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Hello, everyone. Today, we are going to be going through another episode of The Asia Report. And today, I’m going to be talking about value traps. It’s a subject that comes out a lot especially among value investors. I think before I actually go into the topic deeper, it’s probably best to give a simple definition with regards to what a value trap is.
A value trap is essentially a stock that appears to be cheap because the stock has been trading in low multiples of earnings, cash flow, or book value for extended periods of time. The crux though with value traps is that these stocks tend to remain cheap for very long periods of time without ever revaluing. Even though you might think that there is value there, this value is simply never unlocked. Now, I’ve heard a lot of discussions on value traps and the term thrown around very loosely but I think this is a subject in which more care has been to take– you have really to take more care to actually look at a situation.
In my mind, there really is a value trap and there’s a situation where an investment just hasn’t worked out well or your timing is off. It’s very easy to look at the outcome and say, “Hey, this company is a value trap,” whereas it could be simply that the performance– sorry, it could be the timing of the investment was wrong or you were investing in a wrong end of the cycle or it was the case where management simply did not have the same idea as you because their incentives or the agenda was different.
Again, a good example to illustrate this is a company called Mandarin Oriental. This is a company which I also made a similar mistake in classifying them as a value trap. And there were a couple of other hotel companies such Mandarin Oriental, Shangri-La and Hong Kong Hotels, which owns the Peninsula in Hong Kong. Very expensive and very grand old hotel, five stars. One of the things which I noted is that a lot of these hotel companies were essentially trading at deep discounts to book value. I’m talking about 30-40% of book value, which was very interesting.
When I looked at the value of these companies on a book value, I thought, “Okay, this looks cheap. Now, let’s dig deeper.” What I found then when I looked at the companies was that these companies were essentially not generating a lot of free cash flow because the business wasn’t very attractive. If you just invert a bit, it was a situation such that you have a residential property, maybe $2 million and it was only yielding maybe $20,000-30,000. So actually, the net rental yield was only 1-2%. But the asset value, simply because interest rates are so low and had a high multiple attached to it, it was selling at $2 million so your net rental yield was actually very low. The hotel companies, in particular, struck me as something similar. In my mind, this was not a company in which they were about to sell these properties soon to monetize the value of it, even though as a value investor and as someone with a much shorter time horizon, that’s something I want to do.
Lo and behold, I was proven wrong, unfortunately. These companies did revalue but I think the case of Mandarin Oriental was very interesting. In the case of Mandarin Oriental, what had actually happened was that they have a hotel called The Excelsior Hotel located in Causeway Bay in Hong Kong. And this was actually one of the first plots of land that was sold and this is a very, very old hotel. They had a commission review to discuss what to do with the hotel and they had in mind to develop it into a commercial site just because commercial land plots were fetching very high prices in the central area of Hong Kong.
And based on rough estimation and calculation by them and various analysts, they calculated that the entire worth of the hotel will essentially be greater than the market cap of the company itself excluding the other assets and hotels which they own, which was actually quite amazing. When news leaked out that this company, Mandarin Oriental, had decided to look into the situation and the stock obviously revalued. And in the case of a company which many people who have considered a value trap suddenly wasn’t looking like a value trap. This is where it becomes interesting and you can see how that at different time points maybe 2-3– if you held the company for 2-3 years and you look at the company and say, “No, this is a value trap.”
And someone coming in 1-2 months later, maybe bought it just before the news, he would have a different opinion altogether. You can see how this affects what a value trap may be perceived to be. Now interestingly enough, Mandarin Oriental, they sought out bids but they did not actually get the level of bid which they wanted, so they decided, “We’re not going to sell the hotel, we might develop it ourselves.” And the share price came down somewhat to reflect this new news because people were expecting maybe a one-off special dividend or maybe they decided to throw the profits back into a place more profitable. You can see that there’s a lot of timing involved and many times, it is unclear to actually assess what may really be a value trap. Let me give you some things that I look for in deciding whether a company is really a value trap or it’s simply a case where a company actually has assets but it’s deciding not to monetize it for reasons which may be unknown or known to us at the time.
Now, in my mind a real value trap is something that looks superficially cheap but there’s a real reason why the value will never be unlocked. In a case of a situation like Mandarin Oriental or a company or maybe even a hotel company which is family-owned, eventually the guy has an agenda to monetize the asset at some point of time. And if he’s the largest shareholder, the most appropriate way of returning that capital back is to shareholders. In my case, that might not be a value trap and it’s probably not a value trap. Maybe a situation where if I don’t know what the catalyst may be or I don’t know what his agenda is, I may not be so comfortable taking a position. Not because I don’t think it will never revalue but it may take such a long time to revalue that it might not be a worthwhile investment if I can find other opportunities.
