Value investing can be an extremely lucrative style of investing. However, picking value stocks is a treacherous game. When you are hunting for value in the market, you need to be aware of which stocks meet all the value requirements without being value traps. What is a value trap? A value trap looks just like a value investment, but you are unlikely to make any money in a value trap and are more likely to lose everything.
The difference between real value investments and value traps is that value traps are cheap for a reason. Value stocks are cheap because the market misunderstands the opportunity and this in itself presents an attractive opportunity for the astute value investor.
The big question is, how does an investor determine between a real value investment and value trap? On the face of it both of these investments look the same, but further research will quickly reveal which company is attractive from a value perspective and which should be avoided.
Three red flags
Trying to separate the value traps from the value investments is relatively easy if you know what you are looking for. There are three large red flags to look out for in value traps, and while you will never be able to avoid 100% of value traps, these three criteria will go some way to helping you avoid the vast majority of them.
1. Secular decline
Companies that operate in an industry in secular decline are more likely to be value traps than those that operate in cyclical industries.
Take the newspaper industry for example. This is an industry in secular decline and companies such as Gannett Co. Inc.(GCI, Financial), Lee Enterprises (LEE, Financial) and The McClatchy Co. (MNI, Financial) are struggling to make a buck. Companies in secular decline masquerading as companies in cyclical decline should also be avoided. It could be argued that deepwater drilling falls into this bracket as, while the industry is currently suffering from cyclical factors over the long-term, low-cost onshore drilling will weigh on the sector’s growth.
2. Poor management
Shareholders rely on managements to look after their investment. Without a strong management team in place, a company will struggle to achieve sustainable growth and produce attractive returns for investors. There are few superb managers out there, the majority of business managers are fairly average and there are some who are downright terrible. It is companies run by these managers that should be avoided. Firms chasing growth at any cost, making value destructive acquisitions or damaging customer relationships will never be true value investments. What is more, investors should go out of their way to avoid management teams that destroy value by misallocating capital.
3. Under earning
The first two value trap red flags are somewhat subjective, but a red flag number three is much more objective. If a company is chronically under-earning its cost of capital, then the business is not viable. Further, if a company doesn’t earn its cost of equity (the percentage return demanded by investors for the risk taken on by investing), then the shares deserve to trade below book value. Or to put it another way, if a company’s return on invested capital is below its cost of capital, the shares should be trading at a price-to-book ratio of less than one. Just because shares in a company are trading below their book value does not mean the company in question is a value investment.
A final word
One final point to consider when trying to root out value traps is the need to look forward and not backward.
Just because a company has a history of outperforming, achieving steady earnings growth and rewarding shareholders, it does not mean that this trend will continue. Disruption is one of the biggest threats facing many companies today, and an analysis of whether or not a company can maintain its competitive advantage is crucial in assessing whether a business will be able to continue to generate returns going forward. A stock may look cheap when compared to its past earnings, but the market values companies on future earnings and growth of those earnings. What a company has earned in the past will have little to do with its value today.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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