Value investing can be a lucrative style of investing, but it is a research-intensive process.
If you are not willing to do the amount of research required to analyze every opportunity in depth, it might not be the best investing style for you. Indeed, if you fail to do your research, you could end up in a value trap, which is possibly the worst situation a value investor could find themselves in.
The big question is, then, how do you spot a value trap before you end up entangled in one?
While there are no set rules, I have come up with a few guidelines to help avoid these situations.
Structural or cyclical
Before making any investment, I want to determine if the stock I am interested in is cheap for structural or cyclical reasons. If it falls into the former camp, then it is more likely to be a value trap.
Take, for example, the newspaper industry. There are plenty of interesting opportunities in this sector today, but as earnings are falling across the sector, it is difficult to figure out how much these businesses are worth using cash flow forecasts.
On the other hand, cyclical companies such as miners provide a more fertile hunting ground for value as we can estimate how much these companies will be able to earn at different points in the cycle. Granted, we don't know when the cycle will turn, but we do know commodity prices generally go through peaks and troughs and these companies, as long as the demand remains, can adjust costs when prices fall and wait for the next cycle to begin.
Companies operating in industries suffering structural decline do not have the same luxury. No matter how aggressively Sears (SHLDQ, Financial), as an example, cuts costs, the retailer is still part of an industry that undergoing a structural shift.
Debt and cash
The second red flag I like to keep an eye out for is debt and cash. A company that has too much debt and not enough cash is always a red flag for me, but it is more so when that business is struggling to stay alive.
Generally speaking, when the market awards a stock a low valuation, it deserves it. Nine times out of 10, a high level of debt is one of the main reasons why investors are giving the business a wide berth. If the company is struggling to maintain its debt, it is not going to turn around and it could only be a matter of time before the lights go out.
That being said, a stock that is being overlooked by the market due to its high debt levels could also be a great value investment if the company is generating a lot of cash flow, which will allow it to reduce the debt quickly.
That's why I think it is important to keep a close eye on both debt and cash flows.
Management
The third and final big red flag for me is the quality of management and percentage of the company management owns. (Note, other smaller red flags also form part of my process, but if a company fails one of these three, it fails my test immediately.)
In a turnaround situation, if management does not have skin in the game, they have no incentive to complete the turnaround. In my opinion, companies with significant insider ownership, especially those that are still managed by their founders, are more likely to be able to successfully turn themselves around.
If management has no insider ownership and is just using the business as a piggy bank, it might be best to avoid the stock altogether.
Disclosure: The author owns no stocks mentioned.
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