The concept of value investing usually emphasizes two main principles: one is to buy at low prices, and the other is to hold for a long time.

  Specifically, since stock prices always fluctuate up and down around their value, investors should learn to spot companies that are undervalued by the market, buy when their stock price is low, “buy something worth $1 at 40 cents”, and then hold it firmly for a long time, and get a good return naturally. In 1988, Warren Buffett bought a long position in Coca-Cola, the market generally questioned the value of Coca-Cola, and then he increased his holdings several times. 10 years later, the market value of Coca-Cola rose 10 times, enough to bring Buffett a huge gain of $10 billion.

  In reality, there are few people who believe in value investing and adopt similar practices like the “stock gods”, but the result is that the price of the stock in their hands has fallen instead of rising, and it has fallen harder and harder.

  The most famous example is the 2008 financial crisis, when the standard blue-chip Citibank shares from $ 55 all the way down, many people think it’s time to bottom out, they bought and hold, expecting the stock price rebound to earn a fortune, but unexpectedly the stock price fell again and again, once only 1 dollar, countless blind investors have lost a lot of money.

  Why did they lose so much money when they clearly followed the two principles of value investing? The answer is the topic to be discussed in this article – value trap.

  1

  What is the value trap?

  Price will eventually return to value, is the lowest basis of value investment can be established. However, many people think they have bought a cheap enough stock, only to find that the price is still falling, and there is no return to value. What’s more, many people do not stop in time, but still blindly hold firmly, but the result is “hold on to what should not be held”, in the end, only to suffer huge losses.

  This is the so-called “value trap”, that is, investors bought the surface of the valuation is very cheap, but in fact very expensive stocks.

  Looking at history, both the U.S. stock market and the A-share market, there are many real cases of value traps, BlackBerry is one of them.

  Long before Apple and Android phones took off, BlackBerry was also a leader in business smartphones. With the advantages of fast email push, high data security and so on, BlackBerry began to rise since around 2005, and in the following years, once occupying 48% of the U.S. cell phone market, many business people and politicians and legislators are BlackBerry as the brand of choice, the company’s share price also reached an all-time high in July 2007.

  With the changing times, cell phone users have long been dissatisfied with the basic functions such as sending and receiving emails, but more in pursuit of services such as photography, games, video and other entertainment attributes. However, BlackBerry does not think about this, still I do my own way to adhere to the original positioning, even after the emergence of the iPhone, Android phones, BlackBerry management is still unmoved. I do not know, BlackBerry stubbornly adhere to the key point of the smartphone change, let itself in a big step behind, the company’s share price is a sharp decline, and even began to lose money in 2013. Although later, BlackBerry senior forced by market pressure, had to take the “abandon the full keyboard design, switch to the Android camp” and other measures to try to save the decline, but still powerless, and finally in October 2016, BlackBerry officially announced to officially stop the development and production of smart phones, a generation of giants collapsed.

  It is worth noting that in the period from 2007 to 2009, BlackBerry’s P/E ratio fell from 80 times to about 11 times, the company’s valuation is precisely at the lowest level in history. But if you choose to buy BlackBerry shares at this time due to the low valuation, then it becomes a typical case of falling into a value trap – the company’s share price has been all the way down since then, never to regain its former glory, and the investors who entered will surely lose their money.

In addition to Blackberry, Sears in the U.S. retail sector is also one of the representatives of the value trap.

  Throughout its more than 120 years of business history, Sears has had countless moments of glory, with annual revenues once accounting for 1% of U.S. GDP and once topping the list of the world’s largest department store retailers. However, in recent years, under the impact of Amazon and other Internet retailers, Sears’ business performance has deteriorated, with successive losses and debt, the company’s market value shrunk by nearly $30 billion, and finally had to file for bankruptcy protection. Investors who bought Sears stock would have been crying in the toilet.

  The above case tells us that a company caught in a value trap should not be bought, no matter how attractive the stock price is. Simply because the stock price tends to go down but not up, there is certainly no way to talk about returns.

  2

  What kind of companies are prone to fall into a value trap? To summarize, there are three categories.

  First, the boom is in the downward cycle.

  As mentioned above, the company’s low valuation may reflect the industry’s future boom downward, so the company in the boom downward industry often exists in the value trap. There are two possible factors that could lead to a downside in an industry.

  One, the permanent decline of the industry due to technological progress. Typically, film, the king of the film era, failed to capture the technological changes in digital cameras and fell into obscurity, and the company’s market value fell from $31 billion in February 1997 to $2.1 billion in September 2011, evaporating by 99% in more than a decade. The aforementioned Blackberry and Sears are also in this category.

  In this category, future profits are likely to decline year by year or even disappear, so even if the P/E ratio is low, you should not buy. So value investors need to be highly vigilant about the business of fast-changing technology.

  Second, the industry itself is clearly cyclical and is in a downward range. Representative cyclical industries include steel, coal and other bulk raw materials, as well as construction machinery, real estate, cement, aviation, shipping and so on, which are characterized by cyclical fluctuations in product prices, resulting in the rise and fall of the company’s share price with the industry cycle.

  Specifically, when the industry is at the top of the cycle, strong earnings will make the market generally believe that the company’s valuation is low, but the reality is that the strongest earnings are often the most unsustainable, the “low valuation” is likely to reflect the future earnings level of the downside, at this time to buy but easy to lose, if you catch a sustained If you catch a longer period of downturn in the industry, investors are afraid to be long-term trap. As Peter Lynch said, “cyclical stocks should be bought at high PE and sold at low PE”.

