A lot of investors like hunting for value shares. Those are shares that seem very cheap compared to a business’s potential.
Some value shares go on to deliver incredible returns. For example, I could have bought Shoe Zone in November 2020 for 36p a share. Last year the company earned 22p per share and paid out 17p per share in dividends. The share price has increased more than sixfold in under three years.
But other value shares end up being value traps. To many investors, Carillion looked like a great value share. But the price just kept getting lower and lower, until it hit zero.
So, how do I decide whether a value share is really a value trap? Here are some things I look at.
Relevant business model
Often a company sees its shares sink because business performance has plummeted. But there can be different reasons for that.
Sometimes weak management has hurt a firm, but with the right people in charge it could do well again. In other situations, though, a business is basically doomed. Each new setback may seem like it can be overcome in isolation, but in reality the long-term business prospects have irrevocably changed for the worse, for example because of changing customer tastes.
As Warren Buffett noted last month, although he has had some fabulous stock market successes, “along the way, other businesses in which I have invested have died, their products unwanted by the public.”
For value shares to perform strongly in future, their business typically needs to have promising long-term potential.
Balance sheet
A classic mistake investors make when looking for value shares is focussing on a company’s income statement but not its balance sheet.
A company might have a low price-to-earnings ratio, but if it has huge debt then focussing on the earnings alone can be misleading. At some point the debt will need to be repaid, eating heavily into earnings.
Liquidity cushion
When a company is already on the ropes, it can suddenly find cash flows change. Suppliers may demand cash upfront, lenders can suddenly pull loans and customers may try to extend their payment terms.
That is why even a profitable company with solid cash flows can still face a liquidity crisis. Sometimes that is fatal.
So when assessing value shares, I look at what their margin of safety is, including the hard cash on hand and debt on the balance sheet.
Cash flows matter — but so does liquidity. They are not the same thing.
Historical trends
Sometimes what look like value shares seem very different when viewed from a longer timeline. Solid earnings last year or perhaps even in multiple recent years may obscure weaker long-term trends that have been temporarily flattered by an event such as a one-off contract win.
The past is not necessarily a guide to what happens in future. But when looking at a firm’s accounts, I think it is helpful to consider a five- or 10-year period, not just the most recent figures.
