Identifying Value Traps


(narender) #1

Surprising to see no section devoted to the task of identifying value traps and so I have penned down my thoughts below and request fellow boarders to add on to the points.

Over last couple of years, I have had my fair share of value traps from Usher Agro, Zicom electronics, Shilpi Cable (although I made good money) including the current holding of Hinduja Global and some multi-baggers including Time Techno, Avanti, Pondy oxides etc. They key things, I now look at; and possibly that can help you avoid value traps is:

  • Dividend yield: Dividend signifies at the very basic level that the Company is making cash and is distributing it to its shareholders. Although there could be cases of dividend payments being funded with debt; presence of dividends in general is a good thing, especially when investing in small caps or undervalued companies. Absence of dividends is a big no for me while investing; after I burnt my fingers investing in Lycos, a company trading at a PE of 1, generating healthy operating cash flow; but surprise surprise, no dividend payments.

  • Debt: Many a times, a company loaded with debt will appear cheap on PE basis. That is because of financial leverage, that enhances the ROE and PEs. However, when you start looking at EV/EBITDA these companies are not that cheap after all. Couple of examples of such companies are Zicom and Usher, where the debt was high and unsustainable, breaking the Company’s back. Before the losses these companies appeared cheap on PE & ROE basis and thus ended up in my portfolio. Although my losses in these two were limited due to early exit; I have modified my approach to look for sustainability of debt rather than absolute debt levels. By sustainability, I mean stability of the capital structure over time and good operating cash flow generation to pay down interest costs and principals. I am not completely debt averse; and that was one of my reasons for investing in Time Techno in past when it was around 50-60 rs and TCPL in last few weeks.

  • Working capital cycle: It is necessary to study the Company’s working capital cycle especially with respect to its peers. Cash cycles outside of the industry norms are red flag, irrespective of good or bad. Any industry in general has set standard norms and understanding variation from industry practice is very necessary. Shilpi cables is one fine example of such case with elongated cash conversion cycle. Also, Avanti feeds is on the other extreme; the Company has marginal cash conversion cycle (heavy cash discounts keeps receivables low) and this has allowed the Company to grow phenomenally over years as it just requires fixed assets to grow.

  • Management actions: By this I mean the frequency of corporate actions by management. Once upon a time I found Sintex cheap at 100/share, maybe a year and few months ago. Since then this company has gone for further capex on textile unit 2, FCCB issuance, FCCB conversion, demerger and looking for strategic investor in its plastics division. It was cheap compared to its other plastics peers for a good reason (i.e. insane management). Another example of such case is Talwalkars, two FPOs; strategy to mix the lifestyle business and gym together to save costs; followed by complete reversal of the idea and demerging the two business.

  • Earnings quality: Although this is interlinked with many of the points above; I list it separately for companies which are questioned about their accounting practices. These names tend to remain cheap long after questions are raised. My simple strategy has been to avoid such names and sell in case I have a holding. I don’t sit around passing judgement on what might possibly be the actual truth. The two recent examples of this has been Eros and kaveri seeds; both are at a level higher than what I sold, but I am not complaining.

  • Cyclicals: Another set of value traps could be investing in cyclicals at peak earnings. This would be the time when cyclicals would look super cheap aided by earnings expansion and lower PEs.


(yudiagg) #2

A great suggestion. We should have a section on value traps. Would request experts to dissect and share their expert views on past traps.

Request views on two past mega value traps- Opto circuits and Zylog systems. Both declined from about Rs 400 to less than Rs 10. I lost huge amount in both the counters. Their accounts were manipulated - but not flagged by auditors.


(Sreekanth) #3

Hi there

A nice initiative. It would also be useful to actually draw out a case study on one particular company that you have invested and how it actually became a value trap. It would benefit lot of investors as a case based learning.
Regards
Sreekanth


(Kumar Saurabh) #4

An interesting value trap is mushrooming of lot of low grade companies in a sunrise industry . There have been numerous examples in IT, Education etc. Characteristics could be reflected by one or many parameters highlighted by @narender but it’s our greed sometimes which pushes us to overlook them. Usually the motto for such promoters is yo rode the wave . A rule I have developed is to be more cautious in a sunrise industry for example in current parlance SMAC , solar etc


(nipunmohta) #5

I’d like to add Flexituff to the list of value trap companies. I invested in this company basis a low EVEBITDA ratio of 7 at that time of investment which is still at 6, growth in quarterly EBITDA margins (Dec16 vs Dec16 and Sep16 vs Sep15) and growth in annual topline (which further pushes the absolute EBITDA figure given increase in both quarterly margins and base number that is revenue). Also the company has a piotroski score of 9 as per screener. But despite all this the share of the company has tanked from Rs 180 range in early May to Rs 118.3 yesterday and continues to make new 52w low almost on a daily basis. Maybe there is some off books activity that the investors/traders know about which is not apparent from the numbers. Also one red flag is that the company is consistently (in Mar16 and TTM) earning more in other income than its net profit meaning that if there were to be no other income then the company would be in a net loss situation.