  However, this kind of value trap will be repaired later with the change of industry cycle, which is much better than “permanent decline of the industry due to technological progress”.

  Second, the competitive landscape has deteriorated.

  Generally speaking, when an industry enters a mature stage, the competitive pattern will intensify, and the concentration of the industry will continue to rise, the industry’s leading companies in the brand, channels, customer stickiness, operating costs and other aspects of the advantages will only become more and more obvious, and will gradually eat into the market share of other small and medium-sized companies in the industry, and the performance of other small and medium-sized companies will also face continued downward pressure.

  At this time, the market often to give these small and medium-sized companies lower valuation, however, some investors will be because of the outstanding performance of the leading companies, mistakenly think that this is also a good time to buy small and medium-sized companies, but did not realize that the low valuation of small and medium-sized companies is precisely a reflection of its competitive disadvantage, “the boss and the second competition, but the injured is always the third old four “. Since this is the case, then the stock price to achieve counter-trend growth is of course much more difficult, and this is another manifestation of the value trap.

  Third, there are problems with the company’s internal governance.

  In addition to macro and industry-level effects, the company’s own problems also tend to cause value traps. In fact, those companies that fall into the value trap have more or less internal governance problems behind them, either due to poor strategic decisions or financial frauds. For example, LeTV, which was once regarded as a big white horse by numerous institutions and stockholders, suffered from financial fraud that caused its share price to stumble, and even some entrepreneurs took over the company to no avail, and it was eventually delisted by the Shenzhen Stock Exchange, with hundreds of thousands of shareholders suffering heavy losses.

  The above three types of value traps, although different causes, but has a common feature, that is, the company’s fundamentals and the continued deterioration of future earnings expectations.

  Fundamentally, the reason why there is a value trap is that the “cheapness” of the stock does not come from the fact that the company is undervalued by the market, but the continued decline in the company’s competitiveness makes it increasingly worthless, and it is inevitable that the stock price will fall all the way down, just as the old saying goes: “cheap must There is a reason for the cheapness”.

  As for those investors who hold shares in such companies, it can only be said that they misjudged the value of the company before buying. For example, an investor believes that a company’s stock is really worth $100 and chooses to buy it at $60. But it turns out that the stock is not worth $100 at all, and is even far below $60 – buying a stock worth a few dollars at $60 is clearly buying too much, and it is not a value investment.

  3

  How can I avoid the value trap? I believe this is a question of concern to many people.

  Since the value trap stems from the continuous deterioration of the company’s fundamentals, the best way to deal with the value trap is naturally to return to fundamental research, especially the sustainability of the company’s future profitability and cash flow situation.

  The most important way to avoid the value trap is to understand the geometry of the company’s future profitability. This requires us to analyze from macro, meso and micro perspectives.

  At the macro level, we should examine the prosperity of the industry in which the company is located and the position of the cycle, as the trend of the industry will directly affect the company’s future revenue growth rate.

  At the meso level, the competitive landscape of the industry should be analyzed, because changes in the competitive landscape will be reflected in the company’s gross margin, and changes in the company’s position in the competitive landscape will also lead to an increase in its gross margin or not.

  At the micro level, special attention should be paid to the company’s ROE (Return on Equity) – an indicator that Warren Buffett attaches the most importance to, which measures the strength of the company’s profitability. However, what we should look for is the stability and sustainability of the company’s ROE over the years, because short-term ROE increases do not really reflect the company’s profitability, which may be driven by leveraging, etc. In addition, one should always keep track of the company’s strategic decisions and business changes, which may have a bearing on the future fundamental trend of the company.

  In addition to profitability, the cash flow position is also very important and it is considered the lifeline of the company.

  In Warren Buffett’s view, cash flow is the most important variable for estimating the intrinsic value of a company, “the intrinsic value of any asset is essentially the present value of all future cash inflows or outflows discounted at an appropriate interest rate”, “cash flow is oxygen, and a great company must have abundant cash flow “.

  It is also true that if a company has positive and abundant cash year-round, its financial position can be considered very healthy; but if cash flow is tight year-round, the company is in a relatively unfavorable position and is in danger in case of external shocks.

  How is cash flow judged? The common practice is to use the “net present ratio”, which calculates the ratio of net cash flow from operations to net income over the years. If the ratio is always greater than 1, and the net cash flow from operating activities and net profit are both positive, it reflects that all the net profit created by the company can be realized in the form of cash, and the cash flow situation is good, so the company’s fundamentals are not too bad; if the ratio is always less than 1, it is a negative signal, indicating that part of the net profit is realized in the form of debt, and there is a problem that production and operation activities are not sustainable The problem of generating cash flow.

  In addition, the gearing ratio is also a common indicator. If a company’s gearing ratio is too high, it indicates that the company’s financial risk is relatively high, which may lead to insufficient cash flow and future profitability will be affected; once the capital chain has problems, the company cannot repay its debts in time, and it may even trigger a bankruptcy crisis.

  The value trap is not terrible, as long as you can avoid it, investment can become very easy and relaxed. Of course, this has to be built on the basis of our deep enough understanding of the company of our choice, otherwise there is nothing to talk about. This may also reaffirm the eternal truth: there is no shortcut to success, and this is especially true for investment.