At first glance, BHP Billiton (LSE: BLT) looks to be great value. The company’s shares currently trade at a six-year low, support a dividend yield of 6.9% and trade at a historic P/E of 6.2. These metrics make BHP one of the cheapest large-cap stocks in developed markets.
However, while BHP looks cheap at first glance, the company has all the hallmarks of a value trap.
Value trap
Value traps are difficult to spot. Finding them isn’t an exact science, and investors often get sucked into them when searching for bargains.
Nevertheless, there are three key traits most value traps have in common and by avoiding companies that display these traits, you can increase your chances of avoiding these traps.
Secular decline
The first common characteristic of value traps is that of secular decline. More specifically, investors need to ask if the company in questions share price is falling due to cyclical factors, or the company’s business model is under threat.
For example, newspaper publishers such as Trinity Mirror have seen revenues slide over the past decade due to the secular decline of newspaper circulation and print advertising.
However, with BHP it’s pretty easy to see that the company is coming under pressure from cyclical factors. The commodity bubble has burst, and BHP’s earnings are set to fall as a result. But as the market rebalances over the next few years, commodity prices should recover.
So, BHP passes the first value trap test.
Destroying value
The second most common trait of value traps is the destruction of value. In other words, investors need to ask if the company’s management destroyed shareholder value by overpaying for acquisitions and misallocating capital?
Unfortunately, it looks as if BHP’s management is guilty of capital misallocation. The company’s decision to enter the shale oil market has so far cost the group billions.
BHP expanded into US shale in 2011, spending nearly $17 billion to acquire Fayetteville assets from Chesapeake and taking over Petrohawk Energy. But according to figures published at the end of last year, BHP’s Fayetteville assets, acquired for $4.8bn, are now worth only $2.1bn, and Petrohawk’s assets have been written down by $2bn. Further, despite spending nearly $2bn per annum to develop these hydrocarbon assets, management doesn’t expect the division to be free cash flow positive until 2016.
Cost of capital
The third and final most common trait of value traps is a low return on capital invested. Put simply, if a company continuously earns a lower return on invested capital (equity and debt invested in the business) than the group’s cost of capital (debt interest costs), it deserves to trade below book value.
According to my figures, which are based on BHP’s financial reports, over the past twelve months the company has earned a return on invested capital of 11.5%. However, the group’s cost of capital has risen to a staggering 27%. Based on these figures the company deserves to trade below book value as it is destroying value for shareholders. Overall, BHP looks like a value trap to me.
