Our approach to Value Traps

A value trap is an investment that appears to be cheap at the time of making the investment, but then remains cheap forever (or at least for an uncomfortably long time), leading to poor returns. Unsuspecting investors are lured by the cheap valuation.

A growth trap is an investment that appears to offer outstanding returns because it had been growing faster than most alternatives at the time of making the investment. When these run into operational issues, mostly related to the difficulty of managing a fast-growing company, or pressure on management to satisfy very high investor expectations, it can lead to poor returns. Unsuspecting investors are lured by high growth rates.

Knowing that we are value investors, we often get asked the same basic question in different ways: “How do you avoid Value Traps?” The implication behind the question is, “I get that the stock looks cheap, but what if it is CHEAP FOR THE RIGHT REASON,” i.e. the market correctly sees something we don’t?

Value investing is based on the fundamental belief in reversion to the mean. We normally do not invest with a specific event in mind which will unlock value. Value traps are therefore a real phenomenon in our lives that need to be dealt with.

Over and above constant evaluation of the underlying business and conditions, we protect ourselves from falling in love with a position by having a hard cut-off. We impose a time limit on our deep value ideas. If an idea has not worked within a thousand days, it is removed from the portfolio.

As an example – in November 2023, we sold out of a position which had become a value trap in our portfolio – Nu-World Holdings, at just over R27/share.

We originally purchased our first position in February 2020 at a price of R29.76 and bought a second tranche in May 2021 at a price of R29.10. Nu-World qualified as a “net-net” in our portfolio – meaning that in liquidation, the value of the company’s cash, stock and debtors were more than enough to settle all their liabilities and then leave us with more money than what we paid for it. Our net-net values of Nu-World on those dates were R52.03 and R56.39 respectively. The market was saying that the company was worth substantially more dead than alive.

As it turns out, trading conditions for Nu-World, an importer and wholesale distributer of mostly white and electrical homeware, became much tougher after our investment – first due to disruptions in the global supply chain during the COVID panic and thereafter from lacklustre economic growth in South Africa.

Over the period of our ownership, Nu-World produced total profits of R379m (generated on a starting equity value of R1.3bn). Of this, they returned R154m to shareholders as dividends and kept R225m to grow the business. Their annual return on equity deteriorated from an initial 10% to sub-5% as they struggled to apply their retained earnings at higher rates of return in the business.

So, when our value-trap time limit came around, we sold our position at 4.5% less than we had paid for it, but since we had collected four dividends over the period, our internal rate of return (IRR) came in at just over 5% per year.

Chart 1: History of NWL share price and total return since our first investment – dividends make a difference:

At the time of our first investment in Nu-World, the market darling on the JSE (with the best ‘growth prospects’ and the ‘best management team on the JSE’ – according to most commentators and analysts) was a company called Transaction Capital (“TCP”). They had achieved consistent earnings growth, albeit at mediocre returns on equity, of about 13%. We mention the word ‘mediocre’ in the context of market expectations. By February 2020, TCP was trading at multiples of its liquidation value (actually – by our calculations, their liquidation value was negative R9bn at the time, as the business model relies on very high levels of debt) and on a price/earnings multiple which appeared to be around 20x, having grown their earnings per share by 15% per annum over the past 5 years. In short – expectations were high.

By the time we sold our Nu-World position, the TCP share price had collapsed by more than 70%. The same economic factors that deteriorated the economics and profitability of the Nu-World business had impacted TCP’s business – yet the outcomes were very different. The choice faced by investors in November 2023 was as follows: for Nu-World, one had to continue to wonder when, if ever, there would be an event to unlock the underlying liquidation value of the company, but you have the opportunity to take your money and look for another opportunity (as we have done). For TCP shareholders the decision was whether one would be prepared to follow an impending rights issue in the next 18 months, most likely at a discount to the current share price, or take your money and try to make back your loss somewhere else.

Chart 2: Nu-World total return vs TCP total return over Nu-World holding period.

This outcome contrasts the risk of growth traps to that of value traps. When things go wrong with value traps, investors have a level of protection from tangible assets, cash, and dividends. When things go wrong with growth traps, investors are wholly dependent on the kindness of sceptical strangers…

When it comes to the “deep value” bucket of our portfolio, we continue to build in a significant margin of safety (e.g. a “net-net” strategy) in our long positions, meaning that the “bad” outcomes are likely to be positive, even if it is underwhelming. We balance that with a disciplined approach to avoid long-term value traps that do not meet our required rate of return.

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