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 principal 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.
Good management
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 that 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 is 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 judgment 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 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 that, 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 sell products and services that 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 destabilising 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 that 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) that 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 that 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 in which companies operate is constantly changing, although this is more true of some companies and industries than others.
If a company operates in an industry that 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 that 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 that 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 a 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 that 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 is 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
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 that 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.
So, Tesco has been a value trap in the last year or two, but does it remain so?
Warren Buffet got this one wrong, but is now a time to buy?
Hi Andrew, yes Tesco is one of the value traps that bit me this year, and was partly the motivation for this list of questions. However I still don’t think it was obvious beforehand that things would turn out as badly as they have, but such is life as an equity investor. In terms of buying now, your guess is as good as mine, but currently I have no intention of selling my shares just yet.
Hi John — Old Terry Smith thinks the Tesco warning signals were obvious – well of course after the event, but Terry is pretty smart guy and he’s run the slide rule over many of the FTSE100 stocks arriving at investing in only a few including ULVR, Diageo, RB and Imperial Tobacco and IHG in the UK – the rest are US or European based : – here is his quote :-
“One of his danger signs for stocks is when the return on capital falls, when companies have to plough in more money to keep profits growing.
He has warned that Tesco was an obvious example and that shareholders, including Mr Buffett, should have seen it coming. He talks in depth in the video above about his formula for picking winners.”
Some other examples of dramatically falling ROCE are SSE and Pearson.
LR
Hi LR, possibly, but I’m not sure Tesco is either a good example of falling ROCE, or that falling ROCE is significant in spotting value traps, and more specifically Tesco’s problems.
I think falling ROCE can lead companies to take excessive risks in trying to keep growth rates at previous levels, when ROCE was higher. That’s perhaps the main risk from a falling ROCE, but in and of itself I don’t think it’s particularly relevant.
In Tesco’s case debts were quite high, which is one way to boost returns (and risks), and their accounting practices were apparently not as they should be (to put it lightly), but primarily I think they’re a victim of a macro environment which really doesn’t suit them.
It’s quite easy to imagine lots of entirely reasonable alternate realities in which Tesco is still doing well, so the correlation between falling ROCE and its current problems may just be noise.
Hi John, A consistently falling ROCE is a pretty accurate indicator of a company and that it is failing to do the right thing in it’s business or a pretty clear illustration that the business environment has changed beyond the companies control i.e. if prices of competing products fall by 50% there is very little than can be done.
A change over one year can be explained — over 5 years is a reasonably clear indicator. SSE looks similar as does IBM.
You are not invested in either of these by any chance?
LR
Hi LR, perhaps but a company that is failing to do the right thing (at the moment) isn’t necessarily a bad investment; it depends on price and the odds that the company might do better in future.
I have owned SSE for a few years now and it’s been a good dividend payer, although like anybody else I have no idea what will happen in the future especially given the potential for disruption in the energy production/transmission/consumption area.
I will be careful where I use the ‘value trap’ tag. If I am to apply your rules, probably all the banks will fit the bill, including HSBC, Barclays and Standard Chartered, not to say about some of the pharmas.
The definition of a ‘value trap’ comes with ‘an extended period of time’. In my opinion Tesco did not fit the bill on this, probably Morrisons may fit the bill, as there was the Safeway saga in 2006, however even after this there was a ‘false recovery’.
I used the ‘value trap’ tag in the past when describing Yellow Pages, Blockbuster or HMV businesses. I remember Alastair Mundy and Neil Woodford, experienced value investors, trying to save the Yellow pages brand.
For me a ‘value trap’ is a business that suffers from disruption in its market. Morrisons fits this definition, however comparing with Blockbuster or HMV, it owns the land and the buildings fir its shops. This could determine a bid from a private equity firm to take it private and restructure it or otherwise (unless the management change the business around) a long period of bleeding to death. As a shareholder I would prefer a fast death as Blockbuster or HMV, than a long one.
As a value investor you will end up at one time to invest in a ‘value trap’ stock, it is impossible to avoid this. This problem cannot be avoided, it is the investor biases and knowledge afterwards which will determine the outcome. I own now both Morrisons and Tesco, although I reduced my exposure on both, and on Morrisons I have done this at a loss. I have clear expectations from both companies for the next year and if those are not achieved, or worse the situation will deteriorate even further, I will sell both at a loss and move on.
