are are truly rare events for individual stocks. And for entire asset classes they are almost nonexistent. 

Given the low statistical probability of falling prey to genuine "Value Traps", and numerous so-called value investors repeatedly calling them out, knowing what does not constitute a "Value Trap" is the name of the game in deep value investing.

Because it is exactly “The value trap misconception trap” that creates those bargains in the first place. 

Mabuchi Motors: The "Value Trap" That Turned Into a Three-Bagger  

A prime example of the “value trap misconception trap” was my 2012 investment into Mabuchi Motors. 

"‘Cheap, but for a reason is actually close to a definition of a "value trap" for most investors. The great danger of accepting it unconditionally, is not to contemplate reasons why a company should not be cheap." 

Mabuchi Motors, the world largest producer of small RC motors, traded at around liquidation value for a prolonged period of time. But there was total apathy within the value investor community toward the stock, even though the company is a hidden champion in many niche applications. 

It begs the question, why so few fellow investors dared venturing into the stock? From the comments I got, the majority saw the stock as cheap, but for good reasons.  

Declining overall sales, margin pressure due to the high Yen, a lack of new (visible) applications for RC motors, etc. made them see a pattern of operational issues that appeared structural.  

And, most importantly, they seemed vindicated by a relentless downtrend in Mabuchi’s share price over a prolonged period of time. Whereby the last observation gave more insight into the investors time horizon than Mabuchi being a value trap or not.  

It turned out that operational issues at Mabuchi were only temporary. And most value investors missed out on a stock that increased threefold (excl. Dividends) in two years by once again falling prey to the "value trap misconception trap".  

"Cheap, but for a reason" is the definition of a “Value Trap” for most investors. An easy dismissal that prevents from thinking about reasons why a company should not be cheap. 
 
At Mabuchi Motors investors did not reason that applications of its small RC motors had become obsolete before (Record Players, Tape Decks, etc.) and the company having a history of finding new ones successfully shortly after (CD- Players, Hard disc Drives, etc.). 

Falling Prey To The "Value Trap Misconception" 

Missing out on great opportunities, because of repeatedly categorizing companies as "Value Traps" that ain’t is a common error in value investing.

Many value investors do not realize that it is exactly this sort of "misdiagnosis" by fellow investors that is the wet dream of any deep value investor. It can lead to outstanding companies like Mabuchi trading on the stock market significantly below intrinsic value and enables successful investors to compound above market averages over time.  

Let’s finalize the post with another practical example. My investment in Osaka Gas in 2012. Many will argue that a 3% CAGR (excl. Dividends) over 11 years does not seem that much of a bargain anymore. The assertion is true as far as it goes! 
 
However, it is my belief that, as value investors, our main concern should be about capital preservation. Making sure that our downside is protected and not be too bothered about any upside potential.  

Investing into three-bagger stocks like Mabuchi Motors is the exception and not the norm. And they are entirely worthless in a portfolio that does hold just a few severely capital destroying stocks. 
 
As so often with stock market investing, also with “The value trap misconception trap”, we enter a perceptual area that is beyond simple definition and discussion.

A world where many investors are unable to grasp that a stock cannot be a "value trap" one day and not on the other. It either is or it is not! 
 

Reference/ Source:

Just an illusion - Investors often see a value trap where one simply does not exist by Nick Kirrage

The Value Trap: Value Buys Risky Growth; Stephen Penman; Francesco Reggiani (Link)