How to Avoid Value Traps with Fundamental Analysis

Warren Buffett always hammers home the importance of never losing any money. In this insightful guest post, my friend Andrew Sather, who you might know from the popular Money Tree Investing Podcast or his financial blog eInvestingForBeginners, shares how to identify and avoid so called "value traps". Enjoy!

The primary goal of value investing is to buy companies that are trading at a discount to their intrinsic value. This often means buying companies that are out of favor with the market. In some cases, the pessimism is overblown and great returns can be made. However, sometimes the pessimism is justified due to poor financial conditions, and it’s these stocks that become value traps-- resulting in investors “trying to catch a falling knife”.

Fundamental analysis can be a useful tool in identifying value traps, because its chief function is to analyze whether a company has a strong financial condition or not. This type of analysis employs the use of simple financial ratios to give us the opportunity to compare stocks of different sizes or industries. Value investors are famous pioneers of fundamental analysis, using many of these valuations and ratios to identify value situations.

The first most commonly used fundamental ratio is the Price to Earnings, or P/E ratio. This ratio tells an investor how much he is paying for a company’s profits. You want to pay as little as you can for a company’s earnings. The reason for this is because as a company grows its earnings, its ability to compound investor capital increases. A higher price paid for these earnings means that a company needs to grow earnings at a much higher rate to provide the investor with adequate returns.

Price to earnings = Price / earnings = (market capitalization * shares outstanding) / (net earnings)

Not only does this tool help us identify value but it also plays a crucial part in helping to avoid value traps. An extremely high price to earnings ratio can signal a company that is highly in favor with the market, to the point where a bubble can form and investors paying a premium for the stock can lose significantly when the optimism fades.

For example, Microsoft had a P/E of 53.7 in 1999. This is more than double the recommended P/E ratio of under 15 (under 25 with a low P/B) set by Benjamin Graham in The Intelligent Investor. At the time, Microsoft was trading at a market capitalization of over $400 billion. Consider that as of April 2015, the market capitalization still hasn’t recovered, trading at around $338 billion. Over 15 years later and after an extremely strong business performance and bull market run, and investors still lost money due to paying too steep of a price.

The price to earnings ratio also does a great job at identifying value traps that look like value opportunities. A negative P/E ratio signals a company with negative annual net earnings, and is a situation that should be avoided at all costs. From my book, the Value Trap Indicator:

When you buy a company with negative earnings, you might as well go to the casino and put it all on black. Because when you buy a stock that is losing money you aren’t buying a business, you’re buying a liability with a chance of recovery. Sure it might just recover, but the risk isn’t worth it when there are literally thousands of companies out there with positive earnings. Just don’t do it!

Would you buy a broken down car at retail price? Or even if you bought it at a discount, is it worth it? Let’s pretend you actually did have mechanic skills. But imagine buying a car that you aren’t allowed to touch, and it’s going to be repaired by someone randomly off the street. No sane person would ever do that! Yet millions of people do it in the stock market all the time. And the markets, customer wants and demands, and the health of industries and the economy is as random as can be! At least put yourself in a favorable position by buying a company that’s actually making money!”

The danger of investing in a company with negative earnings was made extremely apparent with Circuit City’s bankruptcy in 2008. At the time, Circuit City had a strong balance sheet, attractive cash flow statement, and low price valuations. Yet after only 2 years of negative earnings, and subsequent negative P/E ratios, the company was forced to file bankruptcy. When you consider that the company wasn’t even highly leveraged, with a debt to equity close to the average at 1.5, you’ll start to see the importance of including important valuations such as the price to earnings ratio. While most every other valuation looked promising, it just took one poor valuation of negative P/E to signal a value trap.

In fact, Value Trap Indicator reported that of the biggest 30 bankruptcies since 2000, the single most common characteristic of a company about to go bankrupt was a negative P/E ratio from negative annual earnings. Knowing this fact shows just how much of a gamble an investor faces when investing in such a situation. Because a company’s primary goal is to create profits, it makes sense that one of the most important fundamental ratios to consider measures a company’s profitability with P/E.

Another extremely important fundamental ratio to consider during stock analysis is the debt to equity ratio. Also referenced by Benjamin Graham in Security Analysis, the debt to equity ratios lets us compare a company’s liabilities to its assets, giving us an idea behind a company’s financial strength and liquidity. The lower the ratio, the less risky a company should be to invest in primarily because it carries less debt on its balance sheet.

Debt to Equity = (Total Liabilities) / (Shareholder’s Equity)

Sometimes, you’ll see debt to equity calculated with long term debt instead of total liabilities. I prefer to use the equation above. In a situation where a company is facing troubling waters, a low amount of long term debt won’t keep short term liabilities from forcing bankruptcy—if the number of these liabilities is too high. As such, calculating debt to equity with only long term debt doesn’t consider worst case scenarios and doesn’t accurately portray the amount of risk associated with a stock.

The average debt to equity of any company is around 1. This means that a company with a debt to equity less than 1 is less leveraged than the average company and a company with a debt to equity greater than 1 is more leveraged. The debt to equity can vary depending on industry, but the numbers tend to offset in other categories.

For example, oil companies tend to carry more debt on their balance sheets because of the high capital cost of machinery and equipment. The consequence of that is that these companies tend to be more profitable than other industries, and so you’ll see lower profitability ratios such as P/E and P/S. The key is finding the right balance. What’s increasingly more important in utilizing the debt to equity ratio is using it to avoid highly levered and extremely risky investments.

