Identifying Value Traps

(valuseek) #22

Is My.Educare is becoming a value trap?It started so promisingly,but looks like too many bumps ahed.Though I was lucky to avoid loss at Treehouse but this time I may not be so(holding from 153 level).With expansion mode it took debt,digital teaching not going well,future looks cloudy to me.Price is showing with increasing fall.I will be most happy if proven wrong in 8/12 months.

(Krishnaraj) #23

I have been seduced into buying investment companies, hold cos, which later turned out to be “value traps” - the value was never realized

Examples abound, and the recent run-up of the market has lifted many of them up, but two instrcutive stocks where I learntmy lessons were in Kirloskar Industries Limited (KIL) and BF Investments Limited (BFIL), soon after they came into existence.

Both of them, and especially BFIL had many listed and unlisted companies, cash and equivalents and real estate. They looked very very seductive, especially the difference between book value of quoted investments and their market value. Further, dividends from such companies to BFIL were high enough to give a single digit PE ratio, and low PB.

But soon after I purchased such stocks and labored with them I learnt the following lessons:

  1. The hold cos are not meant to maximize value, like say a Berkshire, but to use cash held or capital received as dividend from some companies in hold-co to fund dud companies (atleast an independent minded shareholder would not have invested) in the group. So say Co A in hold co needs funds for capacity expansion even if returns are poor, cash or dividends from Co B will be used to fund the same. So almost by design most hold cos allocate capital poorly.

  2. The hold cos use the company to pay high salaries to accommodate certain key personnel including management. It becomes very apparent that what can be managed by a part time treasury official (as most of the assets are in long term hold co investments), has many officials drawing large salaries, while also working for another group company. Sometimes, other expenses like rent, vehicle loans etc are drawn from hold cos that fund promoters and managers who devote time elsewhere.

  3. Raise funding in hold co by pledging shares of listed companies in hold co; use it to fund some promoter entity. Some of the listed companies in hold co are pledged to raise funds, that are then placed with another entity where the promoter has substantial interest. Default risk of the lent entity is borne by hold co, even while it will use its internal resources to make good on loans availed by pledged shares. Usually the loans will be good, but if for some reasons the listed company in hold co’s share price falls, and margin calls are made, all hell will break lose.

  4. Any promoter restructuring of the companies held by hold co can put the hold co’s minority shareholders in conflict with promoters who will likely have differing interest in hold co and the listed entity and hence biased to act in a certain manner. A simple but contrived instance would be decision to participate in rights, buyback, subscription of warrants, exercising options and so forth.

  5. Use of hold co’s cash by hold co’s promoter entity to buy hold co shares. I have seen one instance where the hold co had a large advance made to an entity that I suspected was related to the promoter of the listed co which was held by hold co but that entity was not related to hold co. Through the listed company money found its way to one of the promoters of hold co that started buying shares of hold co. Otherwise, I could just not figure out how the promoter company with no business to speak of, could get the funds to buy substantial shares of hold co. Consequently as hold co shares were depressed for a long time cash, I suspected, was funneled out to buy its own shares.

  6. Another surprise for me was that, hold cos at times have investments in multiple listed companies that are controlled by different promoter persons, even as they exercise joint control in the hold co. These promoters have internal covenants not known to other shareholders that place undue restrictions on capital allocation. For eg there may be a requirement to have a certain percentage always held in liquid and debt investments. This acts adversely for a minority shareholder.

There could be many more reasons, and I recall Prof Bakshi has written adversely about it as well.

(kums17) #24

Its an excellent thread.
One point learning for me - Go beyond quantitative data - Quality of company
Thanks to all those contributors.

(Thor) #25

I noticed one or more posts about FLEXITUFF categorized above as value trap.

I checked the fundamentals of this company and in one glance it looked quite okay. But the big red flag is that the promoters have only a 32.88 % share which is about 81,81,603. And, 100% of that is pledged. Also, the promoter holding is low. at 32.88%. No wonder!!

([email protected]) #26

Have been looking at RPP Infra, looks to be a good bet except the fact that the promoter holding has been reducing quite significantly although they currently have more than 50% (came down from 72%) wanted to know from fellow members if this can be considered as a value trap or am I missing anything.

(Adiga) #27

The promoters have pledged 82.36% of the 52.51% of shares they hold.

([email protected]) #28

@kmadiga so I believe this is a definite red flag, is that a right way to assume?

(Adiga) #30

This is one of the reason .Ideally I would like Promoter Holding more then 50% , with no pledged shares

Do your own research and analysis.This is not a recommendation and i am not a Registered SEBI analyst

([email protected]) #31

Thanks @kmadiga for your valuable inputs.

(peeksden) #34

The promoters and the brokers that bring and support them in markets are very smart people. They work very hard to ensure that data looks significantly better in all aspects the investors will analyse, specially with peers.

Many of them focus on Financial engineering rather then building business. Even real Revenues and orders come due to backend financial deals.

The value traps creating some no go rules. You will find that promoters will be able to come with several new tricks.

If you think paying dividends, taxes is key, they will find ways to pay them and still trap the investors.

Learn from value traps but get step ahead and think like a promoter as what you will do to trap the growth investors and then the value investors.

(grohal) #35

India is a growth market. Companies/Investors both have a growth focus here. Value theme is popular in mature markets like Europe where high dividend yield is a norm. I find it amusing when high growth companies doing constant equity dilution but maintain a high dividend to show credibility in India (DHFL).
Since growth is the central theme in India, most companies on a stable growth trajectory are extremely expansive. Here lies the value trap, we look for growth but at cheap valuation, which in an efficient market should not exist.
We spend significant time looking for growth stock at cheap valuation or companies which have future potential for high growth but currently are stagnant.
PE/G is a common metric for valuing growth stocks with stable earnings. We should instead look for companies where this metric doesn’t apply but are already growing, these often turn out to be a multibagger, as market can easily ignore the potential. Most growth companies in their starting years have little earnings to show for and Sales multiple, margin improvements, not PE/G are a better way to value them.
Another way to catch the growth companies at right valuation is to wait for a sudden negative event which you know will not last long but the stock has fallen as if growth story is already finished. Event can be company specific or a broad based disruption like Demonetization or GST but surely will not last long.