Sound value investing demands a disciplined approach to stock picking, an important aspect of this discipline is avoiding value traps. These are companies whose shares only appear to be bargains.
Value traps have some desirable attributes, such as low multiples of earnings (P/E), cash flow (P/CF) or book value (P/B). But there may be good reason for a company's shares to be cheap on the basis of these traditional value criteria. If the company also has poor earnings fundamentals and/or excessive debt, it's most likely to be a value trap.
For example, consider the media company Torstar Corp. TS.B, which would rank in the top tier of value stocks in Canada if the only criteria were price/book value and price/earnings ratios. At 5.3 times, Torstar's forward P/E is relatively low within its industry peer group and historically low for the company itself. The stock is trading near its 52-week low.
However, a closer look reveals a company that fits the profile of a value trap. Torstar, whose main business is newspaper publishing, is in a declining industry with poor profitability.
The company's year-over-year earnings growth is expected to be negative, both for 2014 and for 2015. In the absence of any positive catalysts for an earnings turnaround, investors should steer clear of Torstar for now.
Atlantic Power Corp. ATP AT, a Boston-based power-generation company that operates in the United States and Canada, is definitely a value trap. The stock's P/B of 0.58 is much cheaper than the industry median of 1.04, and the stock currently sports an attractive expected dividend yield of 13%.
In today's low-interest-rate environment, the double-digit yield seems almost too good to be true. And it is. Atlantic Power's debt-to-equity ratio is higher than the industry median, and the company recently cut its dividend. Further dividend cuts may be in store due to the company's high debt-servicing costs. With its weak balance sheet, Atlantic Power is vulnerable to rising interest rates.
Some value traps may arise because of lack of trading liquidity. A stock trading at cheap multiples may end up remaining low-priced because of a lack of buying interest.
For a stock to qualify to be held by a typical institutional investor, liquidity is an essential requirement. Liquidity is determined by how easily and quickly a stock can be bought and sold. Stocks with small floats (the value of all outstanding shares that can be purchased on the open market) are consequently illiquid due to low trading volumes.
One example of such a stock is Brampton Brick Ltd. BBL.A, a manufacturer of bricks and other masonry products. Though it looks attractive on the basis of valuations, this company lacks trading volume because its market float is only $23 million. Since this stock will generally be shunned by institutional investors, investors are at risk of buying into a value trap.
To avoid getting caught in value traps, bargain hunters or value investors should look for catalysts that will move a stock higher, such as positive earnings momentum for the current and next quarter, positive earnings surprise in the current quarter relative to the consensus estimate, and positive analysts' earnings-estimate revisions.
These growth-oriented variables help screen out value traps and help identify stocks that are good bets to outperform their peer group and the broader market.