Most investors know what factors to pay attention to when looking for cheaply priced companies. Metrics like price-to-earnings (P/E) and price-to-book are often used to identify attractive targets. But what happens when a cheap price accurately reflects the value of the company? What if the business you’re buying is cheap because it’s just a bad businesses? Companies that follow this description are known as value traps. Here are four characteristics of value traps.
High levels of debt
Leverage has been the downfall of many a business. A company with high levels of debt on its balance sheet typically has to use a lot of cash to pay the interest on those debts. Additionally, these businesses face the additional risk that interest rates may rise, causing them to default. In particular, investors who pay too much attention to earnings and not enough to the cash flow and balance sheets are likely to miss this warning sign, as a ratio like P/E does not accurately capture this risk. The real problem with debt is that it can limit the time horizon afforded to management to implement a turnaround plan. Even a good team with the best of intentions can be hamstrung by onerous debt payments.
Management acts in its own interest
Of course, not all people have the best of intentions. Often, companies are cheap because their executives and boards are not pursuing the interests of shareholders. Everything else about the business seems fine – it has a healthy balance sheet, good earnings and stable cash flow – but management consistently pursues a course of action that rewards themselves over the owners. Examples of this include excessively generous stock option awards, high salaries and poor corporate communication. Questionable accounting can compound this issue. An especially important red flag is if they do not change their compensation structure during bad times.
The company is fighting a losing battle
In some cases, a business can be well run and well structured, but ultimately be losing market share due to a fundamental disruption of its market or business model. If the company in question is a well-known household name, the temptation to take a chance on its suddenly cheap stock can be especially great – an example of this is Kodak, which at one point controlled most of its market, and has since had to rebrand as a producer of niche film cameras. Look out for falling revenues and sales for an indication of whether your target is a value trap.
Capital is being deployed inefficiently
Warren Buffett famously cares as much about how well his companies use their capital as he does about their ability to make that cash in the first place. Well-managed capital expenditures are crucial to maintaining and expanding market share and improving efficiency. Often, the reason a business becomes disrupted by an upstart is its inability, or unwillingness, to change the way expenditures are managed and directed.
