As a value investor I have always been concerned about a value trap. A Value trap is a company, which remains cheap forever, and you are not able to make any money out of it.

Now a company can be a value trap for a variety of reasons, which can be

1.The company performance keeps deteriorating and as a result the intrinsic value keeps going down
2.The market just ignores the company and the sector because there is nothing exciting happening in that sector and most of the companies are hardly glamorous
3.Management action can result in a value trap too. The management keeps blowing away the excess cash into unprofitable diversification instead of returning it to the shareholders

So how does one avoid a value trap. I think this is a very important consideration of value investors especially if one is investing in ‘graham’ style bargains. A ‘Catalyst’ is something which one should look out for to avoid a value trap.

A catalyst can be any of the following

1.Likely management action such as buyback, bonus etc
2.Likely asset conversion opportunities such as LBO, de-merger, accquisitions (think L&T for an example of de-merger)
3.Likely shift in demand supply in favor of the company due to changes in the business cycle – steel and commodity companies in the last few years come to mind.
4.Regulatory changes – Banking comes to mind
5.Unexpected earnings increase
6.Finally time – However one should have a defined time horizon in which one would expect the investment to work out.

So when I look at value or deep value stock, I tend to look beyond the numbers. Is there a likely catalyst, which would unlock the value, or am I getting into a value trap? and how long will it take for the catalyst to be play out. That would define my expected returns too.

Ofcourse this concept of catalyst is not some original concept of mine. It is referred to frequently by Mario gabelli and Marty whitman.

I work in the tech industry and have always been fascinated by technology and the role it is playing in improving our lives (definitely mine – cannot think of life without broadband, internet, e-mail, google etc).

Back in 2000, during the tech bubble, like others I got swept by the internet and technology mania and went ahead in invested in technology stocks. The basic logic of my analysis was correct, but I got the valuation wrong (overpaid for the optimism). After promptly losing money and later reading munger and buffett’s thoughts on technology, I have changed my approach to technology.

I am by no means a techno-phobe. I spend time reading tech blogs, looking and trying to understand changes happening in technology and how it seems to be impacting various businesses such as newspapers, media, advertising etc. But it is diffcult to realistically forecast a technology business out for several years. It is more so for technology businesses as valuations of most of these companies is high and to make any money, one has to be able to forecast the cash flows for 5 years or more.

Over time based on what I read and based on my experience, I now prefer companies which are predictable than which will have the highest growth. My own experience has been that markets tend to pay more for growth than predictability ( FMCG v/s IT services stock ?)

At the same time the decision to invest in tech stocks also boils down to one’s investing philosophy. I have tend to have a focussed portfolio with a few names and want to hold for 3-5 years with low maintenance (quarter or annual followup). As a result it is difficult for me to hold technology stocks as it requires too much effort to follow them.

As an aside I work in IT services. So my professional career is tied to the Tech industry. The last thing I want to do is put all my eggs in the same basket. That is not the typical way of looking at diversification. But for me the income stream through my career and my stock portfolio need to diversified sufficiently. Who wants to be lose a job and also see the stock portfolio crash at the same time, because the industry hit a roadblock !!