Last year we wrote an article titled Five Ways to Avoid the ‘Value Trap’ which outlined several considerations when assessing companies that look fundamentally cheap. Many investors are hunting for undervalued companies. Specifically, undervalued companies that can compound capital through growth and justify a re-rating over time, rather than undervalued companies that are lacking growth, hence are cheap and may stay cheap for a reason. To us, the latter are not undervalued and can be considered ‘value traps’.
At NAOS we focus on micro and small-cap investing, within this investment universe the difference between a relatively undervalued winner and a value trap can be further magnified through lack of liquidity.
Several of the great ASX large-cap companies began as relatively undervalued small-cap companies and by consistently compounding capital over many years they have proven to be sound long term investments. Of the approximately 2600 companies listed on the ASX, there are many more which stay small and stay ‘cheap’.
These companies can then become very difficult to exit which gives rise to the term ‘trap’ or the Hotel California principle “You can check-out any time you like. But you can never leave", readers may know the lyric from The Eagles song ‘Hotel California’.
In this wire, we breakdown our 5-point value trap checklist and then look at one stock that passes with flying colours.
Value Trap Checklist
To avoid a stay at Hotel California we have highlighted several factors to consider when making an assessment between undervalued growth companies and value traps:
- A healthy return on equity (ROE) and return on asset (ROA) metrics which also display a level of consistency.
- Balance sheet safety, minimal debt and/or strong interest coverage.
- Look beyond a low PE or EV/EBITDA and focus on measures of business quality such as EPS growth, margin growth and cash conversion.
- Do not ignore relevant industry thematics that can shape a specific business outlook. Pay attention to headwinds and tailwinds.
- Have an investment timeframe in place which relates to the company catalysts and stick to it.
The Current Environment
A year or so on from our previous article on this topic we still believe all the above factors translate well into forming a checklist for assessing a value trap. Whilst the notion of a value trap is perceived to be a cheap company that stays cheap, one could argue another form of value trap needs to be considered; the ‘over’ value trap.
If exuberant valuations mean that value is being ignored, then:
- How do you define at what level value exists?
- How far does a loss-making business need to retract before those losses become compelling value?
- Once profitability occurs, is the company valued on a revenue multiple or an earnings multiple?
- If/when the above occurs, how does this change the perception of value?
In our view, what has changed in the last 12 months is that the widening gap between the share price performance of growth and value stocks has created an environment where there are a significant number of companies which have reached our threshold of being an ‘over’ value trap.
Whilst we won’t comment on any specific stocks here, there are some ASX listed technology stocks trading at a significant premium to global peers, some of which we believe have inferior earnings quality, lower competitive moats, inferior business models and inferior outlooks when compared to many of their global technology business peers. We believe these characteristics skew risk vs returns to the downside.
“There’s no such thing as a good or bad idea regardless of price.” ~ Howard Marks, Oaktree Capital
One Stock Passing the Value Trap Checklist
We believe Moelis Australia Limited (ASX: MOE) fits the bill.
MOE is an Australian based financial services business with most of their earnings generated from their property funds management division, characterised by stable, recurring revenues.
We explain how and why MOE meets our value + growth checklist below:
1: Return metrics = PASS
MOE operates with a conservative balance sheet yet has delivered consistent double-digit returns on equity since IPO.
2: Balance sheet safety = PASS
A conservative balance sheet is a characteristic of a good funds management business. With a net cash position (including investments) of circa $240m as at June 30 2019, it represents over 30% of their market cap.
When a company has excellent financial flexibility, it can provide the ability to allocate capital towards value creation opportunities.
3: Quality behind the headline valuation = PASS
Whilst the headline valuations metrics in the form of a cash adjusted P/E and EV/EBITDA represent a discount to both the market and relevant funds management peers, it is not enough to judge a business simply on such metrics to gauge an understanding of business health. We also like MOE because of the following:
- Cash conversion (receipts less payments) is consistently over 100% of EBITDA, meaning the company is continuing to build a cash balance which can be redeployed into value-generating areas.
- EBITDA margins have grown by 15% over the past few years whilst the $ value of EBITDA has close to tripled. To us, this demonstrates a scalable business with increasing leverage over its cost base.
- Organic revenue growth is being generated, meaning we aren’t seeing earnings growth through cost out.
4. Industry thematic = PASS
Can the business be easily disrupted?
We believe property funds management, investment banking, company restructures and capital raisings have survived the test of time. We believe these skill sets are hard to displace, hence we don’t see technology as a headwind.
Search for Yield = Tailwind
The lower for longer yield environment should continue to see a search for yield. The strength in the REIT market demonstrates the value of quality property assets in such an environment. The search for yield has attracted numerous offshore investors to the Australian property market. We expect this to continue, for which MOE should benefit, as evidenced through their recent $670m property mandate win from investment house Singapore Exchange.
With any investment decision, analysis of catalyst expectation vs reality is an important factor. A value trap characteristic may see a divergence between the two, whilst a quality company will be consistent in delivering to expectations. Over time, the market rewards such a quality.
MOE have introduced new business verticals, made acquisitions, attracted offshore capital and scaled existing operations in an efficient manner. Furthermore, a rearview analysis of capital management initiatives for MOE demonstrate a Board of Directors who recognise value when it is offered. MOE recently conducted a buyback, which has benefitted remaining shareholders as it was done at a circa 30% discount to the current share price.
Whilst the above checklist can be important in assessing an undervalued business versus a traditional value trap and we believe MOE is an example of the former, these points can equally be applied to overvalued businesses, where paying too much can cause significant downside risk.
The above factors should be considered alongside a wide range of analysis when assessing any business and avoiding those companies which look compelling but aren’t.
Whilst a stay at Hotel California may sound pleasant, it’s best to avoid it.
At the time of writing this article NAOS Ex-50 Opportunities Company Limited (ASX:NAC) holds a position in Moelis Australia Limited (ASX: MOE).
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Thanks for your comment Harry, the figure is net cash position including investments.
Thank you. An insightful article. I’ve commenced my own research into MOE after reading. Of interest, CommSec Quotes & Research says “Over the last 3 years, earnings at MOE have declined ...annually...worse than the industry average growth of 12.65%.” Do you have any comments on this given the passes to the checklist above?
I get a little concerned when livewire contributors use non GAAP/IFRS metricises such as "cash conversion" and EBITDA as the basis for their analysis. I looked up cash conversion in Investopedia and could only find reference to the 'cash conversion cycle' which the time taken to convert inventory via sales into cash flow, which I don't think Robert is referring to here. Could Robert's reference of "Cash conversion (receipts less payments)" be referring to Gross Profit (customer receipts - COGS)? If so how could they not be over 100% of EBITDA when they have yet to factor in general SG&A overheads? It's all very confusing, what is wrong with using standard measures of profitability such as NPAT.
Thanks for your comments. @Kylie In order to get a true reflection of a company’s operating earnings we believe it can be appropriate to look at underlying profit rather than reported profit in certain circumstances. With that being said, it is important to understand what makes up the ‘one-offs’ that cause the delta. Some publications may only include the reported and not the underlying numbers. @Mark The definition of cash conversion referred to in the article = operating cash flow before interest & tax (i.e. receipts from customers less payments to suppliers) /EBITDA. It can be used as one tool of analysis to measure the level of cash generated from a company’s earnings.