As every value investor knows, market downturns are a good opportunity to find cheap high-quality stocks trading below their intrinsic value. However, cheap does not always mean good.
A value trap is a stock that appears to be cheap because it is trading at some discount -- measured either by price-earnings ratios, book value, cash flow, historical price levels or other such metric -- but in fact is facing serious fundamental challenges that will only drive the price even lower over time.
Here are some Ñommon characteristics of value traps in order to help you avoid falling into them.
The business is facing structural changes
These changes can take many forms, and the extent to which they will affect the business will of course depend on the business itself. A company could be facing some major technological disruption, like video rental companies did in the mid-2000s when the internet became the dominant platform for consuming media. Or the business could be pharmaceutical company facing a patent cliff, with no prospects of new drug discovery.
Shares of Blockbuster certainly looked like a bargain in 2005 at $10 per share based purely off historical prices, but everyone would now agree that that the yearly decline of 50% that took place in 2004 did not represent a good buying opportunity. Of course this seems obvious with hindsight, but at the time betting against the world’s largest did not seem like a sure thing, and plenty of investors thought they were buying value as the stock declined.
Executive compensation structures remain generous
A good company going through a rough patch is going to tell its managers to work to fix the problem, perhaps by making future compensation contingent on an improvement in earnings, or other such way of aligning incentives.
A business that does not change the way that its executives are motivated is unlikely to change even while the rug is being pulled out from underneath it. Moreover, such inactivity could also be a sign of incompetence on the part of the board.
Excessively high dividend yields
Owning a stock that pays a good dividend is of course not in and of itself a bad thing. However, every cent being paid to shareholders is money that will not be reinvested in the business. Incidentally, this is why Warren Buffett (Trades, Portfolio) has only once paid a dividend to shareholders of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) – in 1967.
In the case of a company going through a rough patch, excessive dividend payouts sap capital and make it harder to implement structural reforms. An unwillingness to decrease dividends could also be a sign of short-term thinking on the part of the board and executives, providing more reasons for caution.
Overly-leveraged balance sheets
Excessive debt levels can suffocate a company’s cash flow. This is a fact that is sometimes lost on investors that pay too much attention to price-earnings ratios and profits, and not enough to the balance sheet and cash flow statements.
A company, particularly if it suffers from the issues of poor governance described above, can resort to all sorts of accounting trickery to pad out its profit-loss account – aggressive M&A activity that enhances earnings but does not add to the core value of the business, and capital expenditures financed with short-term debt are examples of such behavior.
Tread carefully out there
It can be very tempting to jump at what seems to be a great opportunity, particularly if the business is a household name, so the main lesson to take away from this discussion is to always do full due diligence, even when your initial assessment of its earnings potential is positive.
Value traps are poor businesses that just look good because of their valuations. Be careful not to fall in. Climbing back out can prove a much stickier challenge.
(This article was co-authored by Stepan Lavrouk, director of research at Atreides Capital LLC and a former research analyst for Almington Capital Merchant Bankers.)
Disclosure: No positions.
