The historically high price-to-earnings ratios being placed on equities today make cheap stocks even more alluring. That makes sense, but be advised that the market is littered with “value traps” — stocks that look cheap but never substantially rebound.
Any way you cut it, value is profoundly out of favor, and not just in 2017. Although proponents of these investments typically are patient people, the long-term differential is large enough to be worrisome. Over the last 10 years, growth has outperformed value by more than 100 percent in small caps and by 50 percent in large caps.
Take General Electric, for example. The company’s shares are down 42 percent since the beginning of the year. Its price/earnings ratio is down by a similar amount in that period. And as we analyzed the growth/value performance data across the board, it became clear that the problem goes a lot deeper than just one company.
The Russell 1000 Growth Index is up 27 percent for the year, while the Value Index is only 7 percent higher; the Russell 2000 Growth index is up 19 percent, but the Value Index version is only 5 percent higher; the S&P 500 Growth Index is up 24 percent, but the Value Index is up only 8 percent.
So, here is how to tell if you own a value trap:
No. 1: The 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.
No. 2: Management compensation structures haven’t changed as the stock has declined or underperformed. If earnings (and/or the stock price) have declined but management pay structures haven’t adapted to address that problem, fundamental changes of behavior in the C-suite are unlikely.
No. 3: The company or industry dominates a smaller U.S. 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 General Motors thought of moving the company headquarters to Geneva. That might have helped bring fresh thinking.
No. 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.
No. 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.
No. 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 any more. So what is management doing differently, and how is that change outlined to shareholders?
No. 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.
No. 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.
No. 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.
No. 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.
No. 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 percent to 40 percent of their day. Deeply entrenched value traps are by their nature corporate turnarounds, whether the boss realizes it or not. They need 100 percent of senior management attention.
No. 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.