Value Trap Or Trapped Value?

Never buy what you don’t want, because it is cheap; it will be dear to you.

John Reynolds

John Reynolds Portfolio Manager, Templeton Global Equity Group

Preview

Life teaches us that when something seems too good to be true, it usually is. Whenever an investment case is built on conclusions like “it has a high free cash flow yield” or “its P/E is at all-time lows” or “if you add cash and minority investments, you get the core business for free”…it’s time to pause and go slow. While these statements can describe companies where value is trapped inside, they more often describe value traps—companies where the risk profile is changing, and fundamentals viewed through the windshield will not resemble those seen in the rear-view mirror. Whether it’s technology or regulation or consumer behaviour, there may be structural changes compromising the business, for good. It may be a long, winding journey, but the ultimate destination is down.

That’s not to say that companies with these valuation attributes are never good investments; on the contrary, they can deliver significant upside. But the standards for due diligence are higher. These attributes do not constitute a value investment case in and of themselves. But they are signs to dig deeper, to understand what we might own, and to focus our efforts on being right, rather than leaning on the crutch of over-diversification to contain the risk of being wrong. Some value investors choose to avoid companies with these attributes entirely. For us, they represent opportunities, but only when we know we are backing companies with the levers available to unlock trapped value and avoiding those that are simply bad businesses—value traps. Whether a company is a bad business now or transitioning from great to good to bad, the endgame is value destruction. The reputation of such companies will ultimately prevail, irrespective of the reputation of the leaders or investors in the company.

What separates value traps from trapped value—and how can we tell the difference?

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WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments; investments in emerging markets involve heightened risks related to the same factors. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.

The companies and case studies shown herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The opinions are intended solely to provide insight into how securities are analyzed. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio. This is not a complete analysis of every material fact regarding any industry, security or investment and should not be viewed as an investment recommendation. This is intended to provide insight into the portfolio selection and research process. Factual statements are taken from sources considered reliable but have not been independently verified for completeness or accuracy. These opinions may not be relied upon as investment advice or as an offer for any particular security. Past performance does not guarantee future results.