Value Trap Or Trapped Value?

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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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