On Value Traps..

One of the most challenging situations for a value investor is  being caught in a  “value trap” – where a cheap investment  suffers a permanent loss of capital.  What strategies and precautions should investors adopt to minimise the risk of being ensnared in a “value trap” ? Rob Arnott, head of Research Affiliates, provides a  helpful perspective on this issue. To summarise:

 

​-​

A “value trap” can either imply that an asset that  looks cheap has enough bad news to possibly justify the price or the investment looks cheap on the way to zero.

 -Ben Graham made a distinction between a drop in price and a permanent impairment of capital – as mean reversion cannot work if he price of a security goes to zero. However, ascribing a “value trap” to an asset which has suffered a large price decline when the underlying fundamentals remain unimpaired, one can make a dangerous error. A “value trap” is a situation  where the asset seems cheap but is permanently impaired.

 -Bargains mainly exist in the presence of fear – by inflicting pain with sharp price drops -  but there are always numerous reasons to avoid buying bargains which deter investors from taking advantage of price drops.

 -How often do individual company stocks present a permanent loss of capital – say a 90% drop in the price in three years or less and no recovery over the next three   years?  At any given time only 5% of US stocks are “value traps” – i.e. they are rare events for individual stocks and almost nonexistent for broad asset classes which represent a broadly diversified array  of companies  and therefore cannot all go to zero.

 -Markets try to seek fair value and are therefore mean reverting. Analysing historical data since 1975 for each major asset class, and defining a significant decline as a two standard deviation move below its long term average, these extreme events have happened only 2% of the time.

 -Comparing the percentage of asset classes and individual stocks (see chart below)  which suffered such  extreme declines and recovering fully over the subsequent five years,  it is clear that asset classes outperformed individuals stocks  by far – more than half the time assets classes made  up their losses within 3 years and 85% did so over five years. However, only 10% of  individuals  stocks recovered with three years and one-third did so over five years.

 

 

-It is painful to experience a price loss – particularly as value has underperformed growth since2013 (and off-and-on since 2007). However, early signs of value outperformance are emerging – particularly for US small cap value stocks and EM equity.

 -A few fundamental truths about investing can help investors to continue pursuing a value-oriented, disciplined and contrarian strategy: 1) value traps are rare events, particularly for asset classes; 2) mean reversion can reward patient, long-term investors; and, 3) history shows that markets eventually trend towards fair value. Investing on a contrarian basis can ultimately provide superior returns to investors.

 -An interesting analysis which supports a well diversified, value based approach to investing despite trying market conditions – as the legendary value investor  Jeremy Grantham of GMO has noted  time and time again - patience is  the key advantage which an individual investor has over the professionals (but unfortunately is squandered too easily as people get caught up with the herd mentality).

 -The other important aspect to value/contrarian investing is having the discipline and courage to spreading  the investments over time (i.e. dollar cost averaging ) thereby allowing one to add to positions which have suffered  sharp price drops. A recent example of this would be Brazil, a country which has been out of favour for several years  and has suffered sharp drops in the equity index as well as the currency (see chart below).

 -Over the last three years, the annual fall in  the dollar denominated country ETF EWZ has been -25%,-16%, -51%, driven by  both a fall in the local currency (-14%, -10%, -34%) and the stock market. An investor employing a dollar cost averaging strategy over the last three years (starting from January, 2013 and deploying one fourth of his total allocation to Brazil  on an annual basis) would show a paper loss of 43% at the beginning  of 2015 versus a paper loss of 67% for an investor who had invested his total allocation at the outset (or was reluctant to add more on declines).  And following the 33% rally in Brazil this year, the  current loss for the dollar averaging investor would be almost halved to -24% versus -44% for the alternative. More complicated dollar averaging strategies  can also be employed utilising pre-specified thresholds based on market movements rather than a fixed time of the year to further optimise returns.

 

 

 

-Of course Brazil could suffer another sharp fall for a myriad of reasons  (i.e. politics/commodities) but having a disciplined  strategy of adding  exposure under that situation (in the context of a well diversified global portfolio with limits on individual  country and asset class allocations) is very likely to yield dividends over time.