The Value Trap
by Josh Logan
Something which has been thrown around in the office recently is the situation of a Value Trap. A value trap occurs when the best company of a particular sector has been acquired to the point of becoming overvalued.
Once this occurs, your average investor will tend veer away from investing in the best companies (blue chips) and start looking for gains elsewhere.
As they do this, they usually do not look very far and come across the 2nd best or 3rd best alternative in a particular sector. These companies appear to be very similar to their sector leader as they sell the same products or services, yet they will be trading at a huge discount in comparison and will look very attractive. Hence, the value trap is created.
What some investors tend to overlook, is that these companies are trading at lower prices for a good reason. They usually have a flaw in the way they operate and conduct their business. We call these companies ‘repeat offenders’ as these flaws will most likely crop up time and time again because they are built into the systems and values of the entire organisation. Tremendous amounts of money, restructuring, and time, is needed to be able to eliminate these core issues, all things that no investor would want to hear as these costs affect the company’s profits and hence, shareholder returns in the long term. Usually the larger the discount, the larger the organisational flaw, the larger the probability of losing money on the investment. As Warren Buffett says ‘It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”.
Below are some examples of the sector leaders vs value trap companies.
BP (BP) VS Exxon Mobile (XOM)
National Australia Bank (NAB) VS Commonwealth Bank of Australia (CBA)
Metcash (MET) VS Wesfarmers (WES)