kcchongnz blog
Identifying value trap kcchongnz
Value investors generally like to invest in stocks when they are selling cheap such as low price-to-earnings, price-to-cash flow and price-to-book ratios. My previous article describes academic research has consistently shown that value stocks have been consistently outperforming that of growth stocks.
http://klse.i3investor.com/blogs/kcchongnz/81690.jsp
I have written many articles on how to identify value stocks such as appear in the links below:
http://klse.i3investor.com/blogs/kcchongnz/75985.jsp
http://klse.i3investor.com/blogs/kcchongnz/75962.jsp
However, many stocks are cheap for good reasons and they are what we term as “value traps”. A value trap is a stock that appears to be cheap but its value is in continuous decline and the original margin of safety buying it cheap disappears over time. Being price sensitive, value investors lost much more money from value traps than from overpaying stocks.
In this article, we will discuss how to identify and avoid a value trap and not stuck into it by looking at two simple but important metrics; profit margins and return on equity. Here I will use my favourite company, London Biscuits as the example.
Business background
London Biscuits is engaged in manufacturing and trading of confectionery and other related foodstuffs. The Company offers packed and ready to eat products, which can be categorize into corn based snacks and cake products, such as Swiss rolls, pie cakes and layer cakes. In addition, it also manufactures range assorted chocolate confectionery, including chocolate-coated peanuts and biscuits, pancake cookies, jelly and puddings, wafer sticks, cup sticks and snack noodles.
Financial performance
London Biscuits reported an earnings per share (EPS) of 20.5 sen for its financial year ended 30th June 2009, up from 11.5 sen the previous financial year. At that time, it is trading at about RM1.00 as shown in Figure 1 below. At that price, it is trading at a PE ratio and P/B ratio of 5.2 and 0.5 respectively then. These ratios are considered very cheap in any standard for a confectionery company involved in the food industry. Its share price rose to about RM1.30 a year later when EPS declined to 15 sen. At that price and EPS, PE ratio is still low at just 8.5. From then on, its share price follows a down trend and close at 75 sen on 21st August 2015. Investors who thought London Biscuits share price was cheap at a PE ratio of 5.2 on June 2009 and bought it would have lost 25% while the broad market has gone up by about 60% during the same 6 years period. That would be a negative alpha of a whopping 85%!
What was and still is the problem with this “value stock”? How could one lose his pants investing in such a company in a recession proof food industry while the broad market has risen by 60% during the same period? Few investors could fathom the reasons.
Here we examine the operating profit of London Biscuits as it more crucial in reflecting organizational productivity before considering how the firm was financed or the contribution of non-operating activities. Investors should always closely monitor operating income, as it provides insight into a firm’s “core business operations.” It is important to examine a company’s operating margins against those of other firms in the same industry, as certain industries have higher or lower operating margins.
Figure 2 below shows the explosive growth in revenue of London Biscuits from RM108m in 2006 to RM360m in 2014, or a compounded annual growth rate of 16.3%, a fantastic growth company many growth investors wold yearn for. Its operating profit, however, fell flat for the whole period. Its share price went straight down to about 60 sen in May 2013. What have gone wrong?
Figure 3 below shows the operating margin of London Biscuits. We can see that it has been in a clear as crystal long term decline. Operating margin deteriorates consistently from 23% in 2006 to less than 10% in 2014. Although revenue grows by leaps and bound, operating profit remains flat. Whereas the operating margin of another confectionery company, Apollo has been relatively steady throughout the years.
Take a look at its trend of return on equity as shown in Figure 4 below. I have deliberated why ROE is the driver of long-range return of stocks, not earnings per share, as shown in the link below.
http://klse.i3investor.com/blogs/kcchongnz/80420.jsp
A picture paints a thousand words. ROE of London Biscuits has been deteriorating unabated by 70% from 12.8% in 2006 to just 4.1% in 2014. This ROE is way below the required return of the equity shareholders, whereas ROE of Apollo has been stable in the teens and consistently much higher than those of London Biscuits.
Investors would avoid investing in London Biscuits or had plenty of time to sell the stock and used the proceeds to invest in other value stocks 6 years ago looking at the low and deteriorating margins and ROE. This would avoid the 30% loss 6 years ago, and would have made 140% from the money to invest in Apollo Food, if they pay attention to the indication of a value trap – the long term decline of profit margins and ROE of London Biscuits compared to the stable margins and ROE of Apollo Food.
Take a close look at the price performance of London Biscuits and Apollo for the last 6 years below.
London Biscuits share price did go up from 60 sen to close to RM1.00 as shown in Figure 1 above when Kenanga and a couple of other analysts recommended it sometime in April last year. However, if investors have paid attention to the poor and declining operating margin and ROE, they could have avoided further losses following those buy calls of some investment banks.
http://klse.i3investor.com/blogs/kcchongnz/60180.jsp
Why You Should Avoid Margin Decliners?
