By: Philip MacKellar

Just how do you avoid the Big Bad Value Trap? This question is often on the minds of investors – especially those in the contrarian and value investing camps.

The traditional definition of a value trap runs somewhere along the lines of a cheap stock that continues to trade at lower and lower multiples, and/or sees its business fundamentals deteriorate.

In addition to this common standard, I would add that it could also be an industry leader, market darling, or corporation in a hot sector. These hot stocks can be a problem too, because they are priced for the most optimistic earnings scenarios.

In short, stocks that are value traps might appear to be a bargain at first glance, but a look under the hood reveals some serious concerns.

Regardless of whether a company has been hyped up or is persistently lagging, value traps tend to share some key features. They nearly all lose money – lots of it. A red bottom line could be the result of declining sales, losing a critical customer, writing off assets, high fixed operating expenses, or trying to grow the top line too quickly. Whatever the cause, persistently losing a lot of money translates into a weak balance sheet.

Value traps tend to have minimal cash on hand, skimpy working capital, a low current ratio, high intangible assets (such as brands) or goodwill, and a large accumulated deficit. To paper over these problems, many companies in this situation turn to debt and/or equity financing. This means a lot of these companies come with a boatload of debt, a rapidly expanding share count, or both.

REITs, utilities, and resource extractors often have physical assets which they collateralize to raise debt. This is not necessarily a bad thing, but businesses can go overboard and blow up their balance sheet in the process. By contrast, junior miners, tech startups, prerevenue pharmaceuticals, and pot stocks do not have a lot of tangible assets (or cash flows) to lend against, and tend to dilute existing owners instead. In the process of issuing new shares, these organizations can destroy a tremendous amount of wealth. Dilution can wipe out old owners or force companies into a share consolidation in order to stay on an exchange like the Nasdaq.

Value traps can be also characterized by issues at the executive level. Insider selling, restating financials, and immediate C-suite or board level departures may suggest a bleak outlook. If an enterprise is doing poorly or there are major issues afoot, it makes sense to see insiders selling and executives running for the exits.

This is not an exhaustive list, and it is imperfect, but these are some of the typical characteristics found in many value traps. There are two caveats worth mentioning. First, an entity in a cyclical industry – such as resource extraction – may exhibit many of these features but go on to make huge gains when the sector cycle finally turns. Second, sometimes firms with awful balance sheets and large net losses can generate huge gains if by some miracle they start to make money. This is rare though, so placing a bet based on this possibility is more of a speculation than an investment.

During 2020 and 2021, when the economy was flush with COVID-era stimulus, many stocks flew high. One such name was Wayfair Inc. (W-N). Though the market was bullish on Wayfair, it looked like a value trap from this angle: the only annual profit was registered in 2020- every other year the enterprise has lost money. In 2022, for example, it lost $1.3-billion. The security was also priced for significant growth, but in 2020 revenues peaked and have fallen since.

The balance sheet did not look good either. Back in early 2021 when the stock peaked, the current ratio was tight and debt was growing quickly – the share count was, too. The company did not have a lot of goodwill or intangible assets, but it did have a huge accumulated deficit, and total liabilities exceeded total assets. Together, this meant that the organization’s net worth was actually negative.

Since 2021, the stock has fallen from a high of over US$340 to around US$40 today. The valuations have compressed, with the price-to-sales ratio falling from 1.9 times to 0.4 times. This prompts the obvious question of, “Is it still a value trap?” From my perspective, the answer is: probably. Revenue declines and steep net losses continue to plague the income statement. The balance sheet has not improved either. The current ratio is now under one, debt continues to climb, and equity stood at minus-$2.7-billion last quarter versus minus-$1.2-billion at the end of 2020.

While the executive team has not been subject to turmoil or unexplained resignations, insiders are selling. According to INK Research, executives and directors have unloaded nearly US$16.2-millionin stock over the past 12 months and have not purchased a single share. This is not an encouraging trend, and if the stock was a buy or a good value, then these individuals should be buying and not selling.

To make a long story short, Wayfair is likely still overvalued. While it could rally, many of the criteria that characterize a value trap remain in place. Investors wondering if the tide is turning can tune into the company’s next earnings release, due out Nov. 1. For our part, we will watch from the sidelines, look for material improvements to the business, and sharpen our focus on the imperfect art of identifying and avoiding value traps.