Avoiding Value Traps

Learning to read financial statements is an essential skill for any investor and, in all honesty, it’s a skill which can take a bit of time to acquire.  It’s not just about reading headline figures like price-to-earnings ratio or earnings before interest, taxes, depreciation and amortisation, it’s about “reading between the lines” and understanding the subtext behind the figures.  With that in mind, here are three warning signs, which may indicate that the company is a “value trap”, which will suck up your portfolio’s profits.  For the sake of completeness, we should add that none of these signs is an absolute (as in life, there are very few investment rules which can be considered absolutes), but each of them should certainly be considered a potential red flag.

Companies which list “exceptional costs” time and time again

“Exceptional costs” should be exactly that – exceptional rather than the rule.  If companies keep listing “exceptional costs” time and time again, then they should have a very good explanation for them.  Good explanations might include purchases related to growth (backed up by actual growth or at least strong indications of potential growth), a desire to modernize an established company (backed up by a sensible and realistic plan of action) or simply the fact that a company has seen great opportunities which are too good to miss and has acted on them (backed up by an explanation of what the opportunity was and how it will benefit investors).  Companies which repeatedly book “exceptional costs” without a good explanation for them are, however, generally best avoided.

Companies with great turnover, but very little in the way of profit

In very simple terms, a company’s top line matters a whole lot less than its bottom line.  Therefore, unless you have strong reason to believe that a company can substantially reduce the money which evaporates on the journey from turnover to profit, then you probably want to avoid companies with very thin profit margins for the same reason as you probably want to avoid the proverbial thin ice.  The one major potential exception to this is if a company has a really solid defensive moat around its business, which makes it unlikely to be threatened by competition, in which case it may be worth further investigation.

NB: On the subject of profit margins, you might also want to be wary of companies which seem to generate very generous profit margins for the size of their turnover, especially if they have a reputation for pursuing very aggressive tax-management strategies.  This probably goes at least double for “digital” companies such as the tech giants, which are coming under increasing pressure from both regulators and governments frustrated with the lack of tax revenue they generate compared to the profits they make.

Companies which are in a process of transformation

If a company is undergoing a process of transformation, then there is a reason for it and, generally speaking, the safer and smarter move is to let the company finish its transformation (or at least make substantial progress along the path to transformation) and then decide whether or not you think it is a worthwhile place for your investment funds.  As always, however, there are exceptions to the rule (or guideline) and, in this instance, the most obvious one is if a company has been put under new management and you have confidence in the new managers, in which case you might want to consider getting in early to benefit from the improvements you expect the new managers to bring.  Be aware, however, that this is a rather risky strategy and that even though managers who achieve success in one industry can often achieve success in another, this is not at all guaranteed.