Take the lesson we can learn about Lehman Brothers and debt to equity. Lehman was one of the banks that was “too big to fail”, and by all intents and purposes seemed like a great value play at the time. Not only did the company boast a low P/E ratio of 10.2, but it also was extremely attractive on a price to book, price to sales, and price to cash basis. EPS growth was steadily increasing every year. Not only that, but Lehman paid a dividend with a healthy payout ratio. Value investors, growth investors and dividend growth investors were all vulnerable to this value trap.

The major and often overlooked debt to equity ratio told a different story. In the year right before bankruptcy, Lehman Brothers had a debt to equity of 29.73. This meant that the company was 29x more leveraged than the average company, and almost 3x more leveraged than the average bank. The company didn’t need a year of negative earnings or other financial turmoil, it just took a simple market crisis to completely wipe out its investors. Market crises such as the one in 2008 aren’t as uncommon as you might think. We’ve seen market crises about once every decade for a very long time.

The importance of noting a high debt to equity can’t be overlooked. Debt to equity isn’t included in many fundamental analysis discussions, partly because a lower ratio doesn’t correlate with better returns. Yet on the flip side, a higher debt to equity does correlate with a greater chance of bankruptcy. Just because a ratio doesn’t find us higher stock returns doesn’t mean it shouldn’t be included in an analysis. In fact, you’ll increase your returns if you can successfully limit your losses through a tool like the debt to equity.

The following excerpt from Value Trap Indicator draws a conclusion to the matter nicely:

“A healthy company with nothing to hide is easy to spot, just as a company who is trying to hide the elephant in the room (like Lehman was). The problem is that Wall Street doesn’t profit from better informed investors, instead they profit on more transactions and bigger headlines. Good stocks are hard to find, but good education is even harder.

The prevalence of this situation will always keep me in business, but it will also open opportunities for average investors like you. Success can be found by limiting losses more so than maximizing gains will. If you remember this principle, you can compound your wealth at a much faster and uninterrupted pace. Like Warren Buffett once said, “Rule number 1 is never lose money. Rule number 2 is never forget rule number 1.”

The Value Trap Indicator was designed to help you avoid losing money. As you can see, it would’ve prevented against the biggest bankruptcy of our time. Take heed of its warnings, and stay away from companies that might look pretty, but conceal venomous fangs.”

Now, we can’t just look at just one side of the preceding argument. The fact remains that each fundamental ratio will have a weakness to consider.

The price to earnings ratio is extremely useful in measuring earnings, but the validity of those earnings can be suspect. It’s much easier for a company to manipulate earnings completely on the fact that they are so complicated to calculate. The decision of an accountant to include earnings in one fiscal year or the other can have an extremely significant effect on a company’s earnings numbers.

Knowing this fact, it’s important to consider other fundamental alternatives. Hewitt Heiserman nicely presented the issue of earnings manipulations with his own solution, which was previously written about on the blog here. The price to sales ratio can also be a great tool to negate the possibility of earnings manipulation because net sales numbers are much harder to manipulate. There’s ways to address the weakness of the P/E ratio but it’s done with more fundamental analysis, not less.

The debt to equity ratio does carry an inherent weakness as well. As I mentioned earlier, the debt to equity can vary depending on industry. This is extremely apparent in the financial services industry like banks and insurance companies. Most of these companies are 10x more leveraged than the average company, with the average debt to equity closer to 10 than 1.

This presents a problem to the value investor. Do we ignore the risks with a higher debt to equity ratio, in the name of “everybody’s doing it”? You can create your own answer to this question, but I strongly believe against making exceptions for a highly leveraged industry like banks. I understand that these banks need to be highly leveraged in order to make their business models work. But that doesn’t mean I see them as valid and prudent investments.

It’s not uncommon for entire industries to be poor investments. Think about how the video rental industry was completely decapitated by new technology, and how railroads were replaced before that. An industry like the airline industry has notoriously been poor for investment, with over 200 bankruptcies occurring in that industry since 1972 alone. I’d like to argue that financial companies with a debt to equity around 10 are also going to be very poor investments.

If you look at the big banks during 2008, they all had a very similar story to Lehman Brothers. From a purely income statement look at the financials, the banks had fantastic numbers. Dividend growth, earnings growth, and gushing cash flow was all common. The only fundamental ratio that looked poor for these stocks was the debt to equity. Yet if you were doing an industry comparison to the average, every bank looked completely fine. They were leveraged like an average bank.

But the results weren’t completely fine or average. Some of these banks got bailed out, but most of them saw significant stock market losses. I’m talking about losses from the $100 range to the $10 range in many banks such as $BAC, $C, $JPM and more. I’m not going to pretend like this situation described is rational in any way. There’s absolutely no way to predict that those kind of results would happen, and no way to prevent it. The best way to avoid the kind of irrational losses like we saw with the highly leveraged banks is to not play. So in that industry, that’s exactly why I do. It’s why I don’t make exceptions at all when it comes to the debt to equity.

You’ll find that there are many different fundamental ratios you can use to evaluate and identify a value trap. I’ve just given you the two most common, and potentially most useful. You can certainly take just the information here and use it to improve your investing performance. If you’re interested in learning about more fundamental ratios, for a total of seven categories in all, and evaluating more of the major bankruptcies since 2000—pick up my book Value Trap Indicator.

The only thing we have to fear is fear itself. Value traps do happen, but they often ensnare only the ones who don’t take the time to educate themselves. Use resources like this blog to educate yourself. It’s the best way to prepare against the next value trap black swan.

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