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:
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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.
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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.
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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.
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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.
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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.
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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.