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Speaking at the Value Investing Conference, Jim Chanos-- President of the Kynikos Associate and a noted short in the market-- listed 5 different sectors and 5 representative stocks as value traps. He lists Chinese banks (or anything China really), Commodities companies dependent on single governments (such as Vale (NYSE:VALE), 59% of revenues from the Chinese demand), liquidating trusts such as oil and gas royalty trusts (he believes Exxon (NYSE:XOM) to be an example), analog to digital distribution (GameStop (NYSE:GME) – the idea is that margins will continue to decline), and for profit education (example ITT (NYSE:ESI) – he calls this a national shame).

Hind sight, but yes, St Joe was a Value Trap in 2006

Value traps are stocks that appear cheap on all the relevant metrics, but investors could still lose money as there are some fundamental issues with either the company or the industry. For example, St. Joe (NYSE:JOE) at one time (circa 2006) was a very interesting value play due to its vast holdings of land in Florida that it was converting to resort style housing developments. The company still holds close to a million acres of land on the Florida coast, and based on its stock market value, at that time the company was being valued at about $2000/acre. Given the state of the Florida real estate market at that time, this valuation was absurdly low. However, when the real estate market imploded, the $2000/acre started to appear quite rich. The stock is now down 80% from its pre-bubble-pop high.

I had invested in St Joe at that time, but eventually sold out with a small loss. I got tired of waiting for the new international airport to be built that will eventually bring more people to its markets and raise the valuation of its holdings. Some notable value investors such as the Fairholme fund (FAIRX) still continue to hold St Joe.

Patience is a virtue in investing, but hope should not be confused with patience.

The New Value Traps

Chanos is on target with his list of 5 value trap sectors. So many industries are undergoing a fundamental shift that the size or profitability of the market that these companies operate in will decline before the market wakes up to the company’s undervaluation. Some stocks and sectors are cheap for a reason. Here I list a few more:

  1. Newsprint: At one time I agonized over purchasing Gannett (NYSE:GCI). It was seriously undervalued, and heck, even Mr Buffett owned it. I could not see any future in the newsprint given the rate at which newspaper readership was declining. Sure, there was-- and is-- a move towards more online presence, but unless there is a pay wall there is hardly any profit online. Perhaps some of the companies will work out a good business model but I was not willing to bet that Gannett would be one of the few winners.
  2. Banks: Perhaps a bit controversial. I firmly believe that banks will become another kind of regulated utilities. Looking at a larger picture, the banks' function is to be a buffer between money producers (the Treasury), savers, and borrowers. The value they create for the shareholders is in direct proportion to the risk they are willing to take in their daily borrowing and lending activity. Future regulations will put a cap on the amount of risk they can take, and this will likely also mean that they will not be allowed to trade on their own accounts. I have nothing against utilities, they are good investments for those who hunt for yields, but a vehicle for outperforming the markets they are not.
  3. Most online media: Barriers to entry for online publishing are non-existent. Advertisement supported business models (Demand Media (NYSE:DMD) and America Online (NYSE:AOL) among others) face margin squeeze. The only way to stay competitive is to build a brand and loyal readership that commands premium advertising rates in the industry. AOL for example, is trying to do this with its purchase of TechCrunch and Huffington Post. However, it is not easy to buy your way to growth. It just doesn’t work that well. Companies pay too much for aspirational acquisitions and get too little out of them. Surely profitable online media companies will arise that command tremendous brand loyalty, supported by a unique or distinct value proposition. For now though, the industry will continue to evolve and see a lot of churn as new companies enter and old ones die.

Ultimately businesses that succeed have one thing in common – they create value in the market with their unique offering. Sometimes the value is in design, quality, service, product, low prices or something else that a customer appreciates and is willing to pay for. Companies providing a generic product in a growing market are not good investment candidates, and neither are those companies, even if they are the best in the industry, that play in a declining market.

Disclaimer: I do not own, neither plan to purchase or sell, any stocks mentioned in this article in next 72 hours.

Source: Identifying New Value Traps