Fellow investment writer Larry MacDonald recently interviewed us about "value traps," and that kept our minds swirling about this fascinating topic. Investopedia defines the term as, "A stock that has experienced a large price depreciation and is mistaken to be a value stock." That's quite straightforward. The curious thing is that the concept can only be applied retrospectively.
In a market transaction, the buyer and seller are fundamentally at odds about their assessment of a stock, with one thinking the price will go up, and the other, down. Whether it's an opportunity or a mistake can only be known over time. The fact the company can be bought at a relatively low price with the potential to sell it high puts it into our contrarian territory. Whether to make a play is a matter of deciding whether that bargain is real or illusory.
The "trap" metaphor doesn't just refer to being stuck with an inglorious loser. It suggests the corporation exhibits many characteristics of a classic value stock; in particular, favourable ratios such as price/earnings, price/book and dividend yield. It's almost as if the company is giving the hapless investor a sultry come-hither look.
We received a question from a subscriber to our investment letter, Contra the Heard, wondering about Tempur-Pedic International (TPX-NYSE). The mattress maker shows some dandy value attributes. The trailing price/earnings is 5.2 and the forward figure is a still superb 5.9. The dividend yield is a tidy 3.8 per cent.
Other metrics testify to the company's success over the past three years. Revenue bounced ahead at an annualized 43-per-cent clip to $1.1-billion (U.S.) in 2007, while earnings per share bulged to $1.77 from 77 cents.
At the moment, Tempur-Pedic's stock is sagging at around $8, far from its 52-week high of $37.87. The entire home furnishing sector is slumping, and competitors Sealy (ZZ-NYSE) and Select Comfort (SCSS-Nasdaq) have taken lumps..
That said, few of us contemplate sleeping on the floor. This sector is bound to spring back. The pertinent question is: Who will be able to ride out this difficult period and prosper when the next mattress replacement cycle kicks in?
In this context, Tempur-Pedic suddenly looks like a bad case of "coyote arm." To achieve its growth, the company borrowed a lot. Since the end of 2006, debt has jumped to almost $600-million from $361-million, while the debt/equity ratio went to a scary 12.5 from a highish 1.7. Tangible book value is negative.
Inventory mushroomed to $107-million from $62-million. At the end of fiscal 2007, management unveiled a plan to reduce inventory. Instead it climbed even higher in the first quarter of 2008.
Freights costs are up, as are the prices for the chemicals to make foam. Chief executive Thomas Bryant announced his retirement in February and has yet to be replaced. Whoever takes the job will have to figure out how to deal with the mountain of unsold mattresses while rolling out new products and absorbing higher manufacturing costs, all the while avoiding violations of the company's debt covenants. As chief financial officer Dale Williams pithily put it in the last conference call: "It's hard to catch a rock rolling downhill."
As the mantra says, "Invest so that you can sleep at night." In the mattress industry, our ability to snooze remains tempered by the possible bed bugs of a value trap.
This column first appeared on GlobeinvestorGOLD