Could somebody throw light on the affairs of the company if they have any idea about it?


(niravacharya) #6

Anything that differentiates value trap from value investing is GROWTH :grin: unless you start seeing one it is all value trap :smile:


(Sarvesh Gupta) #7

Not really, if there is a company which is earning 4 rs per share and is selling at 20 Rs per share with dividend of 2 rs per share, the P/E is just 5 - which signifies value. Now say the company is not growing it’s earning at all. If I am buying this with a dividend yield of 10% forever and an expectation of return of money to shareholders somewhere down the future (every year 3 rs is being added to the company’s kitty assuming no major investment) - then it might be worth a buy.

So I guess the crucial thing is not just looking at growth but whether there is a return to the shareholder’s money if there is no growth. No growth with misuse of shareholder’s money (money being sucked out in loss-making or breakeven projects for instance) is generally disastrous.


(chetanb) #8

RCI Industries is a value trap too. Trading at 2.6x last quarter annualised eps and 7x trailing eps. But last quarter eps was balooned due to huge trading profits in its subsidiary which is purely into trading of copper. this kind of profit from copper trading is not sustainable.


(satish23) #10

Companies with good dividend yield consistently will not trade at cheaper valuation


(raviudeshi) #11

@nipunmohta though I have not tracked flexituff recently, it’s promoters name was in 2010 Money Matters Scan. Also, the promoters have been frequently been active in pledging shares. so that should give you an idea on the management quality.


(Yogesh Sane) #12

Here is a definition of value trap from Investopedia.

What is a ‘Value Trap’

A value trap is a stock that appears to be cheap because the stock has been trading at low multiples of earnings, cash flow or book value for an extended time period.

If a company has done well in the past but the fortunes of the company or industry are likely to turn worse, market may price the stock lower in anticipation of this. If an investor is looking at past fundamentals, such stocks will appear cheap as company will appear to be selling for low multiple of past earnings, cashflow or book value.

Stock begins to move lower once fundamentals begin to turn bad as expected but these numbers still appear to be good for someone looking at long term averages. Long term investors may see this as an opportunity to buy when others are selling. Often, company’s situation worsens rapidly and stock tanks along with it eventually causing even the long term investors to lose patience and sell at a loss. Only speculators or investors who specialize in turnaround stories buy at these levels. But not all turnaround candidates actually turn around.

An interesting scenario is when company’s fundamentals begin to deteriorate from excellent to good or from good to average. As long as company’s fundamentals are deteriorating, market will send the stock lower irrespective of current state of fundamentals. All good things have to come to an end and that includes stocks with excellent fundamentals. A company can do well for 100 years but not at a stretch, there will be low periods along the way.

Value Traps need not result in just ‘Buy High Sell Low’ situations but also ‘Hold High Sell Low’ situations. If the fundamentals deteriorate at a slow rate, it can causes many to hold such stock. Situation is actually worse when there is time correction instead of price correction. i.e. stock price just moves sideways instead of going down. A time correction can induce many value seekers to slowly add to their position. If a stock drops sharply, people get a crash course and may get out of it and move on to something better and limit losses. but if the stock move sideways, it may cause many investors to just hold on to such stock or worse add to their bets under the pretext of being patient and missing out opportunities elsewhere.

A low price more often than not is a sign that fundamentals are likely to deteriorate. Unless you have a strong reason to believe otherwise, you are looking at a value trap.


(Hitesh Patel) #13

Value trap is an interesting discussion and everyone will have their fair share of experiences investing in these kind of companies.

A lot of investors are entrapped in such companies mostly because of quantitative data. Its either low PE, low P/B or assets on the book like cash or shares held of other companies, real estate, just to name a few.

These will often be uncovered by running a screener test. And most investors get stuck only at these levels without bothering to go to the next level of checks. A cursory glance at past few years of annual reports usually gives quite a good idea about the quality of the company. Most of the times we can check exactly what management was talking and what it has delivered.

