Tennessee Williams once wrote that, “We all live in a house on fire, no fire department to call; no way out, just the upstairs window to look out of while the fire burns the house down with us trapped, locked in it.”
That was from his play The Milk Train Doesn’t Stop Here Anymore. And it’s about as bleak a way of looking at life as possible.
It’s also pretty inaccurate.
Yes, sometimes we’re faced with desperate situations that are impossible to solve. But where we end up is so often the result of what we do (or don’t do).
Do we choose right or left? Hard or easy? The long term or the short term?
I consider Steven Wright, a comedian and actor known for his impassive one-liners, much more insightful when he quipped, “There was a power outage at a department store yesterday. Twenty people were trapped on the escalators.”
Because sometimes, being trapped is a choice.
That’s certainly the case with “value traps,” which are investments that promise more than they can provide. It’s a topic I cover in REITs for Dummies, writing:
You don’t want to buy up cheap stocks just because they’re cheap. “One man’s trash is another man’s treasure” might apply well to garage sales and gift ideas, but the saying doesn’t apply to the stock market. It might seem otherwise in the moment, like you’re getting the bargain of a lifetime, but the long-term and often even short-term results say otherwise.
I know I’m always harping on buying quality stocks on the cheap, but there are two parts to that equation:
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Quality
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Cheap
You shouldn’t buy one without the other. And, of the two, quality comes first.
If you forget about that factor, you’re almost guaranteed to get disappointed, if not all-out devastated.
The Science of Spotting a Value Trap
As I said above, investing in value traps is a choice.
If that sounds harsh against anyone who has fallen for a bad investment, it’s not supposed to be. We all make poor decisions sometimes. I know I’ve made my fair share, so I’m not here to judge…
After all, the line between a great value and a value trap can be blurry… and falling on the right side of it can make a world of difference.
Say you see a company that’s trading at a seeming discount, either compared with its own past valuation, its peers, or the larger market. Your next step shouldn’t be to buy; it should be to evaluate.
Stocks do sometimes fall from grace because of market misunderstandings. Perhaps a piece of sector-specific news is getting blown out of proportion. Or maybe a particular company didn’t perform as well as expected, but still has significant potential going forward.
Those could be legitimate reasons to “buy the dip.”
Then again, management might be making poor choices that are hard to come back from. Or something significant may have changed in that particular business or its sector.
That’s another thing I note in REITs for Dummies:
Often a company’s demise can be traced to changes in the cash-generating power of its business model. That’s one of the reasons [real estate investment trust, or REIT] investors should look at past earnings in the form of adjusted funds from operations (“AFFO”). When that’s in a constant state of decline, it only makes sense that the business will find itself declining too.
In which case, its stock is cheap for a reason – because it’s not worth anything more than the low price it’s trading at. Perhaps far less.
A good example of a value trap might be something like global net lease (“GNL”). I singled the REIT out in the spring of 2023. At the time, it owned 309 properties across 15 industries. Its portfolio occupancy was 98%. Even better, its dividend yield was a whopping 15%.
It also looked like a great value. It traded for approximately 6.6 times AFFO. Many of its peers were trading in the 15 times to 17 times range. It looked cheap. And it was… for a reason.
As I explained at the time:
Upon closer inspection, we find the company has around 41% invested in the office sector.
Why is that a problem?
Well, just remember the average office REIT is now trading at an AFFO multiple around 9.5 [times].
I went on to explain how the company’s fundamentals were eroding, how its high payout ratio was a burden on the balance sheet. And I recommended readers avoid it. I’m glad I did.
From early March to today, GNL has fallen by about 43%. And that wonderful dividend? It was cut… from a quarterly $0.40 to $0.275.
Two Value Trap Examples to Keep in Mind
There are plenty of other past examples I can cite to help you make wiser choices in the future. Like Blockbuster, a video rental giant I built over a dozen stores for in its heyday.
When it went public in August 1999, it debuted at $15 per share and raised $465 million. But it soon began showing signs of decline thanks to a plucky little streaming service called Netflix (NFLX).
Management actively ignored that growing threat of online entertainment, however. In fact, in September 2000, CEO John Antioco outright rejected the opportunity to buy Netflix for $50 million. As general counsel member Ed Stead explained to the then struggling streamer, online business just wasn’t sustainable.
(Note: my friend George Johnson was president and board member of Blockbuster in 1993, and he cashed out in 1994 when Blockbuster sold to Viacom for $8.4 billion)
Before Blockbuster closed completely in 2014, however, investors had plenty of time to think its stumbling shares might be worth buying. They had to ignore how Blockbuster fought offering even DVDs, much less streaming services, but hey! A bargain’s a bargain, right?
Until it’s not.
A much more recent value trap example was WeWork. Founded in 2010, it rose to prominence very, very quickly. And so, its private investors made money very, very quickly.
The company attempted a traditional IPO in 2019 at a valuation as high as $47 billion. The only problem was that its fundamentals didn’t come anywhere close to justifying that figure. The IPO was eventually pulled.
And when WeWork finally went public via a special purpose acquisition company merger in 2021, it did so at a more modest level – around $9 billion. Surely, this was a great value.
But it wasn’t…
The company filed for bankruptcy in November of 2023. The shares were delisted by the end of the month.
In short, if it looks too good to be true, it probably is. And if it doesn’t, do your due diligence anyway.
By researching companies instead of buying blind, you save yourself the pain of getting caught in a value trap. It’s your call, of course.
Choose wisely.
Regards,
Brad Thomas
Editor, Wide Moat Daily
PS: Check out The Wide Moat Show on YouTube tomorrow. My co-host Nick Ward and I will be discussing several value traps… a few real value plays… and one that’s a gamble right in between the two.
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Have you ever found yourself dealing with a value trap? Write us at feedback@widemoatresearch.com.