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Value traps: the warning signs fund managers look for

Some low-rated shares have real upside potential, others are going nowhere fast. Here's how fund managers try to avoid dreaded 'value traps'.

 
Value traps: the warning signs fund managers look for
 

Active fund management is as much about stock-avoiding as it is about stock-picking. And, when it comes to equities, managers are keen to avoid value traps.

Paul Mumford, Citywire AA-rated manager of the Cavendish Opportunities and AIM funds , describes it as follows: ‘The basic definition is it’s a share that looks good value, in terms of a low price-to-earnings ratio or potential high yield. But, in fact, there’s something wrong with the company and you get trapped in the share.’

Georgina Hamilton, Citywire A-rated co-manager of the Polar Capital UK Value Opportunities fund, explained prices do not have to fall for it to be a value trap. They can just go sideways. ‘Vodafone (VOD), for example, has gone sideways for a long time,’ she said. ‘A value trap often bumps along the bottom, but never rises.’

HMV Titanic

For value investor Mumford, a classic example he ‘got caught up with in the past’ is music retailer HMV. This company sold CDs, which were in decline. But in 2009 The Beatles had brought out a CD boxset, while Michael Jackson’s recent passing suggested ‘his CDs would fly off the shelf’. However, by October 2012 HMV had suffered half-year losses of £36 million and it went into administration in January 2013.

How can managers avoid being stung? For Mumford, the key is to ensure these sorts of mistakes do not have too damaging effect on the wider portfolio.

‘The way around it, in my opinion, is to have a wide spread of investments. I hold more than 70 companies with an initial investment of no more than 1.5%. If a company goes bust, I lose relatively little.’

Elaine Morgan, Citywire AA-rated manager of the Kames UK Smaller Companies fund, tries to avoid such traps by ensuring a company’s earnings are stable, but with scope to rise. She also makes sure financials are steady.

She added negative structural changes to an industry raise the chances of being in a value trap. Morgan said: ‘This might be a disruptive discounter entering the market, such as with Lidl or Aldi in retail. It may be a change in consumer preferences or a technology change, as happened with Amazon (AMZN.O). Or it could be regulatory changes, with governments tightening up on terms and conditions of trade.’

Regarding financials, Morgan wants companies to use internally generated cashflows to fund the business, pension liabilities and dividends, with scope remaining to invest for growth. ‘All of that means, in addition to traditional value metrics, you must consider management delivery. You need a clear investment case for rising value,’ she said.

Keep an eye for quality

Thomas Buckingham, manager of several JPMorgan equity funds, pointed out: ‘Some stocks are cheap for a reason. These are value traps.’

He tries to identify them by looking at momentum and quality factors, with downgrades to earnings expectations or downward share price momentum serving as 'red flags'. 'Historic earnings momentum is a good predictor of forward earnings momentum,' he said.

The manager defines quality in terms of management; accounting, ensuring cashflow figures compare well with earnings; and the returns profile of the business, for example, in terms of the return on invested capital. ‘We try to avoid stocks that look bad from a combined momentum and quality basis,’ he said.

Despite all these strategies for avoiding value traps, value fund managers will continue to fall into them. But this is no reason to reject the investment style. Growth investing has pitfalls of its own.

‘As value investors, we think expensive shares are risky shares. Any small reduction in expectations can have a disproportionate effect on the share price,’ said Hamilton. ‘With high expectations there’s big room to disappoint, perhaps on product lines or delays in new technology. Often it comes from just slightly slower sales growth.’ 

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