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.
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 is undervalued. The price only comes into consideration after all of the above are 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 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 there 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 overlooked 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 words, a value trap is a company that has long-term concerns, undiscovered deteriorating fundamentals or misleading earnings.
Using fundamental analysis to detect and avoid value traps
Fundamental analysis is always important, 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 it is weighed 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 (Short- + Long-Term Debt / Total Equity) and the Current Ratio (Current Assets / Current Liabilities).
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. The 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. Just head to GuruFocus and click the 15-year Financials tab for any stock symbol to check. The picture above shows you a 10-year history of Apple (AAPL, Financial).
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 (Net Income / Shareholder Equity) and Return on Invested Capital (Net Income After Tax / Total Equity + Long-Term Debt).
ROE is a straight-forward metric that measures return on shareholder investment. Probably one of Warren Buffett (Trades, Portfolio)'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 it can generate solid returns with that capital. Charlie Munger (Trades, Portfolio) identifies ROIC as one of his favorite tools. Look for >15%. Both numbers need to be sustained for at least a five-year period
Management and business: 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 metrics 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. Head here to read more about how it's calculated.
- Altman Z-Score
Formula used to predict the probability of bankruptcy within the next two 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 between 1.81 and 2.99 falls in the "grey zone" and should probably be avoided as well. To read more, click here.
- 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. See the equation here.
- Sloan Ratio
Richard Sloan argued earnings are not always "real." They can contain large amounts of noncash earnings called accruals. For instance, items like accounts receivable. Sloan hypothesized firms with small accruals would outperform those with a substantial amount. So he developed the Sloan ratio to identify companies with low accrual-derived earnings relative to their cash flows. Turns out, he was right. For a 40-year period, a strategy of buying the lowest accrual companies and shorting the highest ones earned an average annual compounded return of 18%, while the Standard & Poor's 500 averaged a mere 7.4%. The equation:
(Net Income - Operating Cash Flow - Cash from Investments) / Total Assets
- Anything in between -10% and 10% = Safe Zone.
- Between -25% and -10% or between 10% and 25% = Warning Zone (Accrual buildup).
- Less than -25% or greater than 25% = Severe zone (Earnings likely to be made up of accruals).
Remember that fundamental analysis is not a cure all. There will always be investments that do not succeed. Peter Lynch once stated he was doing "great" if he got six out of 10 correct. Understanding the industry and the company is very helpful when it comes to identifying value traps.
- A value trap is a company that has long-term concerns, flawed fundamentals or misleading earnings.
- Specific fundamental analysis and verifying management, as well as business plans, can help you uncover and avoid these potential traps.
- Always check metrics which test the company's health as well as its accounting.
- Understand the company is it cyclical?