One major premise of successful long-term investment is basing decisions on company fundamentals, meaning, the real results and evolution of the business behind the shares we invest in, while trying to enter at an attractive price. However, a low valuation multiple is not sufficient basis for finding a good investment alternative. Often detailed analyses reveal that depressed prices correspond to objective causes.
The first indication of a value trap—a company trading at a very cheap valuation but unable to create value for shareholders—is the existence of a heavily indebted balance sheet that absorbs the bulk of the resources generated by the company, leaving little (or no) space to repay capital. Debt also exponentially increases the risk of an investment. As Warren Buffett says, “Having a large amount of leverage is like driving a car with a dagger on the steering wheel pointed at your heart. If you do that, you will be a better driver. There will be fewer accidents but when they happen, they will be fatal.” Debt is not necessarily bad, but we have to know when to use it. Typically, in businesses where cash flows are highly predictable, debt can serve as an extra leverage of profitability for shareholders. However, as we mentioned, it can be lethal in businesses that rely heavily on cyclical sales or are overly exposed to dynamic markets or technological disruptions. In such cases, debt can become a major liability resulting in the need to increase capital or even resort to insolvency.
High indebtedness can be indicative of a poor quality business, one that is unable to organically generate the resources necessary to cover its costs, make the investments needed to grow, or obtain the profitability required for shareholder equity. A climate of zero rates and subsidised debt has favoured the existence of these types of “zombie” companies, which generate just enough to service the debt.
A key issue around debt is its measurement. Typically, the volume of debt is expressed in relation to EBITDA (the company’s earnings before taxes, interest, depreciation and amortisation for the period). This makes it a highly superficial metric, subject to lax accounting criteria and providing no information about whether the income generated by the business is sufficient to service the debt or make the investments necessary to remain competitive in the market. Measuring the creditworthiness of a business requires examining the operating cash generated and comparing it to debt servicing. Ultimately, leverage is an instrument to handle with caution, preferably used to finance stable businesses with predictable cash flows.
Other reasons companies may have depressed valuations include elements such as operating in declining, highly cyclical, or highly competitive industries, having very low margins, minimal cash generation (need for large investments, reducing the creation of equity), or, in general, a low return on invested capital, the indicator that bests approximates the intrinsic quality of a business.
For these reasons, a low P/E ratio or a high dividend yield may not necessarily imply a good investment; these are simply two indicators with which to assess the quality of the businesses in which we invest, which brings us back to the main topic: the importance of stock picking.