Cheap Stocks and Value Traps

When stock prices fall, people tend to buy. Since prices have come down, stocks become cheaper and hence in the future they are expected to go higher again. Investors perceive value in stock prices that have fallen. There is a breed of investors called value investors who specialise in picking value stocks.

In the current stock markets meltdown, so many stocks have fallen 60-80% or more. Value investors are perceiving this to be a good time to pick stocks. But amidst value stocks abound many other 'value traps' - stocks that have fallen a lot but are destined to languish at low levels for really long periods. Investors should avoid such value traps since they block investor capital indefinitely without generating returns.

The reasons a stock is perceived as a value stock are (1) the share price has fallen and the stock is cheap (2) future earnings prospects are good so the company/stock would bounce back.

In contrast, a value trap is a stock whose (1) share price has fallen and the stock is cheap (2) future earnings prospects are bad and the stock/company would not bounce back.

So how does one go about distinguishing between a value stock from a value trap? There is no right or infallible answer. Even seasoned investors make the mistake of buying a value trap that looks like a value stock. Detecting a value trap is not a easy task. But can we at least have some parameters that could guide us in such an endeavour? Here are a few questions that you could answer before you try to seek value in stocks.

(1) Is the company cheap based not on trailing earnings but on future/forward earnings?
Quoted valuation metrics like PE ratio are based on historical earnings, mostly on the trailing 12 months earnings. What really matters is what earnings are going to accrue in the future. If future earnings are going to fall and future earnings down the road are not coming back to current levels again, the stock is only optically cheap and is a value trap. For example, Unitech quotes at a PE of 4.3. It looks very cheap. But if next year's earnings are going to fall by say, 90%, the forward PE is 43, which is quite expensive.

(2) Does the company have a lot of debt on its balance sheet?
Debt works both ways. In good times it boosts earnings. In bad times, it becomes a stone around the company's neck. Debt needs to be serviced in good times as well as in bad. In bad times interest payments takes up a large chunk of earnings. Beware if there is a lot of debt on the balance sheet, especially if you see an economic slowdown coming.

(3) Does the company operate in a cyclical industry?
Cyclical industries, true to the name, are subject to up cycles and down cycles. Typically, such companies have a large fixed cost of operation (usually are capital intensive and hence are loaded with debt). In an up cycle, their product prices are rising, operating efficiencies set in and profits zoom. In down cycles, product prices fall, operating leverage works in reverse and profits plunge. So SAIL might look cheap at a PE of 4.3, but if the steel cycle is down, earnings going forward could be dismal and hence the stock could be a value trap.

(4) Does the company generate free cash flow?
Cash flow is like blood flowing through the body. Stop the cash flow and the body dies. Earnings are different from free cash flow. Earnings can be massaged and managed. Not so for cash flow. Does the company have stable or growing free cash flows? Lack of cash can starve a business and you dont want to be in a company that suffers starvation.

(5) Is the company losing market share?
All businesses go through down cycles and face slowdowns and recessions. But market shares should not suffer recessions. When faced with a slowdown (and when not faced with a slowdown either), does the company maintain or increase its market share in its industry? A company that loses market to its competitors indicates a possible problem. An exception though is if competition is moving out of an industry because the industry has no future. In such a case increasing market share is not a good thing; the industry might not survive at all! Who uses typewriters? Who uses floppy discs today? (In any case you dont want to be invested in an industry that has no future).

(6) Is the stock liquid enough?
While there is no single figure to qualify a stock as liquid or illiquid, stocks need institutional (mutual funds, hedge funds, insurance companies, etc) interest to propel them higher beyond a certain level. Typically, institutions will not buy stocks that have low liquidity. Without the potential for institutional buying, a quick rebound is generally unlikely.

(7) Is the company itself/insiders buying?
It is said that insiders know best the prospects of their company. Is the company itself issuing a share buyback (suggesting that the management thinks that the shares are cheap)? Are insiders buying? Now management optimism could be misplaced and they could be wrong in their judgment of value too. Also, lack of management buying does not necessarily mean lack of value. But when the company itself is buying back its shares or insiders are buying, the share deserves a look.

Make no mistake, identifying a value trap is no mean feat. Well known investors often fail in doing so. The above points are in no way all you need to know. But they can act as a filter in weeding out value traps.

Happy Investing!