VALUE: After Hours (S07 E15): Avoiding Value Traps

During their recent episode, Taylor, Carlisle, and Rich Pzena discussed Avoiding Value Traps. Here’s an excerpt from the episode:

Rich: Well, I think that trying to avoid value traps pretty much ensures that you’re going to avoid value. [Jake laughs] I think the answer is you don’t know which are going to be the value traps. If you think you should know, you’re going to have a tough time as a value investor.

Now what would I say? I would say, if the balance sheet is questionable of the– Because as you said, Jake, that it takes longer than you think. If you’re on the edge, time is not on your side. So, yes, you want to avoid the risk of dilution and you won’t be perfect at that, but you can have smaller exposures to companies where the balance sheets are a little scary.

And then, the businesses that are like everybody knows are in perpetual decline, those are the tough ones also to invest in, because most managements, particularly of public companies can’t accept that they shouldn’t do anything. They want to do something. And doing something means let’s try a different business, because our business is no good.

Jake: Yeah. That’s waste a bunch of money trying to do something else.

Rich: Right. But absent that, being uncertain is part of the game. So, you either live with uncertainty and be a value manager and say, “I’m playing the odds–” I would say, if we are superb at what we do, we’ll be 60/40. We won’t be 80/20. But what I want to be able to say, is that if I’m 50/50 on my judgments of whether this is a value trap or not, I want to have a good record being 50/50, because the ones that go up are going to go up by more than the ones that go down go down. And that’s the key to it all. And then, you try to be 60/40 with a very intensive research effort and that’s– So, you spend all this effort to go from 50/50 to 60/40, that’s how I think of it.

Jake: Mm-hmm. I’ve wondered before too if it’s a bit like– You hear like you would say the fifth best copper producer on price is where all the juice really is in a commodity business and swing. Maybe you’re a coin flip on that one working out. But maybe if you moved up to the best low-cost producer, you’re up to a 80% chance. But it’s a much tighter– Like you’re not going to get the same explosive pay. And so, just going between those is really difficult.

Rich: I would tell you that this is what I think. If you were going to draw like a curve of all use quality metrics, like the low cost producer, but if you’re going to use return on capital employed as a proxy for that, if you study that over time, it’s interesting that if you invest in the companies with the lowest return on capital, that’s generally not the best place to be. And if you invest in the companies with the highest return on capital, it’s also generally not the best place to be. And it peaks in between and it looks like that. It looks like this kind of a curve.

Jake: Like a U-shape.

Rich: Yeah.

Jake: yeah.

Rich: And so, I think that I’d rather own an industrial company that generates a 15% after tax return on capital than one that generates a 50% after tax return on capital.

Tobias: We’ve had the same discussion.

Jake: Yeah. Reversion to the mean is coming for you.

Rich: [laughs] Correct. Correct.

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