Many financial market participants are familiar with what is generally known as the “two basic emotions felt by investors,” greed and fear. Very often, over-enthusiasm is observed accompanying greed during bull markets and over-despondency is seen on the heels of fear during bear markets. Besides the cyclical aspects of investor psychology, there are other aspects of behavioral finance (another name for this branch of psychology) to explore that relate to value trap avoidance.

Understanding Value Traps 

Value traps take the form of companies that seem inexpensive in terms of attractive valuation metrics. Despite this allure, these companies typically possess underlying fundamentals that suggest they are in secular (long-term), not cyclical (shorter-term), decline. Value trap candidates may face other issues that also result in their stock price not appreciating over time. When an attractively priced stock fails to “pan out” and instead depreciates significantly in value, generally, one can say that company represents a value trap.  

Value traps are true pitfalls that can claim many victims under a wide set of circumstances. A value trap company has been likened to an enchanting oasis that proves to be a dangerous mirage upon closer inspection. Mindful of imperfect human tendencies, novice and professional stock-pickers alike do well to survey the financial landscape and exercise caution when approaching enticing investment prospects. Also, cultivating a contrarian segment to your intellect can be helpful in developing the attentiveness and discipline necessary to avoid getting caught up in a market frenzy or malaise.     

The basic approach chosen by many professional value-based investors is fundamental bottom-up company analysis. The focus is on ascertaining the true or intrinsic value of the stock. This intrinsic value is, in turn, based on the company’s ability to reach and sustain an attractive long-term rate of return from its operations. Uncovering information by thoroughly examining company balance sheets is of paramount importance. Value-oriented investors seek to identify companies that have real potential for further earnings growth that has not yet reached fruition. In this scenario, the company typically has a discounted stock price that reflects this perception of recent or past underachievement. These scenarios represent both excess returns opportunity and value trap risk.

 

Avoiding Value Traps

Equity investors wanting to avoid value traps need to do their homework. In conjunction with fundamental analysis, one should consider technological advancement and how it is either incorporated or rejected at the industry, firm, and product line levels. Imagine a hypothetical investor that failed to recognize the “writing on the wall” in time to avoid losses when society transitioned from film to digital camera processing for the lion’s share of picture taking around the world. 

Many other factors play a role in value trap determination.  A value trap may be more likely when:

1) The asset and capital base (both physical and human) of the company is low,

2) The company’s business model is fundamentally flawed,

3) Excessive debt is on the books,

4) Aggressive accounting is employed,

5) Excessive earnings-estimate revisions are commonplace, and

6) Substantial market barriers to entry are present.

In a broader scope, geopolitical factors that influence global demand and evolving consumer tastes and spending patterns, etc., need to be explored and considered in the context of the candidate stock. All of the above are important telltale signs that help determine whether a company represents a value trap or not.

Successful investors realize that once the intrinsic value of a stock is reached, the owner of the shares does well to consider selling them and move on to the next promising investment opportunity. Exiting an equity position at the right time is another control measure employed to lessen value trap risk. Ahem. Not so quick. Is that the whole story? Besides the value trap determinants outlined above, there exist behavioral phenomena that need to be addressed.

Understanding Behavioral Concerns

Five investor psychology issues will be addressed; they are:

• Mental accounting
• Asymmetric loss aversion
•  Random anchoring
• Overconfidence, and
• Hindsight bias. 

 

Each of the five will be described briefly, followed by further discussion of the issues as they relate to avoiding value traps. A simple graphical illustration is used to provide some common ground for the discussion.

Mental accounting usually involves some form of framing (putting into a definite context), measurement, or classification of gains. One form is essentially "easy come and easy go." This type of mental accounting involves people treating money differently depending on how it was acquired or put to use. It's interesting because it, like all the above concerns is not completely objective or rational. For instance, $1,000 of windfall money, let's say it was won on a single roulette table bet, tends to be spent much more easily than $1,000 earned by working a 40-hour week. $1,000 acquired by a lucky bet has the same purchasing power as $1,000 from a week's worth of labor but the easy money – "easy come", is also "easy go" in the minds of most people facing such a scenario.

