When hunting for undervalued companies, investors will inevitably encounter the dreaded ‘value trap’; a stock that’s so cheap that it looks too good to be true. As the old saying goes, if it sounds too good to be true, it probably is.
Large returns could be on offer when picking these unloved stocks, but getting it wrong can mean a total loss of capital. With this in mind, we asked three experienced value investors for the red flags they look for that indicate a potential value trap. Responses come from Alex Shevelev, Forager Funds; Nathan Bell, Peters MacGregor; and Matthew Booker, Spheria Asset Management.
Digging yourself out of a trap
Alex Shevelev, Forager Funds
Generally, if it’s too obvious, it’s probably not cheap. Especially in a buoyant market. Take low earnings multiples for example. Volatility of earnings may be high: as earnings slide, seven times this year’s earnings can quickly turn into 20 times next year’s.
Looking at the balance sheet can pose other issues. Buying a business below tangible asset backing may seem like an easy way to make money. But tangible assets may be overstated. And what if an oversupply of these assets means they will never generate a reasonable return? Another common problem with discounts to tangible assets is that you can be fooled by the net number. For companies with a lot of debt, a big discount on the equity might only be a small discount on the total value of a company’s assets.
It always pays to do some digging to make sure you don’t get caught in a value trap.
Watch for insider buying and selling
Nathan Bell, Peters MacGregor
A statistically low valuation, particularly in a rich environment like we have today, is often a dead giveaway. Usually, a stock is cheap for a reason. Your job is to figure out whether that reason is temporary or terminal. This isn’t always easy, and sometimes you might second guess yourself thinking that someone out there knows more than you i.e. What am I missing?
Other times there are numerous reasons unrelated to the company’s intrinsic value that are keeping investors away. That’s when you need to back your judgment and patiently stay the course.
If I could only pick one, though, it would be insider buying and selling. It never ceases to amaze me how reliable insider selling is at predicting trouble ahead.
When a long-tenured manager owns a large amount of stock or is buying stock in large amounts (i.e. not from gifted options or bonuses), that also piques my interest.
Focus on the balance sheet and cashflows
Matt Booker, Spheria Asset Management
In our view, mistakes are a part of investing, in fact, the average fund manager gets just over half of his/her decisions wrong. Our process is such that many of the companies we buy, while their share price may not take off, they tend to pay off debt quickly and/or pay a solid dividend which underpins the investment, regardless of capital appreciation.
In the case of red flags, our greatest concern is the risk of being stopped out such that the free cash expected is not crystallised. To assess this risk, we scrutinise balance sheets including on and off-balance sheet debt, and have minimum interest and fixed charge cover measures to assess the financial risk inherent in a company. In addition, we assess the sustainability of cash flows by applying a qualitative measure of where the company is in its economic cycle and the operating leverage inherent in the cost base.