The reason is simple. The company is losing its price power or it never had price power. Competition is eating into its market. Or the management has been negligent in managing the company, resulting in rise in costs, and hence declining operating margins and ROE.
There are in fact many other red flags indicating London Biscuits being a value trap, but these two simple metrics do tell a lot about if a stock is a value stock or a value trap.
Will the profit margin and ROE of London Biscuits or other value trapped companies ever recover? That is a “too-hard” question. Why should we put ourselves into this situation when we have so many other choices investing in Bursa?
Investment opportunities in Bursa are here again. For those who are interested in identifying value stocks to invest for long-term wealth building, and at the same time avoid value trap which could serious and adversely impact your investment outcome, please contact me for an online course at
K C Chong
Related Stocks
| Chart | Stock Name | Last | Change | Volume |
|---|
Market Buzz
More articles on kcchongnz blog
Insas Warrants WC and Its Valuation kcchongnz
Created by kcchongnz | Jan 22, 2024
Which to buy, Insas or Insas WC?
Isn’t this the most undervalued stock in Bursa?: Insas Berhad by Kcchongnz
Created by kcchongnz | Jan 15, 2024
2024 New Year Reflection Investing in the Stock Market: Timing the Market
Created by kcchongnz | Jan 01, 2024
2023 Christmas reflection on pitfalls of investing in the Malaysian stock market kcchongnz
Created by kcchongnz | Dec 25, 2023
Introduction: The Complete Dividend Investing Guide That Works by K C Chong
Created by kcchongnz | Oct 02, 2022
Discussions
7 people like this. Showing 21 of 21 comments
Posted by Flintstones > Aug 25, 2015 07:34 PM | Report Abuse
Your kfima is also a value trap Sir
Thanks for your statement. Maybe you should put forward your rationale, what is your context of what a value trap is, and why Kumpulan Fima is a value trap (it may well be one), so that we can learn from you and avoid value traps too. Sometimes I do get things wrong and fall into value traps. I need to curb my cognitive bias of over-confidence too.
2015-08-25 19:52
Sir. I think every stock has an operator. A value trap stock is a stock that fails to attract any operator attention. Some of the reasons are no theme, no good business model, no expansion plan, management too shy from media ect. The operator simply can't find any reason to attract players. How can the operator play by himself?
2015-08-25 19:58
Posted by oregami > Aug 25, 2015 07:58 PM | Report Abuse
Sir. I think every stock has an operator. A value trap stock is a stock that fails to attract any operator attention. Some of the reasons are no theme, no good business model, no expansion plan, management too shy from media ect. The operator simply can't find any reason to attract players. How can the operator play by himself?
Good point. I am not sure what is your "operator" means. I presume it is some kind of share price operators, people who "play" the shares, that the business have some kind of "theme", that the management must be famous and vocal in the media to "sell" the shares, big expansion plan etc.
Well, you have your context of what a value trap is, but it is clearly different from what is written in this article. I respect your context and opinion.
2015-08-25 20:17
No Kfima is not a value trap.
It just that Mr Market, did not realise the true value.
kfima has a declare a dividend rm 0.085.
There is yield & value in kfima,
2015-08-25 20:46
I view a value trap can also be buying a cyclical companny at the peak of its business cycle. Historical numbers look good... but the fact is the profitabiliry is declining...
2015-08-25 21:11
Kc:Not wanting to go into the merits of diversifying;but London biscuits had disastrous acquisition/s (Layhong and TPC)
2015-08-25 23:50
Posted by paperplane3 > Aug 25, 2015 09:40 PM | Report Abuse
Kcchong, your elsoft also Holland now!
Posted by paperplane3 > Aug 25, 2015 09:41 PM | Report Abuse
When tide away, we know who is master and who is not, hahahahaha
Posted by paperplane3 > Aug 25, 2015 11:56 PM | Report Abuse
Seems like value investment d9nt work this time
I am not sure of your context of value investing too. Hope you can enlighten us. My context of value investing is described in my two articles below.
What is value investing?
http://klse.i3investor.com/blogs/kcchongnz/53835.jsp
Why value investing works?
http://klse.i3investor.com/blogs/kcchongnz/50988.jsp
Value investing follows a process of choosing stock. No doubt it can get wrong too, but the probability of being right is generally higher.
http://klse.i3investor.com/blogs/kcchongnz/79050.jsp
I am not sure which group of investors you belong to. Maybe you can teach us your way of investing, so that we can make money for every stock, without exception, today, tomorrow, next week etc. and under whatever market condition, even market/markets plunge. It would be better if you can also provide some evidence of your success, the success of a real master in the stock market
2015-08-26 06:34
hi KC,
london choco roll~~~~~~ london choco roll~~~~~~ choco roll... choco roll.... london choco roll~~~~~~
The song keep rolling in my mind every time someone mention London Biscuit here. They succeed brainwash me.
By any chance, could we spot pump and dump counter using this method too?
ty
2015-08-26 13:22
Very informative post which explains the difference between Apollo and LB. I guess I'll just delete LB from my list. Previously, I had thought it would be a good idea due to the perceived 'value'. Not so, as this post shows.
