Centrica (LSE: CNA) and Utilitywise’s (LSE: UTW) shares have slumped by 18% and 41% respectively over the past 12 months.
These declines are bound to attract bargain hunters. After all, Centrica is now trading at a five-year low and Utilitywise, a favourite of star fund manager Neil Woodford, is trading at a two-year low.
However, while these two companies look cheap at first glance, they could be value traps.
Distinguishing between value traps and genuine value plays isn’t an exact science but most value traps have key three common traits. By avoiding companies that display these characteristics, you can increase your chances of avoiding these traps.
The first common characteristic of value traps is that of secular decline. Simply put, the company may be serving a market that no longer exists in the way it used to. No matter how good the company is at what it does, if the sector itself is contracting, the firm will struggle to instigate a turnaround.
Both Centrica and Utilitywise serve the utility industry, an industry that is renowned for its stability. With this being the case, the two companies shouldn’t come under pressure from either cyclical or secular factors.
That said, Centrica’s upstream (oil and gas production) business is facing cyclical headwinds.
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 has destroyed shareholder value by overpaying for acquisitions and misallocating capital.
Unfortunately, Centrica’s decision to enter the oil and gas business has turned out to be a misallocation of capital by management. Although, Centrica’s new management team is now reversing the decision to get into the oil business.
On the other hand, Utilitywise’s management can’t be accused of destroying shareholder value, but it can be accused of misleading and confusing shareholders.
The company’s accounting methods have drawn plenty of criticism recently and accusations of aggressive accounting have prompted former finance director Andrew Richardson to unexpectedly quit. If it turns out that these accusations are true, Utilitywise could be forced to restate its accounts and shareholders will suffer as a result.
Cost of capital
The third and final most common trait of value traps is a low return on invested capital (ROIC). Put simply, ROIC means the amount of net income returned as a percentage of the money invested in the business. This figure should be above the cost of capital — the cost of funds used for financing a business.
At present, Centrica’s cost of capital is below 5% but last year the company’s ROIC slumped to -3%. However, over the past five years, Centrica’s ROIC has exceeded 10%, while the cost of capital has averaged 5%.
With accusations of aggressive accounting hanging over Utilitywise, it’s impossible to accurately calculate the company’s return figures. Figures suggest that the firm’s ROIC for 2014 was 35%, although it’s not possible to establish how reliable this figure really is.
The bottom line
So overall, Utilitywise looks like a value trap to me. On the other hand, based on this simple analysis, Centrica could be a value play.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has recommended Centrica. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.