Hi Eugen, I think on your first point about banks and pharmas is that a “no” answer to any of the questions in the article doesn’t mean a company is off limits. They’re just things an investor should probably think about before investing, and depending on the answers (such as pharmas depending on blockbusters that have a finite life followed by having to invent new blockbusters) an investor might reduce the price they’re willing to pay, or the amount of debt they will accept, and so on.
My definition of value trap is anything that losses a significant amount of intrinsic value, or earnings power, while I’m owning it. The reduction in intrinsic value would need to be enough such that even a change in sentiment towards the stock wouldn’t be enough to give me a profitable exit and a reasonable rate of return.
So Blockbuster, HMV, Yell and anything that goes bust would fit that definition, but not (yet) Morrisons although perhaps probably Tesco would.
And I totally agree that it’s impossible to never invest in a value trap. The only way to reduce nominal risk to zero is to stay in cash and investors have to accept a certain number of losers if they want to invest in equities. But it’s the number of value traps and losers I want to minimise without compromising, and perhaps even improving, returns.
Why are you holding on to your Tesco shares John? Unless you think they will do much better than a competing investment in future there is no point, except to save face. The market doesn’t know or care what you paid for them. Surely the way to look at a losing investment is would you buy them now. If the answer is no then why are you keeping them? Having said all that I still have a small position in Tesco and trading below NAV I think there is a good reason to buy more.
Andrew
You are absolutely right. I hold Tesco and Morissons because I believe they are good value at the share price they trade today. I may be absolutely wrong, but only the time will tell.
I have sold in the ladt two weeks a swathe of US shares and also shares in Rightmove, Diageo or Imperial Tobaco, because I believe the share price is well high than it should be.
However in investments it is not all white and black, there is no fundamental price for a share, so the behaviour of other investors counts as well. I may see something expensive or cheap, but other investors may push the price even higher or lower.
I know your question was not for me, but I thought my answer will add some meat as well.
Hi Andrew, that’s actually quite a complex question, but I’m basically holding Tesco because the fat lady has yet to sing, as it were. We don’t know how things are going to work out over the next few years and I certainly have no idea what the shares are going to do (halve, double?) so selling seems to be a fear-based reaction based on few if any facts, and that’s not how I like to invest.
I expect to hold the shares until they no longer look like good value, primarily quantitatively, and that isn’t yet the case and probably won’t be for a few years.
And if I didn’t own Tesco I probably wouldn’t buy now, but to me that doesn’t mean I can’t keep holding them. I think investments have three stages of attractiveness: Buy, hold and sell. Tesco isn’t a buy for me, but it isn’t a sell either. It’s a hold.
Interesting discussion. It’s got some parallels to the “don’t catch a falling knife” saying.
If you’re looking at investing into a company that’s facing a challenge that you think they can overcome given time, or that you think is not as big of a deal as the market does, then you have to acknowledge there’s a good chance the price you’re buying at isn’t the lowest the company will get to. If market fear has driven the price down, how do you know the market has had all the fear it’s going to have?
I think a dollar/pound cost averaging approach works here. You think you’ve identified a good company in a temporary quandry that has gotten on Mr Market’s bad side. Just because you buy the stock doesn’t mean the company then starts recovering, or the fall halts. So the approach and discipline I’m trying to develop is not to throw in the maximum I’m prepared to invest at the one time. If it turns out more bad news comes out, you can top up at a cheaper price, which can help you sleep better while you wait for things to improve.
And if the stock takes off soon after you buy, you get to be happy with the profit and just have to guard yourself against the “I should have bought more” mentality.
This is something I wish I’d done with Tesco. I’m tempted to buy more now, but I’m already at a level where I don’t really want to put more into Tesco.
Hi Bob, that’s an interesting idea. I can see the appeal of dripping money into a company over time, especially for more cautious investors. Personally I think I’ll stick with investing in one go, although for me that’s not especially reckless as I only put 3% to 4% in each company.
As for your point on “how do you know”, unfortunately that’s true of just about everything in investing, whether property or equities or anything else that doesn’t have fixed returns! That uncertainty is something we just have to accept if we want the potential for higher returns.
