Wednesday, June 21, 2006

Value trap and the cigar butt analogy

This post is updated in 2024.

Value trap is a stock that looks very cheap but the reason it is super cheap is because it is a crappy company and deserves to be that cheap. This company probably trades below its book value (i.e. Price to Book ratio less than 1x) and had poor earnings and near zero cashflow for the past few years. Buffett likes to give the analogy of the cigar butt. Imagine finding a cigar butt that someone just finished smoking, but there is still a last puff left. The cigar comes free but you get one puff, which doesn't make you feel one hell of a good.

To give another example, a value trap is similar to doing shopping at Ikea (no offense to Ikea and Ikea fans, just an analogy, just an analogy...), you get super cheap stuff but their worth is also just that. If you haven't shop at Ikea before, let me give you an idea. You can get kitchen set (with sink, top and bottom shelf etc) for less than S$1,000 which is like dirt cheap because a Prada bag cost as much. But the kitchen set probably lasts a couple dinners before some panels or screws come loose or some other defects present itself. Yet another example would be "you pay peanuts and you get monkeys", sounds familiar?

In essence value trap means that you are paying cheaply for zero quality. A true value investor pays cheaply for some value, not for garbage.

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