Seeking value without the traps

Value investing is never as easy as finding the lowest valuation stocks. In our experience investing in value opportunities through multiple market cycles, we’ve learned that valuation metrics must be supplemented by a focus on quality and free cash flow. This approach helps us avoid so-called value traps, which represent the pitfalls of overreliance on accounting-derived valuation measures such as P/E and P/B.

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Anatomy of a value trap

A value trap is an investment that appears to be inexpensive but turns out to be anything but. In other words, it may fall statistically into a value category (e.g., by having a low price-to-earnings (P/E) or price-to-book (P/B) ratio) but turns out to be statistically expensive over time due to deteriorating fundamentals. Understanding this means being able to better manage the risk-adjusted return potential in a value-oriented portfolio.

While it’s probably safe to say that value investors don’t intentionally seek out value traps, there are several things to look for to avoid falling into them. We’ve identified three common symptoms that signal the presence of a value trap.

1   Melting ice cube—Sometimes a company can get caught on the wrong side of a secular industry trend, leading to a decline or stagnation in future earnings power. The oft-cited archetype here is a buggy whipmaker at the dawn of the automobile era.

2   Weak FCF conversion—A company’s inability to convert the majority of generally accepted accounting principles (GAAP) earnings to free cash flow (FCF) over time can be a sign of challenged economics or aggressive accounting. As a result, traditional valuation metrics such as P/E or P/B become disconnected from economic reality.

3   Too much debt—Overlevered balance sheets leave little room to navigate unexpected shocks and cyclical downturns. Shareholders typically feel the pain through dilutive equity raises—or worse, bankruptcy—when balance sheets are stretched.

We can look at a computer hardware and services company as an example to help illustrate the melting ice cube phenomenon. In 2011, this business was trading at a seemingly attractive ~12x P/E multiple. Furthermore, this company had steadily grown its revenue and profits over the previous decade. However, net income subsequently declined by ~30% over the subsequent five years as this former technology innovator struggled to stay relevant as customers shifted from on-premise data centers to cloud computing. The ~12x P/E multiple turned into a less-appealing ~18x P/E using the new lower earnings base.

The melting ice cube of declining net income

Sample computer hardware and services company, 12/31/11–3/31/21

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Source: Company filings, Bloomberg, as of April 2021.

An example of how the combination of weak FCF and debt-fueled growth can lead to negative outcomes can be found within a subset of the energy sector: U.S. shale-focused exploration and production companies. As a group, these companies reported significant net income over the most recent decade, but very little FCF. This gap between net income and FCF was ultimately unsustainable and led to several bankruptcies in this market segment.

Intrinsic value versus the value factor

Value investing has increasingly become synonymous with factor-based investing, with portfolios constructed entirely or primarily based on traditional valuation metrics such as P/E and P/B. While we agree that a statistically cheap universe provides a good starting point for finding undervalued stocks, many of the valuation metrics used in the factor-based approach have flaws.

  • P/E uses GAAP or adjusted earnings that can be a weak proxy for cash available to owners.
  • P/B is appropriate for certain capital-intensive businesses, such as banks, where there’s a direct relationship between the asset base and earnings power, but less useful for asset-light businesses.
  • Dividend yield doesn’t indicate whether there’s sufficient cash flow to maintain or grow the dividend and excludes share repurchases; therefore, it fails to capture total cash return to shareholders.

FCF is less subject to the accounting shortcomings listed above and, according to some industry research, has led to strong investment results relative to traditional value factors. In addition, FCF makes common sense. A private business owner cares about how much cash is being generated every year, not an accounting number that doesn’t show up in the bank account.

Not enough cash and excessive debt spell trouble

Bloomberg North American Independent E&P Index adjusted net income vs. free cash flow, 2011–2020

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Source: Bloomberg North American Independent E&P Index, as of 5/7/21. The chart analyzes data from North American independent exploration and production (E&P) valuation peers. Analysis parameters: E&Ps between $1 billion and $50 billion in market capitalization, excluding acquired entities and bankrupt companies. N = 23, equally weighted. RHS refers to right-hand side.

FCF contains better information

When we look for value opportunities, we seek high-quality businesses trading at a discount to intrinsic value. In other words, we look for both a good company and an inexpensive valuation—not just one or the other. The characteristics we look for in a high-quality company include:

  • Ability to generate strong FCF and evidence that return on invested capital is greater than the weighted average cost of capital
  • Ability to grow underlying business value over time
  • Strong balance sheet that we believe has a better chance of withstanding cyclical downturns
  • Sustainable competitive advantages that drive higher predictability of long-term fundamentals
 

Conclusion

Factor-based approaches start and end with statistical cheapness and may be more vulnerable to the risk of investing in challenged businesses. We believe a focus on FCF can reveal clearer signals through the noise when it comes to valuation. Most important, underneath value factor statistics are actual businesses, and we think investors should view themselves as buyers of businesses, not just buyers of factors. In this way, investors can think and act like owners and seek to invest in companies whose management teams have demonstrated they can create sustainable value for key stakeholders.