As value investors we’re looking for “cheap” shares that are unpopular almost by definition. What we don’t want though are “value traps”, shares that are unpopular because the company is heading into permanent decline, or where a crisis is about to explode.
Instead what we want are cheap shares from companies that will continue to be as successful in the future as they have been in the past.
Having been caught out by a couple of value traps recently I decided to investigate this subject further with the goal of avoiding companies where there is a significant risk of a crisis situation occurring during my period of ownership (typically about 5 years).
In the book Corporate Turnaround (by Stuart Slatter and David Lovett), the authors outline a series of principle causes of corporate crisis and decline which tie in almost exactly with my own experience of value traps. So I’ve turned those principle causes into a list of questions that value investors can ask to help them avoid those dreaded value traps.
The questions are phrased so that a “yes” answer is good and a “no” answer is less good, but not necessarily bad.
A “no” doesn’t mean the company is off limits as an investment, but a lot of noes might mean that you’ll only invest if the company has half the amount of debt you would normally accept, for example. In other situations declining to invest might be the right course of action.
Many problems stem from management errors. However, most of these are impossible to spot before a crisis emerges. Those that we can spot from looking at the accounts, such as high levels of leverage or low levels of profitability, I’ve covered before. So here we’re looking for signs of poor management that haven’t yet shown up in the accounts.
One sign of poor management is that the company doesn’t have a clear goal or a clear strategy for achieving that goal. Or, that it has a clear goal and strategy but doesn’t appear to be seriously focused on implementing that strategy successfully. Good management would make all of those things a priority.
1. Does the company have a clear and consistent goal and strategy and is it focused on implementing that strategy successfully?
The goal might be called a vision, mission or purpose, but it shouldn’t take too long to find a statement on the company’s investor relations website or in the latest annual report which explains why the company exists.
Similarly, it should be easy to find a clear description of the company’s strategy as well as a progress update on what actions have been taken as part of that strategy and how successful (or not) they have been.
A sign of good management is that they focus on and take due care of the core business, rather than getting overly excited about endlessly entering new and unfamiliar territory.
In most cases companies have just one or two distinctive capabilities, so if the company is involved in lots of unrelated activities and a strong defensible core business is not obvious, that may be a sign of a weak “jack of all trades” approach.
2. Does the company have an obvious core business upon which its goal, strategy and long-term future are heavily focused?
Adequate financial control
In many cases companies get into trouble because they have focused on the wrong things, such as growing revenues or earnings, without thinking enough about how that growth is being created.
In my opinion companies would do well to focus on things like profitability, leverage, liquidity and investment in the future (i.e. capex), with EPS growth coming as an oblique consequence of running the business well, rather than as the main target.
You can check up on what key metrics management are focused on by looking at a company’s Key Performance Indicators (KPIs) which are in the annual report.
3. Do the company’s KPIs focus on a range of relevant indicators beyond revenue and EPS growth, such as profitability, leverage, liquidity and investment?
This isn’t really a yes or no question, so use your judgement based on how many KPIs a company is tracking beyond revenue and earnings growth from that list.
Low and flexible costs
A company that has a high cost structure is going to struggle to compete on price, even if it does have differentiated products.
One thing that can help to keep costs down is size. In many cases larger companies are able to provide goods and services more cheaply than smaller companies, which is one reason why I prefer to stick to FTSE 350 companies and only rarely venture into the world of small-caps.
However, regardless of absolute size I do prefer companies that are in the leading group within their markets.
4. Is the company in the leading group in terms of market share within its chosen markets?
Another way that companies can do things more efficiently and therefore more cheaply is if they have a lot of experience in their core industries and markets.
5. Has the company had the same core business for many years?
Then there’s the ratio between fixed and variable costs (known as “operational leverage”). It can be very helpful if a company can cut expenses when revenues fall as this will help to keep the company profitable. In turn that can give the company more flexibility in how it deals with the decline.
If most costs are fixed then a small downturn in revenues (or increase in expenses) can quickly lead to large losses and demands from landlords, banks and others who require regular fixed payments.
