Value investors generally like to invest in stocks when they are selling cheap such as low price-to-earnings, price-to-cash flow and price-to-book ratios. My previous article describes academic research has consistently shown that value stocks have been consistently outperforming that of growth stocks.
I have written many articles on how to identify value stocks such as appear in the links below:
However, many stocks are cheap for good reasons and they are what we term as “value traps”. A value trap is a stock that appears to be cheap but its value is in continuous decline and the original margin of safety buying it cheap disappears over time. Being price sensitive, value investors lost much more money from value traps than from overpaying stocks.
In this article, we will discuss how to identify and avoid a value trap and not stuck into it by looking at two simple but important metrics; profit margins and return on equity. Here I will use my favourite company, London Biscuits as the example.
Business background
London Biscuits is engaged in manufacturing and trading of confectionery and other related foodstuffs. The Company offers packed and ready to eat products, which can be categorize into corn based snacks and cake products, such as Swiss rolls, pie cakes and layer cakes. In addition, it also manufactures range assorted chocolate confectionery, including chocolate-coated peanuts and biscuits, pancake cookies, jelly and puddings, wafer sticks, cup sticks and snack noodles.
Financial performance
London Biscuits reported an earnings per share (EPS) of 20.5 sen for its financial year ended 30th June 2009, up from 11.5 sen the previous financial year. At that time, it is trading at about RM1.00 as shown in Figure 1 below. At that price, it is trading at a PE ratio and P/B ratio of 5.2 and 0.5 respectively then. These ratios are considered very cheap in any standard for a confectionery company involved in the food industry. Its share price rose to about RM1.30 a year later when EPS declined to 15 sen. At that price and EPS, PE ratio is still low at just 8.5. From then on, its share price follows a down trend and close at 75 sen on 21st August 2015. Investors who thought London Biscuits share price was cheap at a PE ratio of 5.2 on June 2009 and bought it would have lost 25% while the broad market has gone up by about 60% during the same 6 years period. That would be a negative alpha of a whopping 85%!
What was and still is the problem with this “value stock”? How could one lose his pants investing in such a company in a recession proof food industry while the broad market has risen by 60% during the same period? Few investors could fathom the reasons.
Here we examine the operating profit of London Biscuits as it more crucial in reflecting organizational productivity before considering how the firm was financed or the contribution of non-operating activities. Investors should always closely monitor operating income, as it provides insight into a firm’s “core business operations.” It is important to examine a company’s operating margins against those of other firms in the same industry, as certain industries have higher or lower operating margins.
Figure 2 below shows the explosive growth in revenue of London Biscuits from RM108m in 2006 to RM360m in 2014, or a compounded annual growth rate of 16.3%, a fantastic growth company many growth investors wold yearn for. Its operating profit, however, fell flat for the whole period. Its share price went straight down to about 60 sen in May 2013. What have gone wrong?
Figure 3 below shows the operating margin of London Biscuits. We can see that it has been in a clear as crystal long term decline. Operating margin deteriorates consistently from 23% in 2006 to less than 10% in 2014. Although revenue grows by leaps and bound, operating profit remains flat. Whereas the operating margin of another confectionery company, Apollo has been relatively steady throughout the years.
Take a look at its trend of return on equity as shown in Figure 4 below. I have deliberated why ROE is the driver of long-range return of stocks, not earnings per share, as shown in the link below.
A picture paints a thousand words. ROE of London Biscuits has been deteriorating unabated by 70% from 12.8% in 2006 to just 4.1% in 2014. This ROE is way below the required return of the equity shareholders, whereas ROE of Apollo has been stable in the teens and consistently much higher than those of London Biscuits.
Investors would avoid investing in London Biscuits or had plenty of time to sell the stock and used the proceeds to invest in other value stocks 6 years ago looking at the low and deteriorating margins and ROE. This would avoid the 30% loss 6 years ago, and would have made 140% from the money to invest in Apollo Food, if they pay attention to the indication of a value trap – the long term decline of profit margins and ROE of London Biscuits compared to the stable margins and ROE of Apollo Food.
Take a close look at the price performance of London Biscuits and Apollo for the last 6 years below.
London Biscuits share price did go up from 60 sen to close to RM1.00 as shown in Figure 1 above when Kenanga and a couple of other analysts recommended it sometime in April last year. However, if investors have paid attention to the poor and declining operating margin and ROE, they could have avoided further losses following those buy calls of some investment banks.
Why You Should Avoid Margin Decliners?
The reason is simple. The company is losing its price power or it never had price power. Competition is eating into its market. Or the management has been negligent in managing the company, resulting in rise in costs, and hence declining operating margins and ROE.
There are in fact many other red flags indicating London Biscuits being a value trap, but these two simple metrics do tell a lot about if a stock is a value stock or a value trap.
Will the profit margin and ROE of London Biscuits or other value trapped companies ever recover? That is a “too-hard” question. Why should we put ourselves into this situation when we have so many other choices investing in Bursa?
Investment opportunities in Bursa are here again. For those who are interested in identifying value stocks to invest for long-term wealth building, and at the same time avoid value trap which could serious and adversely impact your investment outcome, please contact me for an online course at
K C Chong
