Rio Tinto (LSE: RIO) and BHP Billiton (LSE: BLT) both look attractive after recent declines, but are these companies really value plays after recent declines or are they value traps?
Value traps are difficult to spot, and investors often get sucked into them when searching for bargains. What’s more, finding value traps isn’t an exact science as the models designed to help investors avoid the traps are highly subjective.
Nevertheless, there are three key traits most value traps have in common and by avoiding companies that display these characteristics, you can increase your chances of avoiding value traps. Although, these rules don’t guarantee that you’ll be able to avoid falling knives entirely.
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 BHP and Rio, it’s pretty easy to say that this isn’t the case, as the two companies are suffering from cyclical rather than secular pressures. The commodity bubble has burst, and earnings are falling as a result but as the market rebalances over the next few years, commodity prices should recover along with earnings.
So, both BHP and Rio pass the first value trap test.
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, both BHP and Rio are guilty of misallocation capital and destroying value.
According to the investment bank Morgan Stanley, between 2005 and 2014 BHP, Rio and Anglo American spent a total of $246bn expanding production. However, the additional capacity brought on-stream by these miners has weighed on commodity prices. The markets for key commodities such as iron ore, coal and copper are now oversupplied. As a result, price declines have cost BHP, Rio and Anglo $29bn, $11bn and $8bn respectively in lost earnings during the last three years alone. Simply put, during the past decade these three miners spent $246bn to lose just under $29bn.
Further, BHP expanded into US shale in 2011, spending nearly $17 billion to acquire assets from several established producers but according to figures published at the end of last year, these assets are now worth only $12bn.
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, over the past twelve months BHP and Rio have earned a return on invested capital of 2.1% and 4.7% respectively, compared to a cost of capital of 7.4% and 16.4%. These figures indicate that both BHP and Rio deserve to trade below book value as they are destroying value for shareholders. And, because the two miners only pass one out of the three value trap criteria, it looks as if BHP and Rio could be value traps.
