Something I have noticed over the past few years is that there is a large and growing number of what first appear to be cheap companies in the market, but these are also companies that I would categorize is being bad businesses.
I'm talking about companies that operate in commoditized sectors such as semiconductor manufacturers, all businesses with high levels of debt and managers that have a track record of poor capital allocation. In other words, these businesses are cheap for a reason.
No longer an easy process
The past decade, the internet has revolutionized the process of finding and analyzing investments. Today, anyone in the world can analyze a stock at the click of a button and get hold of its financial information, which means that it is now harder than ever to find good quality, cheap stocks.
Today, if a stock is cheap, it is almost certainly cheap for a reason, as the chances of there being something hidden on the company's balance sheet that someone else has not spotted are relatively small.
This is a problem for value investors. Buying junk for the sake of buying junk is not a sensible investment strategy, and will almost certainly produce inferior results over the long term.
In this environment, it is more important than ever before to know the red flags that suggest a value trap.
Unfortunately, there is no concrete set of guidelines that outline exactly what to look for in a value trap; we can only use these red flags to narrow down our opportunity set and avoid the companies that have the most obvious problems. Nevertheless, avoiding companies with multiple red flags should swing the odds in your favor.
The quality of earnings
One of the first things I always consider when evaluating a company is the quality of its earnings. For example, I want to know how much net profit is being converted into cash and what sort of accounting trickery management is using in the accounts.
The way a company produces its accounts says a lot about management. If there are a lot of adjustments and non-standard accounting metrics used to try and present the best view possible of the company, then this is a strong indication that the business might not be as strong as management as is making it out to be.
Avoiding companies with massive differences between profits and cash flows would have helped investors avoid some of the most massive frauds of the last 20 years.
Balance sheet quality
If there's one thing I hate to see with a potential investment, it is debt. I will avoid any company that looks as if it has too much leverage. Some companies can maintain a high level of borrowing, and many do for a long time, but the fact is, having a lot of debt means that the company is limited in what it can do.
If investors suddenly decide to stop backing the business, it could quickly become insolvent, and this is something I don't want to be exposed to as an investor. The use of off-balance-sheet vehicles to hide debt i just as much as a warning sign as a lack of cash flows.
Capital allocation
Another red flag I look for is the capital allocation policies of managers. How managers decide to prioritize the spending of company cash flows tells you a lot about their priorities and management skill. For example, a company should be prioritizing investment in its business above anything else, considering mergers and acquisitions only after it has exhausted all opportunities for organic investment and reduced debt to an acceptable level.
Share buybacks and dividends should only be considered when there is no other use for the cash. Prioritizing dividend payments over business investment or debt reduction is sacrificing long-term growth for short-term profits and should be avoided. Even more concerning is when a company tries to slash costs in an attempt to maintain its dividend at all costs. This is a big red flag.
The bottom line
These are just a few red flags I look for before considering any investment. As noted above, they are not designed to be a fail-safe method for avoiding value traps, but they might help me avoid some of the worst offenders.
Disclosure: The author owns no share mentioned.
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Revisiting The Superinvestors of Graham-and-DoddsvilleÂ
Compounding Should Be at the Heart of All Investment StrategiesÂ
John Bogle's Greatest Lesson for InvestorsÂ
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