Mental accounting is also observed in and around financial markets. For instance, shareholders are notorious for treating the monetary gains received from dividends as being different from that received through capital appreciation. Often, the feeling is "don't touch the capital but spending the dividends is okay!" Another example of mental accounting found in finance is a form of framing where investors exercise a strong bias for measuring returns on a calendar year basis. Typically, losses don't feel real for many investors until year's end. Again, this is irrational. There is no coherent logic in waiting until the end of an arbitrary period before recognizing a problem and possible need for action.

Second, asymmetric (one-sided) loss aversion has to do with how humans feel and treat losses differently than gains. Normally, most of us take it very hard when our expectations are not met, so that we tend to require a gain of twice the magnitude of a loss before we feel comfortable with decision-making under 50-50 propositions. For most of us, we are hardwired so that losing money feels twice as bad as gaining money feels good. Additionally, another one-sided aversion we have relates to estimation of probabilities. Behaviorists have observed that most of us overestimate the probability of events that are highly unlikely and underestimate the likelihood of almost-certain events. Although this one is complicated to explain due to a myriad of plausible explanations, the fact remains that this is a bias we should take into account.        

Third, random anchoring involves our (apparently) innate need to see patterns where none exist. The way in which we bypass reality is to develop various "rules of thumb."  These rules of thumb seem logical to those using them until they are scrutinized in the absence of emotion and prejudice. As an example, many 401(k) plan administrators will tell you that when participants are provided with a total of four different investment options, there is a strong tendency toward allocations that are split close to one-fourth of the total contributions in each option (even allocations).

Fourth is overconfidence. Although confidence is an appreciated state of mind, overconfidence can be a huge liability. For instance, sometimes we just "get lucky." When happenstance appears and strings together two or three good decisions for us, we may take on an attitude that we have the "hot hand" or have uncovered a new universal truth and therefore think we are better than we really are. Yes, at this point a person becomes dangerous. Just imagine for a moment, what if this success came about after utilizing a random anchoring system. Reinforced with recent success, now suppose this person is an investor and decides to take on bigger stakes. It doesn't matter what kind of investor, you can easily connect the dots and realize that overconfidence in this venue can be a really, really bad thing.

Fifth, hindsight bias has at least two very important aspects. First we have strong partiality toward treating past events that happened as having been predictable (ostensibly because they did, in fact, happen) and events that don't happen as being unlikely (because, after all, they did not happen).

Combining the bias above with the fact that the vast majority of humans think highly of themselves, results in our remembering the past in ways that put ourselves in the best light. This includes the tendency to think we predicted the future better than we actually did. Without regular checks and balances to offset this inflated sense of self, this hindsight bias can be carried forward and result in overconfidence (the previous issue discussed). 

Investor Psychology Applied to Value Trap Avoidance

Behavioral shortcomings can lead us straight into various investment snares. Having an awareness of these weaknesses is a very important step to take in avoiding all sorts of problems, including value traps. Individual investors may do well to consider the procedures followed by mutual fund managers. Fund managers often follow a host of policies outlined in prospectuses and other fund documents designed to put into play investment parameters that promote rationality and objective actions. This serves as very useful guidance to consider in countering underlying behavioral tendencies. 

Mental accounting and framing – Remember these concepts involve measurement, classification, and timing. One application to consider involves the investor having an idea of where each of their investments is positioned in their respective cycles of appreciation and depreciation. Presented below is a general representation of the cyclical stages investors encounter over the ebbs and flows of most asset classes.