6. Does the company have a low proportion of fixed costs to variable costs (i.e. low operational leverage)?
If a company has a lot of fixed costs you may decide to be more cautious with the amount of debt you are willing to accept, even if the company is in a defensive industry.
Caution with big projects
CEOs who take bold “bet the company” decisions are often praised as heroes (if the bet ends well) but I’d rather not invest in a company that is making, or is likely to make, that sort of bet. While large projects can be exciting for investors, managers and employees alike, they usually come with significant risks if things go wrong.
7. Is the company free of “bold” projects which, if they failed, could push it into a major crisis?
Large projects can occur in any sort of company, but they’re a more common problem for companies that operate in capital intensive industries.
In those situations companies often make large capital expenditures on major projects in order to meet increasing demand when times are good. When the economy inevitably slows down, high and relatively fixed costs can be left inadequately supported by falling revenues.
8. Is the company free of the need for large capital expenditures?
The answer to that question may be obvious or you may want to look at the amount of money the company has spent over the last decade on capital expenditures relative to profits.
Major contracts are another kind of big project and they’re the bread and butter of many companies. Companies can be categorised in two ways: those who sells products and services which are relatively insignificant “small-ticket” purchases for their customers and those whose products and services are major “large-ticket” items to their customers.
There is nothing wrong with companies that sell large-ticket items like houses or 10 year contracts to run government prisons, but they do come with additional risks, especially when customers buy through a process of competitive tendering.
9. Are revenues generated through the sale of a large number of small-ticket items?
Caution with acquisitions and mergers
Personally I have a mild dislike of acquisitions and mergers. They can have a de-stabilising effect on the core business of both companies and in most cases it is the core business which drives sustainable results over the long-term. There is also some empirical evidence which suggests that acquisitions are not generally positive for shareholder returns.
However, I’m not totally against acquisitions; as long as they’re small enough so that even a complete disaster won’t turn into a major crisis for the company as a whole.
10. Has the company avoided major mergers or acquisitions in the last few years?
Another problem with acquisitions is that they can be an easy way for management to grow the company when growth in the core business starts to slow down. Some managers become accustomed to particular growth rates and the salaries and bonuses which go with it, and if the core business fails to produce that growth they’ll start looking to buy growth by (almost) any means necessary.
While a focus on growth may seem like a good thing it may not be if growth comes from the purchase of other companies that are not closely related to the company’s core business.
This purchase of companies in loosely related business areas is sometimes described as diversification, with hoped for synergies, cost savings and cross-selling opportunities. But often the result is acquisitions where the acquiring company is not the “best owner” because it has no special expertise or competitive advantages in those non-core business areas.
Widely diversified businesses are often more complex to run as well and may have higher internal costs due to additional layers of bureaucracy.
11. Has the company avoided acquiring other companies that have little to do with its core capability?
Sound financial policy
Having a sound financial policy is mostly about having a degree of leverage (whether debt or other forms of leverage) which is appropriate for the company and the current stage of its business cycle.
I have written before about rules of thumb for leverage and the guidelines I mentioned there may need to be revised for a particular company depending on the answers to these questions.
12. Is the company conservatively financed based on a review of its operational robustness?
Another side of financial policy is capital investment. All companies need to make some form of capital investment for things such as new factories or new drug patents. These require money to be spent today for a potential but uncertain gain in the future.
The risk here is that a company either invests poorly, such as building factories that will only be marginally profitable or investing in drug research which fails to produce a new “blockbuster” product, or it doesn’t invest enough, preferring to reduce capital expenditure in order to boost short-term profits and dividends.
Knowing whether or not a company is investing enough will be very hard for us as outside investors, but we can look to see if a company has a clear and transparent target rate of return for any capital investment.
13. If the company does need to make large capital expenditures does it have a clear expected rate of return for those investments?
Ability to adapt to changing market demand
The process of creative destruction means that the environment which companies operate in is constantly changing, although this is more true of some companies and industries than others.
