The Strategist

11 signs that a company is not worth your investment

12/27/2017 - 10:04

A record high price-earnings ratio, which we see today in the market, makes investors look narrowly at cheap securities. This is not meaningless, but keep in mind that there are "value traps" in the market. Some stocks seem cheap at first glance, but their true value may be different.

The cost style of investing has lagged behind in recent years. Although it is supported by people who are patient, the long-term difference is big enough to alarm them. Over the past 10 years, growth stocks have outpaced share prices by more than 100% in the segment of low-capitalization and by 50% - in the high-end segment. Take, for example, General Electric. Since the beginning of the year, the company's shares have fallen 42%. During this period, the price/earnings ratio declined accordingly. At the same time, analysis of the dynamics of various stocks shows that the problem is not limited to only one company. Since the beginning of the year, Russell 1000 Growth index has added 27%, while its value analogue grew by only 7%; Russell 2000 Growth index is in the positive by 19%, the corresponding value index increased by 5%. A similar situation is observed among high-capitalization companies. S&P 500 Growth index jumped by 24%, while the value index added only 8%.

How to figure out whether a company is a trap? Here are a few distinctive features:

1. The company remains in a difficult situation at the peak of the operating cycle

After seven years of economic recovery, most US corporations should feel good and show excellent results. If it is not, the problem is in something else. However, there is one obvious exception: the oil and gas sector.

2. Management compensation does not change, despite fall in shares

If profits (and quotes) decrease, and the salary of management remains the same, then serious changes in management strategy and management breakthroughs are unlikely.

3. Poor development of the company or industry
Executives of companies are immersed in a certain environment. If a company is filled with people with outdated beliefs, it is much more difficult to come up with something new. For example, in the early 1990s, the chairman of the board of directors of General Motors was thinking about moving the headquarters to Geneva - this was to bring new ideas and solutions to the company.

4. Loss of market share

Often traps are companies that are inferior to market share competitors. The value of shares usually follows the market share - if it decreases, the quotes also drop.

5. Presence of large shareholders with their own goals

Trade unions and the state own shares in many corporations. If interests of such shareholders and small depositors do not coincide, the latter usually become victims.

6. Opaque or slow capital allocation process

Surprisingly, many companies-traps show a good current free cash flow. Problems arise when capital is used inefficiently and no expected improvement in results occurs. The old ways of doing business no longer work. What innovations leadership does offer and how will they affect shareholders?

7. The company does not change methods of work of ordinary employees

This problem is not easy to follow, but it is very important. To avoid falling into a trap, the company must improve methods of work of ordinary employees. Changes must cover the whole vertical, from the leaders to the lower-level employees.

8. Short-term management goals are not feasible, plans for the past year failed

Cheap shares are a good investment when operating indicators improve in accordance with a strategy chosen by management. Then, stocks start to grow. But if management puts unrealistic goals, then even a moderate improvement in performance escapes attention of investors. That is why the approach "promise less - do more" works perfectly in the markets.
9. Financial leverage exceeds the company's real ability to service its debts 

Typically, the most deadly traps lie at a huge debt level. Because of exorbitant interest payments, companies are dying out faster than management can remedy the situation. Excessive financial leverage can take many forms - too high working capital, large volumes of leasing or need for short-term refinancing.

10. No clear growth strategy
Companies-traps are usually characterized by an unintelligible development strategy. Most likely, the strategy will not work if its full description, including financial analysis, does not fit on one page.
11. The general director and the chairman of the board of directors are the same person

 Ask any chairman how long it takes to work on the board of directors, and he will answer that 25-40% of time. In other words, there is little time to manage the business. All corporation-traps desperately need to restructure management, regardless of the opinion of the CEO.