November 21, 2007

Value Trap

In an interview with super investor Bill Miller, he was asked about value trap, his response is a very good one: Globe Investor Magazine: "How do you avoid value traps? We don't, sometimes. But the nature of a value trap is when people confuse the cyclical and the secular. Toys 'R' Us was a famous value trap from the last seven years before it finally went private. People would look at historical valuations and say, 'Gee, Toys 'R' Us always trades at a 15% or 20% premium to the market. It's the dominant toy retailer. So now that it's at the market multiple or a discount, it's attractive.' But with Toys 'R' Us, it wasn't cyclical, it was secular. Wal-Mart, Target, people like that were systematically picking off their product array, and video games were taking away some of their demographic. Trying to avoid value traps means trying to understand what's in cyclical decline versus what's in secular decline."

Value companies have many time been confused with price declines. Price declines happen for many reasons: economic slow down or cyclical, misunderstanding by the market to its economics, ...etc. What investors need to know is why the decline happened and what motivated the price drop. Without a true understanding of the price drop, buying on the dips is no better than a speculative purchase of 50/50 chance of return. And those odds are not very good.

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