As mentioned earlier by narender, dividends and taxes paid by the company are the signs of real earnings. We can keep these parameters firmly etched in our mind. But these should not be a deterrent to looking into a company further. Many a times companies pay low dividends or no dividends bcos the business is capable of deploying high doses of capital which generates high returns on deployed capital. And in some cases like kaveri seeds, bcos of their status as agrichem cos they dont need to pay taxes.

Two important parameters to look at are cash flows and working capital situation. Progressive deterioration in either or both of the above would be first sign of trouble.

Cyclicals with loads of debt and still expanding would often turn out to be value traps.

Consistently increasing debt and frequent equity dilutions also are red flags to be followed further.

Serial acquisitions with a poor past history of the same should also be a warning sign.

Promoter antics are often indicative of future problems.

I usually go by the business quality and management quality checklists esp for the long term bets. We have whole well opinionated and populated threads on both these aspects so no need to elaborate.

Having said all of the above, most of our multibaggers began as value buys which later on turned into great growth stories and this facilitated huge reratings in such companies. So one has to learn to differentiate between value traps and real value.

For me value traps have been companies like unity infra, lakshmi energy, etc where the tell tale signal were clearly visible but I was not educated enough to heed the warning signs.


(f2003062) #14

@narender

Nice initiative, I am little bit confused about your view on Avanti feeds, are you saying this is value trap?


(ashit) #15

Business earning less than cost of capital and still growing will be the real value trap
This is my belief
Thanks
Ashit


(narender) #16

Flexituff: looks like an interesting debt trap!!

It has an increasing set of revenues and that is the only good thing about it. overall the entire structure looks weak; resulting in low returns on everything from assets to equity.

Although revenue is good, their margins are sub-par. Still it earned 177 cr of ebitda on revenue of 1450 odd crores. flexi looks cheap at ev of 1050 cr (750 debt & 300 equity). but so follows the problem.

interest cost of 110 cr. It looks a bit too high for the debt they have. whatever be the reason, this is the actual cash going out.

depreciation: although i usually dont mind depreciation; but in this case looks like their maintenance capex is bit too high as the decrease in netfat is not so steep. So although cfo will look slightly better for depreciation the company is spending a lot on fixed assets. This also looks strange for the high fixed asset they have. The fixed asset turnover of 2 looks low compared to peers. If they have a high asset base (high unutilized capacities??), the maintenance capex should be low. whatever the reasons, thats again a lot of actual cash gone, just from investing instead of operating.

taxes: funny enough even after earning 180 cr ebitda; the profits are gone. so tax holidays!!

now that the cash is going out!! its coming from operations. Tragically 20 crores was stopped by working capital guards in fy16 and for fy17 looking at the jump (scary!!), it will be around 120 cr. This will eat away the operating cash. low operating cash flow, not enough to fund even interest & capex; company took additional debt to fund it and so goes the figure from 650 cr to 800 cr.

obviously no dividends; the cash bells aren’t ringing.

i have taken a very superficial look and only at financials. but at first glance, this doesnt look like a value buy but more like a vicious debt cycle.


(narender) #17

well metal trading is a general no for me! high commodity values (working cap and short term debt intensive), market price risk, fx risk, credit risk. Add to this super thin margins. Limited scope for error and risk management needs to be very good.

Also, this industry had a lot of taxes and overall a cumulative high no of 20-25% all in; and stupid rules like a manufacturer can have only two layers of traders in between before end consumer for ability to pass on taxes. so a lot of trading was about tax management. This one industry i am waiting how it shapes up after gst. this will create a lot of activity in the sector.

Also these comments are not for rci in particular; but for any metal trading company in general. I will say, understanding benchmark to invest in metal trading should be that one can understand what happened with shilpi!!


(dn2017) #18

TreeHouse is another example.

HGS, however, is a value buy I think.


(Rohit) #19

I lost all my invested money in Tree house , Sudar Ind , shree Ganesh Jwellary etc.due to lack of knowledge. After that I started learning about balance sheets , cash flows , value investing etc. More we learn , easier it is to avoid such financial disasters.

I dont let any stock more than 5-6 % of my portfolio. So even if all money is lost in a particular stock , Value at risk is just 5-6 %. Once I had approx 20% allocation in Kaveri seed , but than stock fell from 1000+ levels to 300.So I started to diversify in other good companies in order to mitigate the risk.


(narender) #20

friends, while sharing your stocks also share the reasons you identified why it turned out to be a value trap and how to stay away!


(Samir ) #21

Thanks Narender,very good insightful topic.Remind me of Peter Lynch(Beating the Street,One up …books).Cash Flow,D/E , decreasing dedt will show co.strength/weakness.But high growth company may not pay dividend at early stages.I appreciate your topic very much.