Bob
You are right, some price averaging makes sense, both when buying and when selling.
If I look at my Tesco transactions with Tesco from the summer, when I bought first time, I can count 9 in total. I have bought first time at around 229p, bought as well at 170p 3.5 times more stock that I own at that time sold nearly half at 194p, bought more at 165p, at the moment the prixe is around 184p, so I am one 1p short of breaking even in the average price. My target price for 1June 2015 is 225p and for end December 2015 is 250p. However along this jurney I expect to get rid or 70-80% of the stock before reaching these prices.
Hi John,
thanks again for another interesting and though-provoking article. I love the idea of asking questions against the stocks. This is of critical importance, and I believe it will help to avoid many so-called value traps.
Might we make the whole process slightly easier by turning it into some kind of SWOT analysis of four squares on a page? For example, we could have looked at Tesco versus its competitors long before the recent problems arose and compared debt levels, market share, etc. etc. and give scores for each of the SWOT components, as is sort of the case with you analysis spreadsheet giving a growth quality percentage. I think the levels of debt Tesco have had for a while are pretty detrimental in a difficult market such as the grocery retail sector. This is one of the reasons I sold my shares last year.
Thanks once again for a thought-provoking article. I’m all in favour of books helping us to improve our investment decision-making processes.
Best Regards,
M
Hi M, I think a SWOT approach makes a lot of sense. I guess the questions in the article are mostly on the weakness side, or more specifically about the avoidance of weaknesses, and there are a few in there on the external threats side (with, if I remember correctly, strengths and weaknesses relating to internal factors while opportunities and threats relate to external factors).
Funnily enough I haven’t written an article on strengths, which I suppose really comes down to competitive advantages. The best book on this for the typical private investor (in my opinion) is The Little Book that Builds Wealth, by Pat Dorsey, which is basically the Morningstar moat model.
As for opportunities, I don’t really think in those terms as it feels a bit speculative to me. I tend to be a “status quo” investor, not that I’m always rocking all over the world, but that my base assumption is that the future will be like the past. Of course that assumption will often be wrong, but I think it will generally be less wrong than any speculations about the future I might make.
As for Tesco’s debts, I don’t think they were excessive. They were a little high, but for such a typically defensive company I think they were reasonable. It’s just that the market changed dramatically and certainly not in their favour. Just as nobody expected the Spanish Inquisition, nobody expected the financial crisis and a near 10-year recession.
I hear you. Thanks for the recommendation of the ‘Little Book’ – I have 4 of the other books in the series, and I have enjoyed them all. I guess the moat a la morningstar or Buffett is a good way to look at things, however I think some people might have used Tesco’s market dominance as an excuse to call that a moat (Tesco themselves included).
Moreover, I think the market change is really not what got Tesco. If you compare prices, some things are (surprisingly) actually more expensive in Aldi and Lidl, but their reputation for being the cheapest wins out following a period of economic hardship. So in some ways, I think Tesco rested on their laurels of being the nation’s biggest retailer… the question is, if we go back to the SWOT terminology, what are the opportunities now? Can they leap forward and progress their offering from their currently battered state? How might they do this? Last time, they rebranded their value range and it was a great success, but they can’t just do that again. It does feel a bit speculative, as you say, and we do not want to speculate, we want to invest in good value companies.
As always, thanks for your insightful commentary, I really enjoy the straightforwardness of your writing.
Cheers
I’d say the opportunity for Tesco is to get back to where they were, but how they do this is up to management who, after all, are paid to answer difficult questions like that!
John,
I really welcome this particular article as it helps rationalise why I haven’t followed a couple of your recent recommendations.
I was troubled by the Serco recommendation having previously suffered a total loss on Mouchel. (Not my only total loss as Yell, Cattles and Maiden all fell into that category and that experience was one of the motivations to become a subscriber)
Applying the tests above would have led to a “No” for Serco, as would the impending wholesale management change.
My motivation and so far very pleasant experience from Value Investor is that there is a simple rigour involved in decision analysis which helps avoid all the psychological biases that plague us amateurs
My only fear is that as further layers of complexity are added into the analysis mix the more we open ourselves to those biases (since we are allowing subjectivity) or we become too scared to assume some risk as you state.
