Glencore (LSE: GLEN) has fallen almost 47% this year, making it the worst performing stock in the FTSE 100.
Such declines are bound to attract bargain hunters. After all, the international mining behemoth’s shares now offer a dividend yield of 7.2% and trade at a historic P/E of 11.8.
However, while Glencore looks cheap at first glance, the company has all the hallmarks of a value trap.
Value trap
Value traps are difficult to spot and finding them isn’t an exact science. More often than not, investors find themselves being sucked into a value trap without realising it.
Nevertheless, most value traps have key three common traits — and by avoiding companies that display these characteristics, you can increase your chances of avoiding these traps.
Still, as mentioned above finding value traps isn’t an exact science, and while it’s possible to improve your chances of avoiding traps, it’s not possible to avoid them entirely.
Secular decline
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. It may also be the case that the company needs to change its business model.
On balance, it looks as if Glencore’s troubles are a direct result of cyclical factors in the commodity market.
So, Glencore 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 has destroyed shareholder value by overpaying for acquisitions and misallocating capital?
Unfortunately, it looks as if Glencore management is guilty of capital misallocation. Indeed, management’s decision to buy peer Xstrata and mid-cap oil producer Caracal Energy at the top of the commodity cycle has cost the group billions.
Glencore paid $1.6bn for Africa-focused Caracal. But on Wednesday, alongside its half-year results Glencore revealed that it was writing down the value of Caracal by $790m, as low oil prices weighed on asset values.
Further, during 2013 Glencore took a $7.7bn write-down on the assets it acquired from Xstrata. The write-off was taken as Glencore decided to mothball some greenfield projects acquired as part of the deal.
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 Glencore’s financial reports, over the past twelve months the company has earned a return on invested capital of 3.3%. Unfortunately, over the same period Glencore’s cost of capital has been 5.8%. Based on these figures, the company deserves to trade below book value as it is destroying value for shareholders.
Overall, Glencore looks like a value trap to me.
