Its been a rough year forusGlaxoSmithKlines(LSE: GSK)shareholders. Year-to-date the companys shares have fallen by around 6%, excluding dividends. That said, including dividends the companys shares have drastically outperformed the FTSE 100. Glaxos shares have produced a total return of 0% since the beginning of 2015, compared to a return of -9% for the wider FTSE 100.
However, after recent declines some City analysts and investors have started to question if Glaxo is a value trap.
Value traps are difficult to spot. Finding them isnt an exact science, and investors often get sucked into them when searching for bargains.
Nevertheless, there are three key traits most value traps have in common and by avoiding companies that display these characteristics, you can increase your chances of avoiding suchtraps.
The first common feature of value trapsis that of secular decline. More specifically, investors need to ask if the company in questions revenue/profit or share price is falling due to cyclical factors, or if the companys business model is under threat.
A great example is that ofTrinity Mirror, which hasseen revenues slide over the past decade due to the secular decline of newspaper circulation and print advertising. Over the same period, the companys share price has slumped 73%.
In comparison, its pretty clear that Glaxo is suffering from neither cyclical nor structural factors. Healthcare isnt a cyclical market and the demand for Glaxos vaccines and consumer healthcare productsremainsrobust.
The second most common trait of value traps is the destruction of value. In other words, investors need to ask: did the companys management destroy shareholder value by overpaying for acquisitions and mis-allocating capital?
It looks as if Glaxo passes this test as well. The company has refrained from bidding for any smaller peers as valuationssurge to eye-watering levels. Additionally, the groups asset swap agreed withNovartisearlier this year seems to have unlocked a lot of value for investors.
Cost of capital
The third and final most common trait of value traps is a low return on capital invested. Put simply, if a company continuously earns a lower return on invested capital (equity and debt invested in the business) than the groups cost of capital (debt interest costs), it deserves to trade below book value.
According to my figures, Glaxos cost of capital is around 8.7%, based on 12-month figures. The same data also shows that Glaxosreturn on invested capital is 18.8%, more than double the groups cost of capital.
The bottom line
So overall, Glaxo passes each of my three value trap tests with flying colours. The companys market isnt in secular decline, management hasnt wasted investors cash chasing expensive acquisitions, and the groups return on capital is more than double its cost of capital.
According to my simple analysis, Glaxo looks like a value play to mebut 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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