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Is GlaxoSmithKline plc A Value Trap Or A Value Play?

It’s been a rough year for us GlaxoSmithKline’s (LSE: GSK) shareholders. Year-to-date the company’s shares have fallen by around 6%, excluding dividends. That said, including dividends the company’s shares have drastically outperformed the FTSE 100. Glaxo’s shares have produced a total return of 0% since the beginning of 2015, compared to a return of -9% for the wider FTSE 100. 

However, after recent declines some City analysts and investors have started to question if Glaxo is a value trap. 

Value trap

Value traps are difficult to spot. Finding them isn’t an exact science, and investors often get sucked into them when searching for bargains. 

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 such traps. 

Secular decline 

The first common feature of value traps is that of secular decline. More specifically, investors need to ask if the company in question’s revenue/profit or share price is falling due to cyclical factors, or if the company’s business model is under threat. 

A great example is that of Trinity Mirror, which has seen revenues slide over the past decade due to the secular decline of newspaper circulation and print advertising. Over the same period, the company’s share price has slumped 73%. 

In comparison, it’s pretty clear that Glaxo is suffering from neither cyclical nor structural factors. Healthcare isn’t a cyclical market and the demand for Glaxo’s vaccines and consumer healthcare products remains robust. 

Destroying value 

The second most common trait of value traps is the destruction of value. In other words, investors need to ask: did the company’s management destroy shareholder value by overpaying for acquisitions and mis-allocating capital? 

It looks as if Glaxo passes this test as well. The company has refrained from bidding for any smaller peers as valuations surge to eye-watering levels. Additionally, the group’s asset swap agreed with Novartis earlier this year seems to have unlocked a lot of value for investors. 

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, Glaxo’s cost of capital is around 8.7%, based on 12-month figures. The same data also shows that Glaxo’s return on invested capital is 18.8%, more than double the group’s cost of capital. 

The bottom line

So overall, Glaxo passes each of my three value trap tests with flying colours. The company’s market isn’t in secular decline, management hasn’t wasted investors’ cash chasing expensive acquisitions, and the group’s return on capital is more than double its cost of capital. 

According to my simple analysis, Glaxo looks like a value play to me but don't just take my word for it. I strongly recommend that you do your own research before making a trading decision - you may come to a different conclusion.

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Rupert Hargreaves owns shares of GlaxoSmithKline. The Motley Fool UK has recommended GlaxoSmithKline. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.