Submitted by Nick Colas of Datatrek Research
Poor, Poor Pitiful… Value Stocks
"Value trap". That’s a phrase we haven’t heard much in recent years, but GE seems to be bringing it back. And as we looked at the dramatic outperformance of growth stocks over value this year, it is clear that there are many such traps in US markets. Having covered the auto industry for a long time, we are well acquainted with the phenomenon. In today’s note: a 12-point list to help you identify value traps.
The outperformance of growth versus value investing in 2017 is dramatic. A few numbers to frame the discussion:
- The Russell 1000 Growth Index is up 24.8% YTD, while its Value Index counterpart is only 6.3% higher on the year. Value underperformance: 1,850 basis points.
- The Russell 2000 Growth index is up 15.7% YTD, but the Value Index version is only 2.1% higher. Value underperformance: 1,360 basis points.
- The S&P 500 Growth Index is +22.5% on the year, but the Value Index for the 500 is up only 7.3%. Value underperformance: 1,520 basis points.
Any way you cut it, value is profoundly out of favor, and not just in 2017. While proponents of this style are typically patient people, the differential is large enough to be worrisome. Over the last 10 years, growth has outperformed value by more than 2:1.
This leads us to believe that there are a lot of “Value traps” out there – stocks that look cheap on valuation, but never substantially rebound. We got to thinking about this term when we saw it applied to GE today. And as we pulled the growth/value performance data, it became clear that the problem goes a lot deeper than just one company.
Simply put, the value side of the US equity market seems littered with traps. It’s not just GE. It is clearly a minefield out there in value land.
For better or worse, we have a lot of experience in identifying value traps from covering the auto industry for much our professional lives.
So (with apologies to Jeff Foxworthy), here is our list of “You might own a value trap if…”
#1 The company is at the peak of an operating cycle and is still troubled. After +7 years of economic recovery, most public companies should be showing peak earnings. If they are not, something else is wrong. One legitimate exception: commodity sector companies like oil and gas.
#2 Management compensation structures haven’t changed as the stock has declined or underperformed. The old adage “What gets measured gets managed” applies here. If earnings (and/or the stock price) have declined but management comp structures haven’t adapted to address that problem, fundamental changes of behavior in the C-suite are unlikely.
#3 The company or industry dominates a smaller US city. This one is deeply informed by my experience visiting Detroit every 90 days for a decade-plus. Managements have to live somewhere, and if that location is full of like-minded people then change is harder to execute. One GM chairman even thought of moving the company headquarters to Geneva in the early 1990s. It might have helped…
#4 The business keeps losing market share. Value traps often occur with companies that are losing out to new competition. Until market share trends higher, the stock seldom does.
#5 There are other powerful stakeholders. Back to the auto industry for an example. Unions can slow the pace of needed change, as can entire governments (see VW, which is partially owned by the German state where it is headquartered). If return on shareholder capital has to fight with other entrenched interests, the pace of change will be slower. Often, much slower.
#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?
#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.
#8 Management’s near term goals are not achievable, and/or they have failed at the majority of prior year goals. Value stocks “Work” when operational results improve according to a predetermined management plan. That’s when investors 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.
#9 The company has more leverage than it can sustain through a multi-year turnaround. Financial 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.
#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.
#11 The CEO 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 25-40% of their day. Deeply entrenched value traps are by their nature corporate turnarounds, whether the boss realizes it or not. They need 100% of senior management attention.
#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.
And finally, for those readers who spotted the Warren Zevon song lyric in the title, a link to the song’s more famous rendition by Linda Ronstadt: https://www.youtube.com/watch?v=Cd2_LKoTYKw