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Warning signs: how investors can avoid the ‘value trap’

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Written by: Darius McDermott
24/01/2018
We all like to pick up a bargain and investments are no different - if a company’s share price falls, it may look cheap and tempting. But when is a stock likely to just get cheaper and not make you any money at all?

Investors who saw Anglo American’s shares fall by 40% in the first six months of 2017 and who leapt to buy at the low, are rubbing their hands together today having seen the share price rise from 959.4p to 1,783.6p.

But as we saw with Carillion last week, it is just as easy to lose money as make it when you fall into a ‘value trap’. Having been in the top ten most bought stocks last year, it has now filed for compulsory bankruptcy.

Here, I identify some of the warning signs to heed, and I identify a few fund managers who do ‘value investing’ well.

Warning signs

  1. Cash is king: forget what the company is telling you about profits or adjusted profits and take a look at the cash flow statement. Is it positive? Is the company generating enough cash to cover its debt repayments?
  2. Good debt or bad debt? If the company has debts, are they rising? If so, why? Some debt is not necessarily a bad thing – the company could be reinvesting in the business and making the most of very cheap loans while it can. But if the debt is rising for no apparent reason, you should be concerned.
  3. What are the profit margins? A healthy margin, well in to high double digits, gives a company a cushion if it hits problems. If the company only has margins of say 5%, there is little room for error.
  4. Is the dividend sustainable? A high yield on a stock can look attractive but can also be a danger sign. Dividends also tend to be the first thing a company stops when it gets into financial difficulties.
  5. Pension deficits: look out for a pension deficit. What level is it and can it be covered in any way? Is it being neglected and is cash being diverted elsewhere?

Value fund managers

You can make money investing in cheap shares, but thorough research is required. Given the risks involved, I prefer to leave it to the professionals – not only do they do the research for you, but they invest in a number of stocks, therefore diversifying your risk.

Alastair Mundy is one of the best-known value managers in the UK. He manages the Investec UK Special Situations and Investec Cautious Managed funds. Alastair describes his approach to stock selection as “looking in other people’s dustbins” for value opportunities. He will often hold his stock choices for four to five years to maximise their recovery potential.

A lesser-known but very good value manager is Henry Dixon, who manages Man GLG UK Income. This fund invests predominantly in UK companies of all sizes (at least 80% of the portfolio) and the flexible mandate allows Dixon to find value in parts of the income market many other managers may ignore, such as smaller companies. He can also invest up to 20% of the portfolio in companies based in Europe, as well as company bonds if he feels the risk/reward characteristics are more favourable.

I also like Alex Wright who manages Fidelity Special Values Investment trust. Launched in 1994, the trust aims to achieve capital growth by investing primarily in unloved UK companies, waiting for them to come back into favour. The manager has been in place since 2012 and is drawn to unfashionable stocks that are out-of-favour, and trade on cheap valuations. He looks for potential positive change that others haven’t yet seen.

Darius McDermott is managing director of FundCalibre.com

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