How to Avoid Value Traps

What they are, how to identify them, and potential ways to avoid them

Finding and Avoiding Value Traps

Has there ever been a time when you thought there was just no way something could go wrong... and then it did.

Don't feel bad, every investor has felt the same heartache at one point or another. Just ask Bill Ackman and his recent Valeant Pharmaceuticals stumble. But I want to focus on a more specific type of error - the inevitable value trap.





Summary

  • A value trap is a company which has long-term concerns, flawed fundamentals, or misleading earnings.
  • Specific fundamental analysis and verifying management, as well as their business plans, can help you uncover and avoid these potential traps.
  • Always check metrics which test the company's health as well as their accounting.
  • Understand the company - is it cyclical?



What is a Value Trap?

In order to identify and potentially avoid value traps, we must first understand what they really are. And realize they can come in many different forms. I decided to create this post largely in light of the recent downturn with many stocks being batted down. With pessimism and fear high, these are perfect times for value investors. When stock prices plummet, there are often bargains to be had. But the common sense value investor knows stock price often has little to do with actual value.

An attractive value investment is only considered attractive if the company is healthy, has strong fundamentals, and undervalued. The price only comes into consideration after all of the above is analyzed. Even then it's important to uncover every stone to see why the stock is taking a beating. Is it a temporary setback? Fundamental problems? Future disruptions? All important questions and sometimes very difficult to answer.



Which is why the conventional theory of a value trap can be quite misleading. For one, most explanations begin and end with stock price. Either the price has decreased, or is declining, and it appears cheap compared to certain valuations. While this may be partially accurate, there is obviously much more to it than that. Rarely is their ever any mention of fundamental analysis. Checking the company's financial health, balance sheet, and debt. Instead we get lectured on stock price trends, technical jargon, and relative valuation metrics.

This is not precise enough. While certain aspects of fundamental analysis are hinted at, much of the focus stems from viewing stocks as paper and not as pieces of a company. A true value trap usually has defining characteristics that were either looked over, or hidden from the investor. Don't get me wrong, a value trap can include stocks with deceiving P/E, P/S, or even P/CF, but we must look deeper in order to detect and avoid them. In other a words, a value trap is a company that has long-term concerns, undiscovered deteriorating fundamentals, or misleading earnings




Using Fundamental Analysis to Detect & Avoid Traps

Fundamental analysis is always important, and especially if pessimism and fear is swirling about the stock. If you're buying stocks that have fallen out of favor, you need to verify you're in the right. But since we're talking about value traps, let me be more specific. Checking relative valuations such as P/E is not nearly enough. Even calculating intrinsic values will often not do the trick. They are traps, after all. So let's take a look at specific areas where we can improve our chances of detecting them:

The Balance Sheet
A firm can have great earnings, positive cash flow, growing sales, and still be in trouble if they are weighted down by too much debt. When positive numbers are overshadowed by debt you should be very worried. All it takes is a minor setback for the company to experience severe problems. Which is why analyzing the balance sheet is an excellent place to start when attempting to avoid value traps. Two metrics to identify are Debt to Equity and the Current Ratio. The debt to equity ratio identifies if the company is being financed too heavily with debt. Obviously companies with lower debt/equity ratios are preferable (ideally < 0.5). The current ratio identifies if the firm can meet short-term obligations with short-term assets. Higher the better (ideally > 2).

Verify Earnings
Earnings don't always resemble real profits (just ask Enron shareholders). So verify using sales (revenue) and cash. You can use a variety of cash flow metrics such as operating cash flow or free cash flow. We want to not only make sure they're positive, but also that they're increasing.


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Ensure Competitive Advantage Exists
One of the easiest ways to make sure you avoid traps is to only invest in companies with wide moats. I know, this is easier said than done. But there are a few numbers to analyze that can be very revealing. Return on Equity and Return on Invested Capital. ROE is a straightforward metric that measures return on shareholder investment. Probably one of Warren Buffett's favorite numbers and one his investments must pass. He wants to see an ROE > 15%. ROIC is probably the single best metric to determine if a competitive advantage exists. It gives you a picture of how the company uses its capital and whether or not it can generate solid returns with that capital. Charlie Munger identifies ROIC as one of his favorite tools. Look for > 15%. Both numbers need to also be sustained for at least a 5-yr period.

Management and Business
Lastly, it's not enough to stare at numbers all day. In order to truly detect and potentially avoid these traps you must delve into the 10-K and other financial documents. A company can have great numbers, great growth , and great potential, but if management is too inept to properly get it there, it could be in trouble. Similarly just because a business appears beaten down, primarily with relative valuations, confirm the business plan is adequate. For example, you don't want to see the majority of sales coming from one big customer, outdated technologies, or vague outlines.



Key Metrics to Keep in Mind

A few other numbers to keep in mind when trying to avoid value traps.

Piotroski F-Score
Based on metrics related to profitability, leverage, and operating efficiency. Developed by an accounting professor who wanted to create a strategy to produce higher returns with value investing. The strategy averaged 23% annual returns from 1976-1996. Any score above 7 is great.



Altman Z-Score
Formula used to predict the probability of bankruptcy within the next 2 years. Assesses distress levels for individual companies. Excellent metric to weed out any possible companies that could potentially be traps. A score of less than 1.81 signals a company is in the distress zone and should be avoided. A score in between 1.81 and 2.99 falls in the "grey zone" and should probably be avoided as well.

Beneish M-Score
Similar to the Altman Z-Score but optimized to detect earnings manipulation. The metric successfully recognized Enron's foul play and is a great weapon to keep in your arsenal. A score of greater than -2.22 suggests the company may be a manipulator.