Centrica(LSE: CNA) andUtilitywises(LSE: UTW)shares have slumped by 18% and 41% respectivelyover the past 12months.
These declines are bound to attract bargain hunters. After all, Centrica is now trading at a five-year low and Utilitywise, afavouriteof star fund manager NeilWoodford,is trading at a two-year low.
However, while these two companies look cheap at first glance, they could be value traps.
Value trap
Distinguishing between value traps and genuine value plays isnt an exact science but most value traps have key three common traits. By avoiding companies that display these characteristics, you can increase your chances of avoiding these traps.
The first common characteristic of value trapsis that of secular decline. Simply put, the company may be serving a market that no longer exists in the way it used to. No matter how good the company is at what it does, if the sector itself is contracting, the firm will struggle to instigate a turnaround.
Both Centrica and Utilitywise serve the utility industry, an industry that is renowned for its stability. With this being the case, the two companies shouldnt come under pressure from either cyclical or secular factors.
That said, Centricas upstream (oil and gas production) business is facing cyclical headwinds.
Destroying value
The second most common trait of value traps is the destruction of value. In other words, investors need to ask if the companys management has destroyed shareholder value by overpaying for acquisitions and misallocating capital.
Unfortunately, Centricas decision to enter the oil and gas business has turned out to be a misallocation of capital by management. Although, Centricas new management team is now reversing the decision to get into the oil business.
On the other hand, Utilitywises management cant be accused of destroying shareholdervalue, but it can be accused of misleading and confusing shareholders.
The companys accounting methods have drawn plenty of criticism recently and accusations of aggressive accounting have promptedformer finance director Andrew Richardson to unexpectedly quit. If it turns out that these accusations are true, Utilitywise could be forced to restate its accounts and shareholders will suffer as a result.
Cost of capital
The third and final most common trait of value traps is a low return on invested capital (ROIC). Put simply, ROIC means the amount of net income returned as a percentage of the money invested in the business. This figure should be above the cost of capital the cost of fundsused for financing a business.
At present, Centricas cost of capital is below 5% but last year the companys ROIC slumped to -3%. However, over the past five years, Centricas ROIC has exceeded 10%, while the cost of capital has averaged 5%.
With accusations of aggressive accounting hanging over Utilitywise, its impossible to accurately calculate the companys return figures. Figures suggest that the firms ROIC for 2014 was 35%, although its not possible to establish how reliable this figure really is.
The bottom line
So overall, Utilitywise looks like a value trap to me. On the other hand, based on this simple analysis, Centrica could be a value play.
But don’t just take my word for it.I strongly recommend that you do your own research before making a trading decision — you may come to a different conclusion.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has recommended Centrica. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.