I'll also be paying more attention to ROE. Admittedly, all this while I'm a lot more focused on EPS. Still will be, but with ROE also taken into the mix.
2015-08-26 16:11
@ks55 That's what I'm trying very hard to stick to despite the very tempting prices we see everywhere. Can't stay totally at the sidelines, of course - if we want to try make a profit, we must be in the game first. However, based on environment right now, I'm also being cautious. Protecting one's capital is called given the possibilities we're facing now.
For those with significant holdings in the stock market, it may be a good idea to buy some insurance "just in case". Specifically, put warrants. Should something happen, at least there will be some consolation. One will also sleep better at night knowing he is somewhat covered and not totally exposed and hapless in a sudden crash. The problem is, our local put warrants have become overpriced.
2015-08-26 16:24
aiyah....
KC had thought us so many method to evaluate a company, ROIC, FCF, EV/EBIT,DY...
is that not enough to assess whether a company is worthwhile investing or not ?
to a income investor like me , investing is very very .. simple
I have a set of strict stock pick criteria, as long as a particular stock is still meeting my criteria ,I will not sell, even though you tell me market going to crash tomorrow. because I know very well , if you are talk about things of tomorrow , you are none other than fortune teller. it is most foolish to believe a fortune teller but not believe your own calculation
KC has thought you so much valuation techniques , why you have never learnt?
I have thought you so many time , it is near impossible to get the best deal and be wise to be happy with the right deal, why you never learnt?
if you can choose a kunyit ot musang king durian trees to plant, do you need to sell your plantation if the fruits don't fetch good price this year and hope to buy back bigger plantation next year, you have seen the gain, but you family has already missed the fruit (dividend) this year and next year
I am going to get RM 20k from gadang later . 5k from flbhd tomorrow, 2k from matrix, 5k from favco, 3k from matrix,...
do you think , I will scare of the market crash?
I will tell the market, you go on to crash, I go holidays with my family because KC valuation told me my companies will not crash with you but keep generating more dividend for to spend
no fear, no worries when you know what you are doing is not right though not the best
Thank KCChong.
2015-08-27 11:38
ks55,
you worry too much already
why people scare of market crash?
the reason is simple,
THEY WANT TO MAKE THE MOST !
if you change your mentality to " CAN MAKE BUT THE BEST"
then kcchong articles will help you a lot
I do not pay him a sen, but I learnt a lot from , I am very happy
feel very happy
no fear, even though tomorrow KLCI drop 200 points
why?
I still got my dividend to spend or to buy more at lower price
2015-08-27 11:56
go lah...., go and buy those companies I mentioned above
they are not value trap, they are value buys
mark my words, if anytime within 5 years from now, you can't get a capital gain of average 20% per year + reasonable dividend, come back here to tell me how do you want to punish me.
I can assure you here,
I will not tell you :THE DECISION IS YOURS" or "I DID NOT POINT A GUN AT YOUR HEAD TO ASK YOU TO BELIEVE AND FOLLOW"
hahahaha.......
2015-08-27 12:10
pisang, serious one or not ? if anytime within 5 years from now and I still quote "holding, not willing to cut loss, are grumbling, groaning and mourning" --- can punish you ? I come and cut of your most precious part i.e your pisang ? ..... make goreng pisang can ? ha ha ha you are a funny guy :)
2015-08-27 16:11
Posted by pisanggoreng > Aug 27, 2015 11:38 AM | Report Abuse
I am going to get RM 20k from gadang later . 5k from flbhd tomorrow, 2k from matrix, 5k from favco, 3k from matrix,...
do you think , I will scare of the market crash?
With those stocks, I am not afraid of market crashes too. They are all magic formula type of stocks which are for long-term investment.
2015-08-27 16:20
Babu,
If you are smart and rational in thinking then definitely you know what I actually want to tell you is " valuation and confident to act" not challenge to cut gu-gu-chiao .
You are very funny
2015-08-28 09:21
pisang, no offence meant - was just trying to make light of your punishment offer. I am sorry. Your comments have always been very useful in this forum and I should not have made light of your "mark my words"..... please excuse this young naïve young boy :)
2015-08-28 17:10
Post a Comment
Featured Posts
Apps
Top Articles
1
2
save malaysia!
3
RHB Investment Research Reports
6
BFM Podcast
7
BFM Podcast
8
BFM Podcast
#
Stock
Score
Daily Stocks
Stock Name
Last
Change
Volume
Stock Name
Last
Change
Volume
Stock Name
Last
Change
Volume
Featured Advertisers / Partners
Ride The Bull Short The Bear
CS Tan
4.9 / 5.0
This book is the result of the author's many years of experience and observation throughout his 26 years in the stockbroking industry. It was written for general public to learn to invest based on facts and not on fantasies or hearsay....
Flintstones
Your kfima is also a value trap Sir
2015-08-25 19:34