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Avoid value traps. I suspect most of us look back on some of our investment decisions and ask 'what was I thinking!?'.
I was lulled into investing in some value traps because of:
- attractive valuation metrics for an extended period (ie. price to earnings (P/E), price to cash flow (P/CF), or price to book value (P/B));
- a high dividend yield; and/or
- a history of greatness.
Looking back at some of my poor investment decisions is humbling. I will, therefore, limit the number of companies in which I provide information.
My Partial List Of Shame
BCE (BCE.to)
I was probably around 5 years old when my parents acquired BCE shares for me. I KNOW they knew very little about investing and the only reason they acquired shares is because BCE had a reputation of being a safe investment.
BCE has a host of challenges but operating a capital intensive business in a highly regulated industry where the government is trying to expand the number of industry participants is a recipe for disaster.
The company's balance sheet is bloated with debt and it has consistently generated negative free cash flow (FCF) for several years.
BCE faces a real conundrum because its investor base expects a steady stream of dividend income; it HAS to regularly increase its dividend. A dividend freeze or cut will undoubtedly decimate the share price. The company, however, generates insufficient cash flow to maintain the dividend at the current level.
Look at BCE's subordinated debt credit ratings. DBRS, S&P, and Moody's all assign a rating that is one tier above 'junk'. If you hold BCE shares...you have 'junk' risk.
Enbridge (ENB.to)
More 'junk' risk if you hold shares in this 'dog' that operates in a highly capital intensive and highly regulated industry when the environmental risks are high.
Moody's rates the preferred shares Ba1. This is 'junk' so common shareholders have deeper 'junk' exposure.
The other rating agencies have yet to catch up on their ratings. They still assign a rating that is barely above 'junk'.
Viatris (VTRS)
What a horrible company! I was lulled into investing in this company because of its rock bottom valuation.
The company's domestic long-term issuer rating was one tier above 'junk' and I thought it could improve this over time. I see the credit ratings have not budged.
Fortunately I exited this holding within months of initiating a position.
And There Are More
Don't think I just made 3 stupid investment decisions. Here are a few more.
- Smart Real Estate Investment Trust (SRU.un - to) - in general, stay away from real estate investment trusts!!!
- Hormel (HRL) - some of their food products are not fit for human consumption (eg. SPAM)
- J.M. Smucker (SJM) - some of their food products are not fit for human consumption (eg. Twinkies)
- AT&T (T)
- Verizon (VZ)
- Telus (TU.to)
- Tyson Foods (TSN) - John R. Tyson, the great grandson of the founder of the meat processing company, was arrested in 2022 on charges of public intoxication and criminal trespass. He was arrested again in June 2024 on charges of DWI and careless driving. And this was the company's CFO?
- 3M (MMM) - lawsuits galore. It was a great company...once upon a time.
Fortunately, my exposure to these companies was so insignificant that it did not have any material impact on my portfolio.
REALLY!?
I could have invested in great companies if I avoided these value traps. I shudder to think how much further ahead I would be if I had either increased my exposure or initiated a position in Berkshire Hathaway (BRK-b), HEICO (HEI or HEI-a), Copart (CPRT), Intuitive Surgical (ISRG), Moody's (MCO), or S&P Global (SPGI)...to name a few.
None of these companies have attractive dividend metrics. Heck, BRK-b, CPRT and ISRG do not distribute a dividend and HEI distributes a dividend only twice a year and the dividend yield is negligible.
The Attractive Dividend Yield Trap
In multiple posts I suggest that investors focus on investing in great companies that are well managed. This business of investing based on an attractive dividend yield is often a 'red flag'.
In my You Don’t Need 10 Bagger Stocks To Create Financial Freedom post, I explain that you can do extremely well over the long term by finding multi-baggers. You do not necessarily need to find the next '10-bagger'.
If a company is distributing a good chunk of its earnings and free cash flow in the form of dividends, it becomes somewhat more difficult for this company to become a multi-bagger.
The attractiveness of a regular stream of dividend income wore off a long time ago when I started to pay closer attention to the tax implications of my investment decisions.
I shy away from investing in Canadian companies and the vast majority of my exposure is to US companies. Every time I receive dividend income from a holding held in a taxable account, I incur a 15% haircut (dividend withholding tax)...BEFORE any money hits my brokerage account.
Given that my wife and I are employing a Registered Retirement Savings Plan meltdown strategy, our marginal tax rate is already high enough. Add dividend income to the equation and we're really taking a hit.
If we can invest in great companies that can grow their earnings, it stands to reason that over the very long-term, the value of our investment should appreciate considerably. Naturally, we can't be acquiring shares at ridiculous valuations.
Should we refrain from selling any shares for years (decades?), we can delay our tax liability. In doing so, we can let our money grow uninterrupted.
We can always access other sources of funds if an urgent need arises.
How To Avoid A Value Trap
These are some considerations to avoid a value trap.
- What are the barriers to entry and exit? A really terrible industry is where the barriers to entry are low and the barriers to entry are high. Anybody and their dog can open a restaurant. Exiting is tough when you consider hundreds of thousands of dollars have been sunk in leasehold improvements and equipment.
- Is the industry very highly regulated? Ask the Canadian telecommunications companies how they have fared.
- Does the company have a sustainable competitive advantage that can protect its market position and profitability? How does a branded food manufacturer remain competitive against 'no name' brands...especially when consumers are price sensitive!
- What are the potential hidden risks, such as pending litigation, regulatory challenges, or unfavorable market dynamics? The Risk section of a company's Form 10-K is a good place to start. Look at the risk section within 3M's Form 10-K!
- What is the company's financial health? You want to invest in a growing company with healthy margins which does not have a Balance Sheet that is bloated with debt. The first financial statement I look at is the Consolidated Statements of Cash Flows.
- What is management's track record? Tyson Foods had a drunk as a CFO! In addition, I never invested in Carvana but one of the largest shareholders has a criminal record.
- How relevant is the industry? Is the industry growing, stable, or declining. BCE and Telus have been hemorrhaging landline customers for years! Think of Blockbuster.
- What are the company's growth catalysts? Strategic initiatives, new products, market expansion?
- Is the company highly capital intensive? Airlines and auto manufacturers are generally terrible investments. They need to spend billions of dollars every year just to remain in operation.
- To what extent does senior management have 'skin in the game'?
- How is the company's relations with its employees?
- To what extent does the company generate annual recurring revenue? A company that has revenue on 'auto pilot' is more appealing than an industry where you have to continuously work hard to make the next sale.
I am certain you can think of other things to consider.
Final Thoughts
The purpose of this post is to prompt you to assess whether some of your investments are value traps. If you do determine an investment is a value trap, exit ASAP. The odds are against you if you are hoping and praying the value trap will one day miraculously become a multi-bagger.
Don't put yourself in a position where years into the future you are wondering 'what was I thinking!?'.
Note: Please send any feedback, corrections, or questions to [email protected].
Disclosure: I have no exposure to the companies referenced in this post.
Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation. I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with any company mentioned in this article.
