Over the years we have often cautioned investors to beware of penny stocks, especially those that have seen better days. While investing in a grand old name in hopes of a recovery it is important to learn how to spot a value trap investment. This issue came up recently when we wondered what was wrong at Kraft Heinz. As bargains become harder to find in an aging bull market there is a temptation to go bottom feeding in search of an investment miracle. Here is some advice about what to watch out for.
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Spotting a Value Trap
A couple of years back Bloomberg published a useful article with 12 signs a cheap stock is a value trap.
The historically high price-to-earnings ratios being placed on equities today make cheap stocks even more alluring. That makes sense, but be advised that the market is littered with “value traps” or stocks that look cheap but never substantially rebound.
Any way you cut it, value is profoundly out of favor, and not just in 2017. Although proponents of these investments typically are patient people, the long-term differential is large enough to be worrisome. Over the last 10 years, growth has outperformed value by more than 100 percent in small caps and by 50 percent in large caps.
Thus, knowing how to spot a value trap is doubly important at this time. Here are dozen suggestions from Bloomberg. The ideas are theirs but rewritten by us for the sake of brevity.
Still Troubled at the Top of Its Operating Cycle
The U.S. economy and the vast majority of stocks have long recovered from the 2008 stock market crash and financial crisis. If the company you are looking at is performing poorly in the best of times it may well be a value trap. Something is wrong as is not being fixed or cannot be repaired.
Low Profits but High Management Compensation
When a company falls on hard times it typically puts the screws to management by cutting salaries and tying compensation benefits to performance. When this is not the case, management is milking the company for every last dollar before bailing out. This is a strong sign of the stock being a value trap.
Lack of Fresh Insights
When an industry like the U.S. auto industry is centered in one city or area like Detroit, everyone works with and socializes with like-minded people. But, when fresh ideas are needed this can be a real hindrance and create value traps of otherwise strong companies.
Market Share Continues to Slip
When someone else starts taking market share away from an old stalwart, you need to see them fighting with all that they have to regain that share and succeeding. Otherwise, they have become a value trap.
Too Many Fingers in the Pie
Many times a well-established company has many stakeholders such as labor unions, foundations, or old family control. The goals of these folks may not be consistent with a good return on investment by those who hold their stock. Consider such companies to be value traps until proven otherwise.
Not Managing Capital Effectively
A company that has historically been a cash cow may have gotten by for years by just putting money in the bank instead of reinvesting in R&D, acquisitions, and the like. When this company starts to slip it needs to shift gears or it is a value trap. And, the changes in how they manage capital need to be clearly articulated to investors and need to begin to show results.
Fat and Inefficient Management Structure
It is said that when Sears built the Sears Tower that they took up 22 floors for management, each floor a different level. No one was paying attention to how management was being carried out and no one was making changes. When a company does not upgrade and modernize how it operates on the day by day and decision by decision level, it becomes a value trap because its competitors will outperform it every day of the year.
Unrealistic and Fantasy Management Goals
When a company is in trouble it needs to regroup and it needs to explain those plans to both employees and investors. When management’s new goals are simply unrealistic no good will come of them. You can often see this by looking at old financial statements and the goals articulated in previous years and the fact that nothing useful has happened, ever! This situation is a clear sign that the company is a huge value trap. The better situation is when management promises a little but delivers a lot on a recurring basis.
Too Much Debt
The final nail in the coffin of most struggling companies is that they cannot pay their mounting debts with their dwindling cash flow. No matter how hard they try, how creative they are, and how much they economize, excessive debt is a killer and makes a stock a value trap.
Muddled Thinking and Poor Insight
The so-called strategic vision or the company is all muddled or simply lacking. When management’s plans for the coming years ramble on and repeat themselves, it is time to consider that stock a value trap, absorb your losses, and move on.
Split Attention between CEO and Board Chairman Responsibilities
When it is time to turn around a failing company it takes all of the time and attention that the CEO has. When he is spending a third of the time answering to the board of directors when he or she should be making changes from the ground up that is a sign of impending failure. Turnarounds need the full attention of the CEO or they become and remain value traps.
The Takeover Activists Are Nowhere in Sight
When a company has been mismanaged but has a lot of hidden value, there is always a Carl Icahn or his clone interested. When nobody shows up, that is a clear sign that the company really is a value trap and you should avoid it as well!
How to Spot a Value Trap Investment
The tips provided by Bloomberg are useful in spotting and avoiding a value trap. They all fall into the categories of fundamental analysis and evaluation of intrinsic stock value. While growth stocks have been leading the market in the last few years, there is a definite place for value in your portfolio. The trick is recognizing true and lasting value in an investment by understanding and appreciating how a company makes its money and how it will continue to do so well into the future.