Hi Richard, you’re right, Serco would have scored quite a few noes with it being in a cyclical industry selling large-ticket items, and with several large contracts due to expire soon.
However, I’m not sure that would have been enough to stop me investing. What would definitely have stopped me was its debt levels, which were acceptable under the old UKVI Debt Ratio based on estimated future earnings, but not the new one which is based on historic earnings.
Also, I’ve reduced the maximum allowable Debt Ratio for cyclical companies like Serco, down from 5 to 4 (Serco’s is about 5.3) and so by that measure if has quite a bit too much debt given the nature of its business.
I think if Serco had had a debt ratio of perhaps 2 or 3 (i.e. about half its current amount of debt) I might have invested. It would still have subsequently fallen off a cliff and needed a crisis turnaround, but the crisis situation would have been significantly less demanding and risky if debts had been around half their actual levels.
As for your fears about adding too much complexity, you’re right, there are a lot of risks associated with a complex strategy. I think the major risk is that super-detailed analysis leads the analyst to believe that they can predict what will happen with greater accuracy, but I don’t think that’s true. However, the UKVI strategy is far from over-complex yet, in my opinion, and these questions will just replace the existing questions that already get asked (apart from the question about competitive advantages will which be asked after the value trap questions).
Merry Christmas
And just so that the FCA don’t throw me in jail I should also point out that technically I don’t make “recommendations”!
https://www.ukvalueinvestor.com/disclaimer/
John, Would you say that BT is a value trap?
Do you guys consider BT as having grown it’s profitability by cost cutting, whilst living with a static or declining revenue — it has now reached the end of the road, so they need to show growth by acquiring EE at huge cost?
The positives set out for BT are that they will own the biggest 4G network which was a threat to the underlying speed of their broadband over copper offering and the negatives are that you have to increase debt, give away significant equity to Deutsch and Orange, and merge two complex organisations. The latter is a threat and it maybe unclear that BT has the management expertise to integrate them well.
LR
Hi LR, I don’t like big acquisitions and £12.5 billion (price of EE) is a huge purchase for a company (BT) earning less than £2 billion after tax. I would rather avoid on that basis alone.
Other than that though BT has too much debt for my liking and as you say, it hasn’t grown at all in a very long time and shows no particular ability to do so in future.
I was forced to sell some BT stock as well because of the announcement of buying EE. It is not the price which worries me, as I would buy shares in the EE in an initial offering at the price BT would buy the EE shares.
However I cannot see how BT would benefit of this acquisition, I just do not get it. Yes, there could be some cross-selling, but I don’t think it is enough.
I switched from BSkyB to BT when Murdoch saga erupted. That was the time when BT benefited, launched new services including its BT box, and I am a client. It worked.
I expect disruption now, it is more apparent that you will not need a “linear” tv anymore and to wait to see the new movie, you will be able to get those on demand, and I am afraid but Google and Apple will be first to capitalise on this.
John – thinking back to your last review of BT in June, you mentioned under the disclosure that you held Vodafone. I guess you have now sold that given that it has a P/E 37.5 — some 167% above the market average, has an uncovered dividend and a collapse in earnings of 64% on the cards for the current financial year.
On top of this Vodafone has been using the money from the Verizon sale in an acquisition spree for various overseas cable companies and seemingly desperate expansion attempts in what would appear to be a sellers market for country based telecom infrastructure. (not so for specific wireless where O2 and EE have been desperate to sell in the UK)
To follow your views re a value company must avoid the pattern of no growth aka BT, Vodafone represents perhaps a worse example of top line growth in that it’s revenue in 2010 was £44.7Bn and yet it is still only forecasting £43Bn in 2016, granted with the Verizon component released from the company – still management’s job is to grow companies profitably.
Vodafone has seemingly failed on both fronts!!
Hi LR, no I still hold Vodafone and expect to do so for some time yet (barring disaster or a massive share price increase).
I’m not overly keen on Project Spring (I’d have rather they return the money to me!) but we shall see how they get on, although it will probably take a few years to have an idea of the sort of return on investment they manage to get.
The Verizon sale also complicates things so it will probably take a few years before it’s clear how things are progressing without it, but I do think it’s a better proposition than BT.
