Value Traps: Look Past Surface To Identify True Value

Value Traps: Look Past Surface To Identify True Value

by Mark MelinJune 19, 2014, 11:40 am

Morningstar pannel advises to avoid Chinese banks and other companies that look like values but aren’t, rather look for strong management in battered down geographic regions or market sectors exposed to long term growth trends

In finding value in today’s market environment, three professional investors shared a common theme: don’t let where the company is domiciled taint your view. This was the view of a morning keynote speech at theMorningstar investment Conference held today in Chicago- the panelists were Harry Hartford, Causeway Capital Management, David Herro, Oakmark Funds, and Rob Lovelace, The Capital Group.

In focusing on the developing world, “valuations not as compelling as they were three or four years ago,” said panel participant Harry Hartford, Causeway Capital Management. He noted that many times a country or geographic region can be beaten down by investors while quality companies within that region may be hiding.

Value traps: You should look where a company earns and generates cash

“Let’s not look at where a company is domiciled but look at where a company earns and generates cash,” said David Herro, Oakmark Funds. Many companies might be domiciled in countries with questionable stability, but their revenue stream is generated outside of their domicile.

Herro is enthused about emerging markets in the long term, despite short term valuation issues, citing generational growth trends will usher in a new middle class.  He is, however, skeptical of state owned enterprises where price to earnings look cheap, specifically pointing out Chinese banks, which have questionable long to loss ratios of less than one percent.  “Never bank on an individual politician,” he advises. “Look for companies that have exposure to growing trends in emerging markets.”

Herro says price and quality of company need to come together, and offers a specific formula to prevent you from falling into a value trap. Determine the quality of the company, the durability of their earnings, and then project their real value.  Fixed assets, hard overhead costs combined with sales concentration and a lot of debt is risky. “Value to us is combination of low price and high quality. Revenue needs to be durable and how they allocate free cash is an issue.

Value traps are inevitable

Value traps are inevitable that some stocks keep you awake at night, Hartford said. “Value manager looks for stocks out of favor. The challenge for a value manager is avoid entities that optically appear cheap, but making a fundamental error at what is going on at the company level.”

What investments does Herro like? He likes to find beaten down firms where their value is 40% higher than the current stock price. The wider the spread between the current stock price and their internal valuation is the opportunity that receives a high allocation.

Value traps: Risk is not volatility

When considering risk, Herro made the point “risk is not volatility,” he said, questioning the common academic thought that marries volatility and risk. “Risk is the probability of not getting your money back and not getting a return that justifies the time value of money.”

“Academics have assigned volatility with risk and this is not entirely accurate,” Rob Lovelace of the Capital Group added, while noting that investors find volatility more challenging than do professional investors.