If a company operates in an industry which is or has the potential to be affected by large scale changes, or “disrupted” as it’s usually called today, investors face the risk that the company will not be able to adapt competitively.
14. Does the company operate in an industry which has been stable for a long time and is expected to remain stable for a long time to come?
As well as change we also need to be alert to industries which are in decline, even if they are not changing. However, we need to be careful and try to differentiate between a long-term decline which is unlikely to be reversed and a more normal cyclical decline, which may well turn into a new boom within a few years at most.
15. Does the company operate in an industry which is not in long-term decline?
Even if a company is in an industry which is in long-term decline it doesn’t necessarily mean you shouldn’t invest in it. It would depend on the speed of decline and your estimate of the speed of decline should be reflected in the price (although industries in rapid decline probably should be avoided).
For example, the fossil fuel industry is likely to be in long-term decline through the rest of this century, but few investors think that this long-term decline will have any significant impact on oil and gas related profits within the next decade or two. Because of that the long-term decline’s impact on current valuations is minimal (which may change if the carbon bubble meme becomes popular).
Competitive products, services and price
Companies obviously need to provide competitive products and services at competitive prices in order to be successful, but because of creative destruction products that were successful in the past may not be successful in the future.
Imagine a computer company, company A, which has been successful for many years because it designed and now sells the best computer in the world.
At some point that computer will become obsolete and no longer sell because other computer companies will have built even better computers. Company A will then have to design and sell a new computer which may or may not be as successful as the first one.
That’s basically what happened to Apple and its Apple II computer. It had a long run of success but then struggled to have a similar degree of success with the Apple II’s successors, the Apple III, Lisa and Macintosh.
This sort of situation is also common in the pharmaceutical industry where large portions of a company’s profits can come from a single blockbuster drug for many years while it is protected from competition by a patent. When the patent runs out the protection and profits disappear very quickly and if a new replacement drug cannot be developed then shareholder returns will suffer.
This is very similar to the problems faced by companies that rely on major projects and contracts. In both cases the need to replace existing successful products or contracts represents a significant risk.
16. Does the company generate most of its profits from products or contracts that do not need to be replaced in the next 10 years?
As for competitive pricing, an important contributing factor to companies that get into trouble is that they sell products or services which are commodities, i.e. they are virtually indistinguishable from the products or services of competitors.
Commodity products must compete almost purely on price and so a company that depends on commodity products for its success must have some sort of enduring advantage on the cost side if it is ever to generate high returns on capital.
For example, Saudi Arabia is one of the lowest cost producers of oil and BHP Billiton one of the lowest cost iron ore producers because they own unique assets that can produce these commodity products as cheaply or cheaper than anyone else in the world. But without that advantage a company selling commodity products will be more susceptible to changes in the market.
17. Does the company sell differentiated products that do not compete purely on price?
Indifferent to commodity prices
And on the subject of commodities, another risk that companies face, and which robust and defensive companies are less affected by, is commodity prices.
The price of oil, iron, copper and other commodities can be very volatile and companies who operate in the industries which extract, refine and sell these commodities can also be very volatile. So for example when the price of oil goes up, companies that own oil assets and the companies that support them can be expected to do well, while the opposite may be true if oil prices fall.
What is perhaps less obvious is that companies in entirely different industries can also be affected by commodity price movements.
An example here might be a company that makes sausages, where its expenses are things like fuel for tractors and feed for pigs. Both tractor fuel and pig feed prices follow oil prices up and down, so the sausage company’s expenses go up when oil goes up which will reduce its profits.
18. Is the company likely to be relatively immune to commodity price movements?
Avoiding value traps
Once you’ve answered those questions you should have a pretty good idea of what sort of company you’re looking at, how cyclical or defensive it might be and, most importantly, how likely it is that you’re looking at a potential value trap rather than a solid value investment.
Of course the future is always going to be uncertain, and things can go wrong with even the most robust and defensive of companies, but by using questions like these the odds of catastrophe will hopefully be reduced considerably.