Hi John, I’m curious as to how Vodafone can pass your selection criteria (your top 50 or 100 list) if it has these numbers :-
“P/E 37.5 — some 167% above the market average, has an uncovered dividend and a collapse in earnings of 64% on the cards for the current financial year.”
LR
It still looks attractive because I use PE10 (price/10yr avg earnings) rather than PE as a valuation multiple, and so lower earnings in a single year don’t have that much impact.
Also a prospective collapse of earnings which hasn’t happened yet also won’t get factored in as I don’t look at forward earnings or other projections.
If such a fall in earnings does appear it will affect Vodafone’s implied intrinsic value, but not until then, and if revenues and dividends hold up then it probably wouldn’t have too much impact either unless the declines were sustained over several years.
Hi John, I see you are using an overall smoothing effect with PE 10.
I would have thought the profit falls from 2012 from a level of £9.5Bn profit to a loss of £3.8Bn in one year was alarming, but then for it to be repeated again to a further larger loss in 2014 of £5.2Bn would have been enough to call time on Vodafone.
The most alarming aspect for me is that the lions share of the profitability of Vodafone over the last 5 years plus was derived from the 45% share in Verizon. All other acquisitions undertaken by Vodafone have been pretty unsuccessful, to put it kindly.
I have no confidence that the recent acquisitions will be any more successful and the vast proceeds from the sale of Verizon are draining away.
Vodafone also appears to be in a panic to align it’s next action in the much quoted “quad play” game. It’s likely that the activities at BT will Vodafone into it’s own expensive next move for fear of being left behind.
They currently £13Bn of borrowings and £10Bn in the bank. I wonder where it will be next year?
I’m with you on the scariness of the £12.5Bn BT is entering into, however, I consider Vodafone’s plight worse.
Time will tell – but I don’t consider Vodafone a value share, in fact sans Verizon it’s a value destructor.
LR
Hi LR, those recent losses are write-downs of its mostly European businesses, so they’re not in the adjusted results which is what I look at. So while the losses look really bad they’re significantly less bad if you look at the underlying business, and specifically they’re not cash losses.
However I would agree that Vodafone is a destroyer of value in terms of its retained earnings as it has a very low return on capital and that’s likely to be true in future. They have to spend vast amounts of shareholder’s money on infrastructure which benefits its customers but not shareholders. It’s like the old adage of Buffett where everybody stands on tiptoe to watch a horse race; the result is more effort for zero gain in visibility.
My figures say its median 10 year net ROCE is 7%, which is pretty rubbish to be honest, leaving it as the 173rd most profitable company out of the 235 that I monitor.
Loses are loses, those businesses were bought with borrowed money. Now the company has still to repay the loans, however it has a shrinking balance sheet. It will need to borrow again to repay those loans and because the smaller balance sheet, the bond markets will penalise the company, resulting in a higher interest rate for the new loans.
I was only briefly invested in Vodafone to take advantage of the special situation: long Vodafone, short Verizon Communications. For me it worked.
I cannot see a case to invest in Vodafone now. I will buy EE at the price BT would aquire it, but I will not touch Vodafone with a barge pole.
John, good points about the right downs. I think I’ll pass on Vodafone and keep a stop on BT just in case the city discovers the truth 🙂
Top tip for 2015 if of interest :-
EBAY
LR – Merry Christmas to you guys.
LR
Hard to see lots of value in ebay. I bought this share at $22 in 2011 and sold it at $58.6 in 2013. I still have a little (1.5% of my portfolio), but it is not something to be exited about.
It has a high ROCE of 19.7% to justify the high PER of 19.3 but this is all.
I am more exited about a few airlines I bought or added to recently. They can make a buck or two as a result of cheaper petrol.
Hi Eugen,
The value in eBay is in PayPal which it owns and has committed to spin off in 2015. The consensus and with pressure from Icahn an activist investor, PayPal could be worth up to $100BN — The combined company is currently $68Bn. Paypal anything north of $68Bn and eBay is free.
I’d never invest in airlines, as the raw cost of capital always (always since airlines were first launched) ends up being greater than the return on capital employed to the investor. A punt on upswings maybe, but an investment – I don’t think so.
LR