Value Investing 2015: 3 Value Traps to Avoid

By Markets Fool.com


Think you've found value? It might be a trap.

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Value investing is a great strategy, though it's not as easy as it may seem. The idea is simple: Find companies trading at prices below the value of the company's assets, factoring in some margin of error as a cushion of safety. This includes companies which have had their stocks fall to the point where the liquidation value of the company's assets exceeds the market price of the stock, or a company with predictable earnings power from its business, but the stock is selling for less than its historical valuation or that of its peers.

However, sometimes we can fall for a value trap -- a company that looks tantalizingly cheap, but doesn't really contain the value that we think is there. We asked Motley Fool contributors Maxx Chatsko, Jason Hall, and Tyler Crowe for their thoughts, and they came up with two companies, Westport Innovations andSolazyme, and an entire industry -- coal -- that smack like the sounds of a value traps in 2015. Let's take a closer look.

Maxx Chatsko:(SZYM) I know you want to pull the trigger on renewable oils manufacturer Solazyme, which has dropped 69% since early November, but there are good reasons to reconsider. The company's market cap touched $1 billion less than one year ago; so what could have possibly changed that makes the company worth less than $200 million today? As it turns out, a lot.

Solazyme once promised to churn out cheap commodity replacements for paints, soaps, and even niche fuel blends; but three factors forced the company to pivot production and rely solely on its highest-margin products for at least the next year. First, prices for palm kernel oil and petroleum, which set the selling price for commodity replacements, fell dramatically. Second, Solazyme's production costs failed to decline fast enough, as its first commercial scale facilities increased production from lowly start-up volumes. Third, there simply doesn't appear to be enough near-term demand for the company's products.

While most other industrial biotechs have also shifted from low-cost commodities to high-value speciality products in recent years, Solazyme has yet to demonstrate profitable gross product margins on its own commercial scale production. Worse yet, Solazyme's 100,000-metric-ton-per-year facility in Brazil -- it's largest -- has been delayed until at least the second half of 2015. This means it won't be running at full capacity until at least the end of 2016.

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The company could be in serious trouble -- it could very well go bankrupt in the next several years. It can only produce limited volumes of product going forward, and is far from covering companywide overhead. I wouldn't start a new position or add to an existing one until Solazyme demonstrates big improvements, which may not occur anytime soon -- if ever.

Jason Hall:(WPRT) I've been a big believer in natural gas for transportation for several years, and I remain optimistic in its future. Even after what can only be described as a terrible, horrible, awful year, I haven't sold a single share of Westport stock. And I don't plan to, even after losing more than 80% of its value during the past year:

WPRT Chart

WPRT data by YCharts.

However, that doesn't mean I'm planning to back up the truck, either.Yes... this is the same stock that reached $48 in 2012, and the current $3.50 share price could turn into a steal; but almost none of the promise that led investors to drive the stock price up has yet to produce measurable results. There remains a lot of uncertainty around the future for Westport's business.

What makes Westport stock a classic value trap right now? Even as much as the stock has fallen, there are no guarantees that its assets offer any reasonable margin of safety from further losses. From an operations perspective, the company is burning through its cash: free cash flow wasnegative$112 million during the past year, and the company's cash position decreased to $129 million. Yes, management continues to make inroads at cutting costs, but Westport's biggest problem right now is simple: lack of profitable growth, with only -- maybe -- a couple of year's worth of capital.

Until Westport's core business stabilizes, and its new initiatives in heavy-duty engine development begin to show growth, Westport remains a speculative -- and quite risky -- investment.

Tyler Crowe: (coal companies)When a commodity is as beaten down as coal during the past few years, it can be tempting to look at companies trading at such massive discounts to their tangible book value and say, "It can't get any worse than this":

BTU Chart

BTU data by YCharts.

Company Price to Tangible Book Value
Peabody Energy 0.51x
Cloud Peak Energy 0.49x
Arch Coal 0.14x
Alpha Natural Resources

0.08x

Source: S&P Capital IQ.

I mean, my gosh, if a company's assets are trading for $0.08 on the dollar, this has to be a value pick, right? Unfortunately, there are just too many things working against coal -- both in the short and long term -- to make it profitable any time soon.

In the short run, bigger diversified mining players such as BHP Billiton and Rio Tinto have just brought massive Australian mines with cheap coal online, which is oversupplying the export markets and will likely do so for several years to come. In the long run, coal demand will be in structural demand if China -- consumer of more than 50% of global coal -- wants to achieve peak coal demand in five years. Add that to already declining coal use in the U.S. and you have a recipe for a widely oversupplied market.

To make matters worse, both Arch Coal and Alpha Natural Resources have debt loads up to their ears:

Company Interest Expense/EBITDA Net Debt/ EBITDA
Arch Coal 0.48x 22.13x
Alpha Natural Resources 0.74x 13.21x

Source:S&P Capital IQ.

A commodity market with little hopes of improving during the next several years and a few overlevered companies spell V-A-L-U-E T-R-A-P.

The article Value Investing 2015: 3 Value Traps to Avoid originally appeared on Fool.com.

Jason Hall owns shares of Westport Innovations. Maxx Chatsko has no position in any stocks mentioned. Tyler Crowe owns shares of Westport Innovations. The Motley Fool recommends Westport Innovations. The Motley Fool owns shares of Solazyme and Westport Innovations. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.