value trap or trapped value?€¦ · efforts on being right, rather than leaning on the crutch of...

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John Reynolds

Portfolio Manager,

Templeton Global

Equity Group

VALUE TRAP OR TRAPPED VALUE?

May 2020 Life teaches us that when something seems too good to be true, it usually is. Whenever an investment case is built on conclusions like “it has a high free cash fl ow yield” or “its P/E is at all-time lows” or “if you add cash and minority investments, you get the core business for free”…it’s time to pause and go slow. While these statements can describe companies where value is trapped inside, they more often describe value traps—companies where the risk profi le is changing, and fundamentals viewed through the windshield will not resemble those seen in the rear-view mirror. Whether it’s technology or regulation or consumer behaviour, there may be structural changes compromising the business, for good. It may be a long, winding journey, but the ultimate destination is down.

That’s not to say that companies with these valuation attributes are never good investments; on the contrary, they can deliver signifi cant upside. But the standards for due diligence are higher. These attributes do not constitute a value investment case in and of themselves. But they are signs to dig deeper, to understand what we might own, and to focus our efforts on being right, rather than leaning on the crutch of over-diversifi cation to contain the risk of being wrong. Some value investors choose to avoid companies with these attributes entirely. For us, they represent opportunities, but only when we know we are backing companies with the levers available to unlock trapped value and avoiding those that are simply bad businesses—value traps. Whether a company is a bad business now or transitioning from great to good to bad, the endgame is value destruction. The reputation of such companies will ultimately prevail, irrespective of the reputation of the leaders or investors in the company.

What separates value traps from trapped value—and how can we tell the difference? While neither exhaustive nor mutually exclusive, several characteristics stand out as poten-tial indicators of value traps.

“Never buy what you don’t want, because it is cheap; it will be dear to you.”Thomas Jefferson, 1825

TEMPLETON VALUES

Perspective from Templeton Global Equity Group

2 Value trap or trapped value?

1. Pricing trends: Per-unit prices falling for the sector (or falling faster for the company than its peers) is likely to indicate that buyer behaviour or choices have changed, perhaps permanently.

2. Growth: Consistent deceleration in growth rates, whether price- or volume-driven, is likely to signal structural change and is difficult to reverse.

3. Portfolio concentration: Companies overly reliant on single businesses for financial performance often fail to see the breadth and depth of problems in those businesses fast enough to fund turnarounds and/or moves into new, growing, adjacent businesses.

4. Corporate strategy reliant on expense reduction: Cost removal and capital allocation strategies that are not linked to funding growth investments will eventually run out of road and will fail to deliver any sustained turnaround in financial performance.

5. Progressive dividends = progressive debt: Funding dividends from debt is a clear sign that the operating model is broken (or breaking) and that volumes/prices are failing to cover operating expenses, interest expenses and capital expenses.

6. Divergence of cash flows from profits: As value traps deteriorate, management teams begin to find adjustments and reporting changes that are favourable to earnings but obfuscate underlying fundamentals.

7. Bond yields: Bondholders maintain a high degree of visibility on fundamentals and the cash flow required to pay them back. By contrast, equity holders can sometimes become seduced by the “narrative” or “story,” allowing equity valuations to diverge from fundamentals, even if temporarily. It’s important to understand the implications for cash flow and liquidity should bondholders lose confidence in the company.

The presence of some or all of these attributes indicate that cash flows and profits could decline (or stay negative) for prolonged periods of time, eventually leading to liquidity pressure or worse, corporate failure.

Of course, companies with trapped value may also exhibit one or more of the above charac-teristics. There could be short-lived disruptions in their product markets, temporary cost pressures or fixable strategic errors. Or they could be on the path to becoming value traps but have sufficient time (and capital) to unlock what value remains and to reposition into products or geographies that are more likely to drive profitable growth. There are several questions an investor might ask to determine if a company has sufficient “levers” to pull to unlock value. For example:

• Is pricing and growth weakness consistent across the sector? Or, could weakness be driven by mistakes made in product innovation, causing customers to make a switch? If so, can the innovation gap be closed in the near term and within the company’s financial framework?

• While the portfolio may be highly concentrated, are there pockets of higher growth and return (brands, geographies, new products) which could become larger, more meaningful contributors to business performance if given greater resources? Equally, are there pockets of meaningful detractors that can be sold or closed to reduce the negative netting effect on the overall business?


• Is the cost and capex reduction strategy driven by a need to withstand top-line weak-ness? Or is it intended to convert more of the top-line strength into peer-leading profi t and cash fl ow? Can cost savings be reinvested into new lines of business that are likely to drive growth and profi t upside in the future?

• Does the management team recognise the value trap warning signs, and are they taking aggressive action to reposition the company? Does the strategic plan include sensible, inorganic actions to concentrate capital in higher growth and return businesses? Or, does it include increased investment in R&D to build sustainable defences against competitive erosion? Or, is the strategic plan just more of the same, only better?

The task for value investors and analysts is to conduct narrow and deep due diligence that sheds light on whether we have a company that is already permanently impaired or in permanent decline (i.e., a bad business). Or, whether we have a company that has under-managed its way into temporary underperformance and—with the right leadership team—can move resources (capital, people, time) around to either accelerate growth and profi ts from existing parts of the portfolio or build profi tably growing businesses alongside the core business.

By the end of December 2013, Intu’s valuation fell to its lowest level in four years. While not deeply discounted, it sold off to a 10% discount to book vs. historically trading at a 10% premium and went from trading at a 20% premium to peers to a 15% discount to peers. It was “cheap” and the number of buy ratings tripled while sells fell by a third.

