Red flags to look out for in value-trap stocks

Few things bring fear in value investors' hearts than realizing that they invested in a value trap.

A value trap is a stock that looks like a bargain, based on key valuation metrics such as price-to-earnings or price-to-book ratios, but it falls further in price and fails to recover within a value investor's investment horizon of three to five years and at worst goes bankrupt, either because of a fundamental shift in the company's business or because of changes in the environment in which the company operates. The changes are not business cycle related, but instead they are secular, structural and mostly permanent. Having said that, and unlike common belief, the value trap reference applies to more than the case of a company in a dying industry.

So what sort of a company has the potential to become or develop into a value trap?

First, a company with poor management, particularly if it operates in a free-entry market – i.e. no barriers to entry or lacking competitive advantage. For a company that has competitive advantage, even bad management cannot inflict mortal damage, but for a company without it, watch out.

Who are potentially bad managers?

-Managers who lack industry experience and relevant background.

-Managers who will not tolerate dissent.

-Those who love to be the face of the company and are dangerously egotistical – Enron's management comes to mind.

-Managers who believe that all problems are temporary.

-Managers who create complex corporate or ownership structures, and are extremely active with mergers, acquisitions or divestitures, thus building up excessive goodwill on the balance sheet, followed by large writedowns – Tyco and Nortel Networks Corp. come to mind.

Second, a bad company. Even good managers, according to Warren Buffett, will fail when they try to manage and rehabilitate bad companies. For example, the last CEO of Nortel, Mike Zafirovski, in my opinion, was a good manager, but the bad company eventually won.

Which are potentially bad companies?

• Companies whose organizational structure is convoluted and whose strategy is complex even when dealing with small problems.
• Companies with asset impairment, non-transparent accounting and aggressive accounting and revenue recognition – Eastman Kodak Co., Enron and Tyco come to mind.
• Companies with excessive leverage given the industry they belong to – even good companies can go down in a recession when they are excessively leveraged.
• Companies whose key executives antagonize shareholders and investors, make unplanned or sudden exits and miss milestones in a product launch.
• Companies with complex corporate structures and securities and those that make excessive use of stock options – why make things complicated unless a company wants to hide something within its complexity?
• Bad or inappropriate business models also make bad companies, as well as companies in industries that are in secular decline due to the emergence of a new/better product, changing customer tastes or technological change.

Third, a company with a bad strategy. For a company that operates in an industry without barriers to entry, a strategy that involves embarking on acquisitions hoping to achieve economies of scale, cost advantage or demand advantage, or diversify in adjacent markets that also lack barriers to entry is a sure step toward becoming a value trap. As is a company's strategy that involves rationalizing operations in a mature or declining industry. Dell Inc., for example, spent $13-billion (U.S.) on acquisitions between 2008 and 2012, including $12-billion in 2012, which did not change a poorly differentiated company in a free-entry market.

While it is difficult to identify a value trap beforehand, which only becomes apparent afterward, the aforementioned checklist accompanied by a careful assessment of a company's intrinsic value, which takes into consideration all areas discussed above, will go a long way in helping an investor identify and avoid a potential value trap before it is too late. Investing is more than buying low P/E or P/B stocks. Many times a stock can have a low valuation simply because it is a bad stock. That is why value investors refer to low P/E or P/B stocks as potentially undervalued, rather than truly undervalued.

George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.