Reblog: How to Spot Value Traps

Growth stocks have outperformed value style equities for some time now, but there are rumours brewing value investing to stage a comeback. But to be a successful value investor, you have to be able to differentiate undervalued equities from value traps.

That’s especially true in the current UK environment, with a number of cheap-looking companies having seen further falls. Just this year, we’ve seen big share price drops from Debenhams (DEB), Capita (CPI), WPP (WPP) and ITV (ITV).

Brexit is in part to blame, but so too are the companies themselves. Carillion was a case in point – declining profit margins and excessive leverage did the outsourcer no favours.

Some of these cheap companies will pique the interest of value investors. In fact, Steve Magill, head of UBS’s European Value team, says his “natural hunting ground” is in areas where we’re seeing profit warnings. Though, he adds: “We’re trying to finesse our timing because we do know that where you have one profit warning, you’ll have many profit warnings. But that’s a time of opportunity.”

Value investors will point out that buying the cheapest shares in the market will provide a portfolio that outperforms the most expensive shares in the long term. But there are risks attached. Some are cheap for a reason – are will most likely continue to stay cheap.

“One of the criticisms of value investors is definitely owning traps,” says Gareth Rudd, co-manager of the soon-to-be-launched Chelverton European Select Fund.

But how can investors tell whether a company is value, or a value trap? We asked a few fund managers to highlight some of their top red flags.

Too High Dividend Yields

Generally, a company that has fallen to a low ebb will have seen its dividend yield spike. The prospect of being paid to wait until the share price re-rates can often be attractive.

But Carillion and Capita show investors shouldn’t take high yields at face value. Both were yielding in excess of 7%, sucking income seekers in before suspending said payout. The former, of course, eventually collapsed.

David Goldman, co-manager of the BlackRock UK Income Fund, says investors should be wary of excessively high yields in general. “There’s a very clear relationship in the historical data which show that as the dividend yield on a share goes up the likelihood of you actually receiving that yield falls,” he explains.

Indeed, he reckons 4% is the key level. Below that, you’re generally safe; “once you start getting 5%, 6%, 7% yields then the odds are you’re not necessarily going to get that. Some of those companies are going to be cutting their dividends”.

Investors should be wary of very high payout ratios – how much of a company’s earnings are being paid out as dividends – and low dividend cover – the number of times a company can pay its dividend out of earnings – according to Stephen Message, manager of the L&G UK Equity Income Fund.

A dividend cover ratio of 2 times or higher is what one should look for. Anything under 1.5 times warrants further examination. A high payout ratio leaves a company’s dividend vulnerable to a decline in earnings.

Cash Flow and the Balance Sheet

There’s an adage that profit is an opinion, cash is a fact. This seems to get lost on investors sometimes, though. Russ Mould, investment director at AJ Bell, says investors should check the balance sheet first and cash flow statement second. Then they can examine the profit and loss account.

Goldman agrees, saying he focuses on cash generation first and foremost. His companies must have strong balance sheets.

Debt and leverage are also considerations, especially off-balance sheet items. These can take the forms of joint ventures, operating leases and securitised bank loans.

While Carillion had faced increasingly competitive markets in what were low-margin areas, the excessive financial leverage it had built up over the years amplified this, saddling it with crippling debt.

When asked about the Capita situation, Goldman says: “The high-profile situations that you alluded to, and there are other examples, the warning signs were definitely there.

“These were companies where the cash flow didn’t match the profitability; that is a clear warning sign for us. Consequently, these companies were forced to use ever-more esoteric and imaginative ways of funding themselves.”

M&A

Like debt, M&A can be fantastic for a company, but it can also spell trouble. “It’s important to differentiate between the two,” says Goldman. He says that when a company is undertaking M&A activity purely to enhance earnings, or the strategic rationale behind the deals do not add up, “it makes us very nervous”.

“M&A tends to work best when small, bolt-on deals are used to supplement existing momentum, not create it,” adds Mould.

Other Factors?

Investors should also look out for structural challenges. Message says a factor that would make him shy away from potential value opportunities are where the operating environment is out of the control of the company. For example, “where they are exposed to political or general macroeconomic risks”.

The threat of disruption is another structural issue worrying Rudd and co-manager Dale Robertson, who describe themselves as “modern value investors”. This means they don’t own companies from sectors where value investors traditionally flock to: telecoms, oil major, auto OEMs, media or retail.

“For a lot of these types of businesses, this isn’t cyclical,” says Rudd. “There are structural reasons why these companies have had whatever competitive advantage or earnings ability eroded away. We don’t see it coming back in a hurry.”

Magill points out that value investors are bound to fall into these traps regularly. “In a portfolio of 60 companies we’ll have some that are very poor, some that are quite poor and some that are spectacular.”

He says his investment in HMV has “scarred us like a tattoo”. “We can’t say that we won’t make mistakes. We try and avoid them and we try to learn lessons from them.”

For those who actively want to avoid traps, these are just a few things to look out for. While they won’t be easy to spot, Robertson says they tend to cross correlate with each other. “If a company’s got one or two of these things, you tend to find three, four or five flags coming up.”

You also get sectoral patterns, but it’s important not to just avoid everything, says Robertson. if you do, you’ll miss some great opportunities.

Magill agrees. He says he recently sold shares in a UK outsourcer at “a significant  loss”. “We decided that if we reinvested in another similar company that had similar upside but much lower risk, that would be the correct thing to do.” And, despite his experience with HMV, he’s still investing in retailers.