How To Avoid Value Traps

A value trap is a relatively cheap stock whose price simply doesn’t rise no matter how long you hold it. I’ve done a research study of factors that might characterize value traps, and here are the ones that I think provide the best warning signs. After going through these factors, I’ll tell you how I performed the study, describe some systems that incorporate these factors, give their performance, and recommend some value stocks that I think are not value traps.

  1. Avoid companies who file late. The SEC has set deadlines for company filings; most companies must file a 10-Q within 40 days of the end of their fiscal quarter, though companies with a market cap of less than $75 million can take up to 45 days. After that, companies need to file a form NT (for “Non-Timely”), which will give them a five-day grace period. If a company doesn’t file a form NT or takes more than the five days given, it may face deregistration, delisting, and an inability to raise capital. In general, companies who are late with a quarterly or annual filing tend to do poorly over the next few months, lagging the S&P 500 by an average of more than 2% annually.
  2. Avoid companies with negative or very low unlevered free cash flow. Unlevered free cash flow is cash flow from operating activities plus after-tax interest expenditures minus capital expenditures. If a company’s unlevered free cash flow is less than 2% of its enterprise value (the sum of its market cap, non-controlling interest, preferred equity, and debt minus its cash on hand), it’s going to be hard for it to grow enough to escape value-trap status.
  3. Avoid any company whose negative cash flow from investing activities is a lot bigger than its cash flow from operating activities, or whose cash flow from operating activities is negative to begin with. A company may look like a good value, but if its cash flow from investing activities (which includes capital expenditures, acquisitions and divestitures, sales and purchases of investments and plants, and other investing activities) is negative $100 million while its cash flow from operations is only $50 million, it’s going to face a pretty tough year. To rank companies on this measure, I take the cash flow from operations, add it to the cash flow from investing (which is usually a negative number), and divide the total by the sales for the year.
  4. Avoid companies with high balance-sheet accruals. Balance sheet accruals are the increase in the most recent year’s net operating assets (NOA) over the previous year’s, divided by the last two years’ average total assets. Anything over 5% is pretty dangerous and represents a serious threat to future financing. If your NOA is growing, your proportion of cash and non-debt liabilities to total assets is shrinking, leaving you little breathing room to exceed investor expectations.
  5. Avoid industries with poor unlevered free cash flow to enterprise value ratios. Right now the industries with the worst ratio of unlevered free cash flow to enterprise value are hospitality, construction, aerospace and defense, mining, food, construction materials, utilities, car manufacturers, air freight companies, communications equipment, trains and trucks, airlines, tobacco, and energy equipment. This list may change, of course, and certainly, some of these industries have had better days in the past. But at the moment, they’re not the best industries to invest in.
  6. Avoid companies whose price is extremely low compared to recent highs. Look at the company’s ten-month high one month ago, and compare that to its current price. If the latter is only a small fraction of the former (say, 60% or less), it’s going to take a good long time for the company to regain its former glory.
  7. Avoid industries with strong negative momentum. Industries whose companies have, on the aggregate, fallen most sharply in price over the last year are probably best to avoid. As of early February, those industries are diversified telecom, mining, direct marketing retail, diversified financial services, consumer durables, distributors, car manufacturers, auto parts, pharma, biotech, energy equipment, and transportation infrastructure.
  8. Avoid companies with low volume-weighted momentum. Divide the company’s VMA(15) by its VMA(200). If the result is below 0.8, that stock may well be in deep trouble.
  9. Avoid companies with low projected EPS growth. In a previous post, I talked about five predictive signals for EPS growth: low profit margin or ROA, high EPS estimates, low accruals, strong momentum, and strong operating earnings growth. If those signals are mostly negative—i.e., if the company is showing high-profit margin or ROA, low EPS estimates, high accruals, low momentum, and shrinking operating earnings—that’s a strong warning that the company is going to have a very hard time growing its earnings.
  10. Avoid companies with a low ratio of gross profit to enterprise value. If using TTM numbers, I’d set my threshold around 0.15. Anything lower than that and the company is probably overvalued rather than undervalued.
  11. Avoid companies that are issuing a lot more shares. Equity financing is far more expensive than debt financing, and a company that is issuing more shares rather than buying them back may be desperate for cash, leveraged to the hilt, or simply not fiscally foresighted.
  12. Avoid companies whose trailing twelve months sales are either a lot higher or a lot lower than their sales the previous year. When looking at value companies, you want to see somewhat steady sales—ideally, sales growth should be close to the average for all companies. Companies with huge increases in sales are likely to disappoint investors in the near future; companies with huge decreases in sales are unlikely to easily make up for them. As a rule of thumb, avoid companies in the top or bottom decile in terms of sales growth (the most recent twelve months over the prior twelve months).
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Disclosure: My ten largest holdings right now: ARC, GSB, PCMI, CTEK, PERI, PFSW, OSIR, PDEX, HALL, CLCT. I also own a fair amount of SCX and NTWK. My CAGR since 1/1/16: 40%.

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