Notice how greed appears at the top of the cycle and fear (as well as a few other negative descriptors) appears near the bottom. Value-oriented investors have good reason to be positioned on the left side of the graph, near the beginning of the cycle upswing. The descriptors positioned along the way up depict the very real emotions that investors experience. The goal under these circumstances is to exit investment positions as close to the end of peaks as possible. It is no small feat to accomplish. Sometimes facing facts and letting go of something good is very difficult. This is especially true when you consider that every cycle is a bit different. Peaks can become plateaus that last, well, who knows how long? Regardless, this is a nice problem to have; it just requires discipline in order to manage it properly. Perhaps writing down and following guidelines is the best thing to do to remain in touch with rationality. Paying attention to the signs in the specific asset marketplace and evaluating your own feelings against the general framework presented in the graph can be a useful aid in keeping your investment decisions on a rational track.

Asymmetric loss aversion – This involves two tendencies; one is to feel a loss at roughly twice the magnitude we feel a gain. The other relates the tendency to underestimate the probability of likely events and vice-versa. Keep in mind that the graph above tracks emotions and feelings over the most likely course of investing events, that being a cyclical pattern. Full realization of this is beneficial in helping to shape investment actions. Though asset values may ebb and flow, we need to arm ourselves with foreknowledge to do mental combat with our irrational feelings. Otherwise, we could be robbed of our energy while riding the emotion rollercoaster up and down the high peaks and low valleys.

Random anchoring – This concept addresses how easy it is for us to depart from objectiveness and rationality because it simply feels more comforting to employ a subjective rule of thumb. It’s interesting that most of us “know better” than to do this but it is “not knowing enough” that causes us to do it anyway. Confronting daunting situations with only limited and otherwise imperfect information at our disposal is, admittedly, a difficult thing to do. Utilizing a simple general model that has some basis in real-world observations can be helpful. Remember Occam’s razor, which states that “the simplest, workable models are the best” to employ. If the earlier graph does not work for you, develop a different one that does (only be careful to not include random anchors such as arbitrary time periods as a key ingredient).

Overconfidence – Overconfidence can lead us to believe we are better at decision-making across time than we actually are. We want to be very careful whenever we think we can buck trends and come out on top, consistently. When examining the investor psychology graph we notice ups and downs, which, continued over time, tend to average out. The ups and downs reflect general observations in asset markets from period to period. The descriptors in the graph describe how we perceive and react to these movements of asset values over time. In general, there is a tendency toward reversion to the mean (returns average out) over longer time periods. Over time, we win some and lose some. Though we can take steps to win more often and lose less frequently, we do well to not become overconfident so as to think we can consistently beat very powerful forces such as mean reversion.

Hindsight bias – This bias would have us going forward based on a distorted view of the past. Again, actually writing down and keeping track of your decisions compared to a proper baseline can help us in sorting out “follow the herd” instincts that are at odds with contrarian (against the herd) notions. Harvard economist Andrei Shleifer has found in numerous studies that out-of-favor (value) stocks tend to perform better than higher-priced glamour (growth) stocks over time. One reason for this is due to (over)confident investors projecting the glamour stocks’ high growth rates out into the future indefinitely, and thus setting the stage for future disappointment. On the other hand, the expectations toward value stocks are low enough than any earnings surprise tends to be a positive one. By staying mindful of where your investment has been in the recent past, one can better track where it is currently in cyclical terms and perhaps this can help in avoiding any secular downturns that might be in the offing.

As our outline shows, there is more to consider in value-oriented investing than just the greed that can lead us to value traps and the fear that ensues when falling into one. By developing a definite construct, grounded in real-world observations, we can utilize this as a system of useful guidance that encourages each of us to be more cognizant of our imperfect mental tendencies toward investing. Diligence and discipline are the traits to develop in order to do a better job of avoiding value traps and other investment snares.

 

Disclosures:

The opinions expressed are those of Steven Petty and are no guarantee of the future performance of any American Century investment portfolio or any specific asset class relative to another.

For educational use only. This information is not intended to serve as investment advice.

Asset classes refer to the type of investment based on specific characteristics. For instance, taxable fixed income and large-cap growth equities can be considered as two examples of separate, distinct asset classes.

“Good News for Value Stocks: Further Evidence on Market Efficiency”, The Journal of Finance, Volume LII, No.2, June 1997

 

 

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