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12 Signs a Cheap Stock is a Value Trap

Bloomberg: 12 Signs a Cheap Stock is a Value Trap, November 30, 2017

  1. Company is at the peak of an operating cycle and is still troubled. After more than seven years of economic recovery, most public companies should be showing strong earnings. If they are not, something else is wrong. One legitimate exception: commodity-sector companies such as oil and gas
  2. Management compensation structures haven’t changed as the stock has declined but management pay structures haven’t adapted to address that problem, fundamental changes of behavior in the C-suite are unlikely
  3. The company or industry dominates a smaller US city. Managers have to live somewhere, and if that location is full of like-minded people, then change is harder to execute. As one example, in the early 1990s the chairman of GM thought of moving the company headquarters to Geneva. That might have helped bring fresh thinking
  4. The business keeps losing market share. Value traps often occur with companies that are ceding ground to new competition. Until market share trends higher, the stock seldom does
  5. There are other powerful stakeholders. Unions and governments hold real sway in many large public companies, for example. But if return on shareholder capital has to fight with other entrenched interests, the pace of change will be slower
  6. The capital allocation process isn’t changing fast enough or is unclear. The funny thing about many value traps is that they still have decent current free cash flow. The “trap” comes from not using that capital efficiently to reinvigorate the business. By definition, the old ways of allocating capital don’t work anymore. So what is management doing differently, and how is that change outlined to shareholders?
  7. The company isn’t changing how it evaluates line managers. This one is deep in the weeds, but it is important. For a company to escape “value trap” status, it has to change its operational DNA. And that means pushing those changes down to the operating level where customers see the difference
  8. Management’s near-term goals are not achievable, and/or managers have failed at the majority of prior-year goals. Value stocks are a good investment when operational results improve according to a predetermined management plan. That’s when markets start to build in a better valuation multiple. But if management sets out unrealistic goals, even modest improvement doesn’t get that bump. That’s why “underpromise and overdeliver” is so important
  9. The company has more financial leverage than it can sustain through a multiyear turnaround. Debt is the actual trigger for the most deadly value traps, snapping shut before management can turn things around. This can come in many forms, including working capital requirements, leases and short-term refinancing
  10. The strategic vision is cloudy. Value traps almost always suffer from fuzzy management strategies. If the whole thing – financial analysis included – doesn’t fit on one page, it probably won’t work
  11. The chief executive and chairperson of the board are the same person. Ask any CEO how much time managing their board takes and the number will likely be 25% to 40% of their day. Deeply entrenched value traps are by their nature corporate turnarounds, whether the boss realizes it or not. They need 100% of senior management attention
  12. Even activist investors stay away. In the end, any good value story with non-lethal problems should attract activist shareholders. If it doesn’t, you can scratch an important catalyst off the list

Image Source: Arbor Investment Planner

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