Now, what is a real value trap? A real value trap, in my opinion, is a company which has two things– which falls in two categories. Number one, it appears to have assets but the assets are not really there. For those of you who are familiar with a lot of S-Chip companies or China companies listed in Singapore or even China companies listed overseas, you’ll be familiar with this. And these are cases of outright financial fraud. They’re trading at 20-30% of book value but the cash is not actually there or the receipts and trade receivables are actually fake.
Even worse, it could be a situation whereby the cash was actually there but when the guy decided that the business was not doing well, he found a way to actually get the money out of the company and run away with it. And this is another unfortunate familiar story involving many Chinese companies listed in Singapore. So you have a situation like that. Another situation where maybe that it’s not that the asset is not being– in a situation like if you have a property, a residential property yielding 1-2%, this is not a case whereby you have– management is acting up maliciously, it’s more of a situation where asset values are inflated and there’s not much they can do unless they change the business completely. I have a certain amount of sympathy for people in situations like that.
But in a different kind of situation where the company has real assets, it’s generating money but because of the misalignment of interests, it may be that management simply wants to milk this company either by paying themselves extremely high salaries and not rewarding shareholders with dividends or taking the money and engaging in related party transactions such as selling below market prices to another company which they also own. In that case, I also feel that it is very hard for investors to actually realize the profits because management, in this case, is– I’m not sure if the word to use is malicious, but they’re definitely acting in direct conflict of interest as opposed to not monetizing the assets fully in what the case is a question of competence as opposed to a conflict of interest.
In a situation where you have a conflict of interest and someone is smart and actively working against your interests and he’s also the controlling shareholder or management, the only way that you will be able to monetize this asset and realize a good return is if an activist shareholder came in or management were to pass away and the new management coming in is very different. And to me, that’s a very, very difficult bet to make unless you know of this activist shareholder coming in, and there is one case which has happened before, so I don’t want to discount it either.
Now, what I like about assets which are not being fully monetized well, or management is– in a way you can say they’re more lazy, maybe they’re quite old, they’re 70-80 years old, I feel a lot of Japanese companies in the same way. They have a lot of net cash, they’re not bothering to redistribute it as dividends, they’re letting the cash pile up earning negligible interest rates. The good thing about situations like that is that this is a situation that is easily reversed if competent management comes in or maybe a new shareholder comes in or people just simply realize it and cover it to point out the possibility of monetizing these assets. Some examples I have seen which I can relate to, maybe a company has industrial property which is not yielding a lot, they decide to sell the property to a company that actually needs to use it. Let’s say the industrial property is worth $10 million, they sell it at full market value, maybe a slight discount, but the company is trading 30% of book value, it really means that you are simply buying this industrial property for $3 million and waiting for the day when it revalues.
The best way I can conceptualize and think about this is to really think of these companies as “free options”. If you buy anything at 30-40% of book value and there’s no financial fraud going on, that normally means that the business is probably not being run as well or has a lot of assets not generating a lot of income. If you can find situations like that but management is not working against your interests but is not very competent, the road to revaluation is actually very simple. It just involves the selling of an asset or leasing of an asset which is not leased out that then can lead to a good revaluation.
The issue of that I think is that in situations like that, it is often unclear because inertia is a powerful force. Sometimes management simply chooses to do nothing instead. Your rate of investment could take a very long time– your investment could take a very long time to play out which is obviously going to affect what your compounded growth rate on that particular investment is.
In situations like that, I tend to like to go to these AGMs and EGMs to speak to management to see whether they have an interest in actually monetizing these assets down the road. And also to look at their salaries, to look at how they normally compensate themselves. Is it through dividends or income? And that will give me a rough idea of whether this has a high probability of paying out. But, of course, as Mandarin Oriental shows, sometimes there’s a element of luck involved of course and you never really know when this is actually going to happen.
I think that’s why the case can be made to buy 10 to 12 of these very, very cheap companies with reasonable management, cheap discounts to price-to-book with good assets and you simply just hold maybe 10-20% of your portfolio in that and that is a way to go about doing it. In a situation like that, an investment does not play out as you think it is, these are not what I consider value traps. To really look at value traps, you always go back to the same few things. You always go back to– Is it a financial fraud? You look at the country of incorporation, you look at how management has acted before, you look at their remunerations relative to the income of the company, you look at related party transactions or interested party transactions to see whether maybe he’s selling the goods of this company or to another company at below market prices, and you also look at the holding structures of the companies.
This is a brief introduction to the subject of value traps, something which I’m quite fascinated by. If you want to know more about value traps in general, I recommend reading a very, very good book written by Tan Chin Hwee, which I’ll leave in the article blurb. He wrote a very good book called Asian Financial Statement Analysis that covers a lot of financial fraud or deception that happens in Asia which will provide you a very good guide to want to look for in avoiding real value traps.