How to avoid value traps

Those who manage special situations funds are particularly adept at avoiding such pitfalls; after all, the very nature of their mandates means they do it all the time. One of the more successful special situations managers over the years has been Alastair Mundy, who runs the Investec Special Situations Fund. This is consistently among the top 25 per cent of funds in the UK All Companies sector.

So what does Mr Mundy do to avoid value traps? "Often investors really want to buy something, but we try and be objective," he says.

Then there's that old virtue, patience. "Allow shares to fall significantly before purchase, so that any bad news on the company comes out as the shares are falling. For example, with the banks during the financial crisis, by the time they had fallen 50 per cent most of the bad news was out. It also typically allows us to avoid buying in-favour momentum stocks before they collapse, and ensure we can be more aware of the negatives when we are analysing the stocks."

But being cheap alone is not enough, since shares may well be cheap for a reason. Mr Mundy likes to make sure that a number of different outcomes are tested to ensure the company's balance sheet is appropriate. "Analysts are employed to come up with what is right, but often they are not right," he says. "We are not going to get it right with absolute precision, so we look at how the future could unravel, and which companies might get back to where they fell from, and which ones won't. If a company goes bust before it reverts, it's a bit of a problem!"

As a result of this approach, he holds virtually no banks, as he fears more capital-raising may be needed. The only exception is HSBC, the third-largest holding (6.7 per cent of assets) in the Investec Special Situations Fund. This bank has lots of deposits and few loans, as well as a good balance sheet and competitive advantage through its exposure to Asia.

Although Mr Mundy tries to envisage the consequences of possible scenarios, he does not believe in forecasting the future. "This is very difficult to do, and can lead to the risk of overconfidence and refusal to consider other alternatives," he says.

He also does not believe in investing in unfamiliar areas. "Establish your circles of competence and only deal in what you understand, as you cannot hope to be experts on everything," he says. "Some subjects are harder than others, so pick ones where you know enough about them."

This is perhaps a reason why he avoids initial public offerings (IPOs). "I have only bought two of these in the past 10 years, the last one being in 2003," he says. "These are just totally against what we believe in. The odds certainly appear to be against the long-term investor in IPOs. The company selling its shares picks the time to sell, which suggests it has an inherent advantage over the buyer. In addition, the seller, particularly in recent times, employs a long list of well-remunerated investment banks to portray the company in as attractive a light as possible, simultaneously ensuring the number of naysayers is reduced."

Numbers can speak louder than words. "Analysts often focus on a company's profit and loss account, but sometimes the greatest clues are in the balance sheet," says Mr Mundy. "This is very important - it is information that gives you a competitive advantage, because it is terribly dull and not everyone wants to look at it."

Surprisingly, for such a high-profile manager, he and his team do not always meet company managers. "They stretch the truth well, and are typically very plausible. They really believe conditions will improve. But belief is not always enough. And they will not provide inside information anyway."

Even when they do meet company managers, Mr Mundy says it's not easy to tell who is good, "although we are getting better at working out who is bad." His team uses sell-side research extensively, as well as other secondary sources. "There are some great bloggers out there," he adds.

Brave new world

In recent years, new considerations have emerged. "The internet has destroyed many businesses," he says. "You also have to be aware that business cycles are much quicker these days and all industries are much more competitive, with more new entrants."

You should monitor which companies are doing well within their industries. "Industries that exhibit large moves in market shares suggest companies are more likely to implode," he says. "Industries that don't see large moves in market share, for example builders' merchants, are better options. Travis Perkins is a good example of this. The brand means nothing, but local monopolies and presence on the ground allowing good market share are important."