Value shares – or value traps?

Many investors like to hunt for value stocks. This is a stock that looks very cheap compared to its business potential.

Some value stocks continue to generate outstanding returns. For example, I can buy The Shoe Zone in November 2020 it is 36 Euros. Last year the company earned 22p per share and paid 17p per share in dividends. The share price has increased more than six times in less than three years.

But other value stocks are value traps. For many investors, Carillion looks like a good stock. But the value keeps decreasing, until it reaches zero.

So how do I decide if value sharing is really a value trap? Here are some things I looked at.

Relevant business models

Oftentimes companies see their stock drop because business performance has declined. But there could be various reasons.

Sometimes weak management hurts a company, but with someone in charge, it can get back on track. However, in other situations, the business is likely to break even. Each new setback looks like it can be overcome independently, but in reality the long-term business prospects have changed for the worse, for example due to changing customer tastes.

As Warren Buffett noted last month, despite his success in the stock market, “along the way, other businesses that I have invested in have died, their products are not wanted by the public.”

For a stock to perform strongly in the future, its business usually needs to have promising long-term potential.

balance sheet

A classic mistake investors make when looking for value stocks is to focus on a company’s earnings report but not its balance sheet.

A company may have a low price-to-earnings ratio, but if it has huge debt, then focusing on earnings can only be misleading. At some point debt has to be paid off, eating a lot becomes income.

Liquidity cushion

When a company is on the ropes, it can suddenly find a change in cash flow. Suppliers may ask for cash up front, lenders may suddenly pull loans and customers may try to extend payment terms.

Therefore even profitable companies with solid cash flow can still face a liquidity crisis. Sometimes that is fatal.

So when assessing Share Value, I look at what is the margin of safety, including hard cash in hand and debt on the balance sheet.

Cash flow is important – but so is liquidity. They are not the same thing.

Historical trends

Sometimes what looks like a value stock looks very different when viewed from a longer time line. Solid earnings in the past year or perhaps in the past several years may hide a weaker long-term trend that has been temporarily dampened by events such as one-off contract wins.

The past is not always a guide to what will happen in the future. But when looking at a company’s accounts, I think it’s useful to consider a period of five or 10 years, not just the latest figures.