Last week I gave a presentation on mining services at the Value Investing Seminar in Trani, Italy. One attendee was very vociferous in his opposition to the idea, calling Australian mining services stocks classic ‘value traps’. A few Bristlemouth commenters have used exactly the same term to question our investments in the space.
I’m not going to defend the ideas. Constantly questioning our theses and listening to criticism is a very healthy part of the investment process. And constantly trying to rebut the bear case can blind us to risks. Suffice to say we have been preparing for a China meltdown for a long time and have thought long and hard about the impact of a 20-year commodity bear market on these businesses.
But the term ‘value trap’ is something that has always irked me. According to Investopedia, the definition is as follows:
“A stock that appears to be cheap because the stock has been trading at low multiples of earnings, cash flow or book value for an extended time period. Stock traps attract investors who are looking for a bargain because these stocks are inexpensive. The trap springs when investors buy into the company at low prices and the stock never improves. Trading that occurs at low multiples of earnings, cash flow or book value for long periods of time might indicate that the company or the entire sector is in trouble, and that stock prices may not move higher.”
The value of a company has nothing to do with earnings multiples or book value. The value of a company is simply the present value of the cash flows it is going to return to shareholders over its lifetime. If you get your estimate of that value right, the company will return you the estimated cashflow and you will earn your expected return, irrespective of what happens to the share price.
Sure, we use earnings multiples, cash flow multiples and book values as indicators that a stock might be cheap. But in every single instance we sit down and work out how much cash is going to come back to shareholders and when. We own one small European company that is loss making, burning through about €10m of cash per year and trades at 14 times book value. It wouldn’t show up on any of the usual value metrics. The investment thesis is that its future cashflows are forecastable and that they will amount to an excellent return on today’s share price. That’s value investing.
We make mistakes. Those investors who have been with us for most of our six year history can tell you about a few. And some of these mining services stocks might one day gain entry to the Hall of Shame. If so, it will be because we overestimated the cashflows that they can generate, not because we blindly walked into a trap of buying every stock trading at a low multiple of book value.
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