How do you decide whether it is a value trap or not?
Value traps are statistically very cheap and very alluring.
First question to ask: “Why is God so kind on you that you are the only one who has this tremendous insight that this stock is cheap and all the other people who are very active, smart and intelligent in the market are ignoring this company?”
Is there an embedded growth optionality in the company? Can the company have a growth phase? Can the company come out with some new product offering which can introduce growth?
This is a dynamic exercise. You will need to revisit the hypothesis every now and again, at intervals.
Two characteristics of value traps are:
- (1) They typically don’t tend to grow more than the nominal GDP
- (2) They cannot reinvest their cash flow.
So the question you should ask is what is the catalyst which will change this and allow them to reinvest the capital which they are throwing off? In its absence, you have a classic example where the company had great cash flows and no catalyst.
Your sole focus of whether to participate in a seemingly value trap could be you calling out the catalyst that will catapult it out of this situation.
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