Value investing is easy. All you have to do is buy the cheapest stocks and hold them until you make a profit, right?
Unfortunately, it’s not that easy.
Only around 5% of the value investing process is devoted to finding the cheapest stocks to buy. The rest is time spent separating the good stocks from potential value traps, and it’s this part of value investing that is the most critical for investors.
Avoiding the value traps
Value traps come in many shapes and sizes. Just because a company is cheap doesn’t mean it is worth buying. In most cases, the stock is cheap for a reason.
Occasionally, it is not possible to determine this reason; the market may dislike management or not trust the firm’s growth outlook. It is these cases that are the worst. If you cannot determine why a stock is cheap, it’s probably best to avoid it altogether.
In this article, I have highlighted two stocks that look as if investors should give them a wide berth as while they are cheap, they look as if they are in terminal decline and will never produce a return for investors.
Leaning on creditors
The first stock on the list is Lee Enterprises (LEE, Financial). Lee has all the hallmarks of a traditional cheap stock. The shares trade at a forward price-earnings (P/E) ratio of 7.6, PEG ratio of 0.4, EV to EBITDA ratio of 4.4 and price-free cash flow ratio of 2.3. However, the group is drowning in debt.
Gross gearing is 494% and including pension obligations gearing is 538%. Book value per share is -$2.3 based on year-end fiscal 2016 figures.
Still, the one shining light in Lee’s financials is the group’s free cash flow per share, which came in at $1.30 for fiscal 2016. But while this figure might seem appealing, it is in fact nearly 50% below the figure of $2.10 reported for fiscal 2011.
Net debt has declined since 2011, but it’s still extortionately high. At year-end 2011 net debt was $971 million compared to $574 million. The way it is heading, one day Lee will be debt free, but that’s only if everything remains constant. If interest rates rise much more, the company is forced to cover a significant, unforeseen expense or bankers decide to pull the plug on business, Lee could quickly collapse.
The problem with highly indebted companies like Lee is that they do not have control of their destinies. Lee may be pulling off a remarkable recovery today, but this will only continue for as long as creditors are cooperative. There’s an enormous amount of risk here for which even Lee’s depressed valuation does not account.
Hoping for the best
Next up is a diversified manufacturing company, Cenveo Inc. (CVO, Financial). Cenveo manufactures mailing items such as letters and envelopes, and while the company’s revenue has remained steady for the past five years, profitability has remained elusive.
That said, for 2016 Wall Street analysts expect the group to report earnings per share of $1.50, which translates into a forward earnings multiple of 4.4. For 2017, earnings per share of $2.03 are expected implying a forward P/E ratio of three. These numbers are highly attractive, but like Lee, Cenveo is drowning in debt. At the end of the third calendar quarter of 2016, total debt was over $1 billion in total shareholder equity was -$582 million.
This debt mountain looks way too risky. Creditors are in control if the business cannot meet targets, bad news for investors and certainly not a hallmark of a value investment.
Disclosure: The author owns no share mentioned.
Start a free seven-day trial of Premium Membership to GuruFocus.