At the time of writing, Intu is valued at a 97% discount to its book value, and that is after a 50% fall in book value due to property valuation write-downs.

What happened? Did Intu investors just miss something—or did they choose to turn a blind eye to what was already evident?

The evidence was available well before December 2013. Following the de-merger from Liberty in 2010, Intu reported £1 billion earnings against negative £170 million in free cash fl ow, well short of the what was needed to fund the £435 million in dividends the company paid. Since the operating entity fell well short of funding this, the company relied on investors, raising approximately £700 million of debt and equity, clear evidence of characteristics of #5 on the previous page.

Intu Properties is one of the UK’s largest owners of retail real estate, with a range of assets across the country. It was formed as part of the 2010 de-merger from Liberty, which originally owned both Intu’s assets and Capital and Counties’ assets.

2010–2013

Sources: FactSet Fundamentals. Important data provider notices and terms available at www.franklintempletondatasources.com.

1.20

1.00

.80

.60

.40

.20

Price to Book

2010–2012 December 2013

Intu Peer Mean

No Fiscal Stimulus Moderate Pass through of Fiscal Stimulus Strong Pass through of Fiscal StimulusTrend

2010–2013


200

0

-200

-400

-600

-800

2010–2013 Cumulative (£M)

OCF M&A Capex Dividends


And of #6 with a clear disconnect between earnings and free cash flow.

What was going on? For investors that dug deeper, what would they have seen?

First, a significant change in like-for-like net rents in the years following the global financial crisis (GFC) of 2007–2008. This growth deceleration (#2) was driven by unit price pressure (#1).

The structural change caused by online shopping had been rippling through the UK’s high street for some time and underpinned the large move down in net rental growth.

Second, Intu is a highly concentrated company, with almost 100% of its portfolio in retail shopping centres (#3). And, given the financial situation already highlighted, Intu lacked the funds to make significant moves in its portfolio to diversify away from the online issue. Instead, the company focused on operational, tactical improvements to improve the quality of its centres and to encourage digital shopping onsite.

Ultimately, net rental growth fell to –9.1% in 2019 and averaged –1% per year since 2013, with one good year in 2016 (+3.6%). Along the way, Intu’s rental income fell 20%, it wrote down £3 billion in assets and its market cap fell from £3 billion in December 2013 to £79 million today.

2010–2013


1,200

1,000800

600

400

2000

-200

2010–2013 Cumulative (£M)

Earnings FCF

2004–2013


6%

5%

4%

3%

2%

1%

Like-for-Like Net Rental Growth

Pre GFC (avg ’04–’07) Post GFC (avg ’10–’13)

Sources: UK Of�ce for National Statistics, Retail Sales Index. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses and sales charges. Past performance is not an indicator or a guarantee of future performance. Important data provider notices and terms available at www.franklintempletondatasources.com.

-10%

-20%

0%

10%

20%

30%

40%

Jan’08

Nov’08

Sep’09

Jul’10

May’11

Mar’12

Jan’13

Nov’13

Sep’14

Jul’15

May’16

Mar’17

Jan’18

Nov’18

Sep’19

Mar’20

Stores Online

As of March 2020Sustained Underperformance of UK Store Sales Growth


Value traps are an occupational hazard for value investors. What principles can increase the probability that value managers avoid these destructive pitfalls? We can think of several:

1. Define the investable universe by fundamentals and fundamental trends— not just valuation.

2. Build a case around the business first, understand whether the valuation makes sense second.

3. Growth matters. If growth is slowing or unprofitable, value is harder to create.

4. Make investments evidence-based, not narrative-led, even if it means paying more.

5. Build investment cases off primary research; use market participants to test— not form—hypotheses.

Now more than ever, value investors face the challenge of separating traps from trapped. Economic deterioration is increasing the number of possible traps. It’s a certainty that some companies will experience an “M-” shaped future irrespective of the letter that best describes the recovery of the overall economy. We must simultaneously avoid such situa-tions while maintaining the confidence to take calculated risks and uncover trapped value.

Perhaps the biggest stumbling block for value investors is their regular failure to properly value growth. “Growth” and “value” are not different investment strategies. Without growth, value creation—growth of returns on capital greater than the cost of capital—is harder. It’s not impossible, but it makes the management challenge much harder. Value investors should be looking for companies with the potential to sustain or improve growth rates at returns that are above, or moving above, the company’s cost of capital. Without value creation, companies will struggle to sustainably increase intrinsic value. And that is what matters most—that intrinsic value can be expected to go up over time. Many value investors justify stagnant intrinsic value by pointing out the margin of safety it provides at any one time. That’s not good enough. We want to see signs of growth, or at least a clear path towards progress. We just don’t want to overpay for it. That’s no easy task—the process is fraught with dangerous value traps—but, with the right tools and the right framework, we believe active managers can identify and unlock trapped value for their clients.

John Reynolds is a London-based Portfolio Manager and Analyst with over 25 years of investment

and corporate advisory experience. At Templeton Global Equity Group, John is involved in idea

generation and equity analysis across all European markets, with specific coverage responsibilities for

European Utilities, Energy and Cyclicals.


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The companies and case studies shown herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The opinions are intended solely to provide insight into how securities are analyzed. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio. This is not a complete analysis of every material fact regarding any industry, security or investment and should not be viewed as an investment recommendation. This is intended to provide insight into the portfolio selection and research process. Factual statements are taken from sources considered reliable but have not been independently verified for completeness or accuracy. These opinions may not be relied upon as investment advice or as an offer for any particular security. Past performance does not guarantee future results.

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value trap or trapped value?€¦ · efforts on being right, rather than leaning on the crutch of...

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