Wednesday, August 31, 2011

Hart Stores: The Value Trap

As value investors, we gravitate towards the most shunned investments around. The most hated stocks often make for the best investments. But no matter how disliked a company may be, if it possesses certain attributes, it may still not make sense as a value investment. Hart Stores (HIS) provides such an example.

Hart was discussed on this site just five months ago due to its low price to book ratio and profitable history. But a number of red flags suggested value investors should stay away. Those flags turned into grenades shortly thereafter, resulting in the company filing for bankruptcy protection yesterday. Though this stock had a lot of value attributes, this investment clearly would not have worked out for shareholders. As such, it's worthwhile to review some of the signs investors should look out for so that they do not fall victim to similar circumstances in the future.

The first point worth making is that debt is the main (and virtually only) cause of bankruptcy. Though Hart had a price to book ratio of 0.4, it also had recent earnings which were not high enough to cover the company's interest payments. The company's $32 million in debt compared to earnings in the low single-digit millions just doesn't give the company any room to maneuver if things go wrong. Right away, this kind of debt risk threatens the stock investor's principal, putting him at risk of violating both the first and second rules of value investing.

Amidst the lack of financial flexibility, the company was clearly suffering from deteriorating business conditions; this is a recipe for disaster. Though business conditions should have been favourable (a strong Canadian dollar reduces this company's costs), Hart's margins were compressing and the company was losing money.

Under such precarious circumstances, the prudent thing to do is shed unprofitable assets (in this case, sell assets and close the least profitable stores) in order to buy time to improve operations. Not so for Hart's management, however, who kept trucking along, increasing capital investments and adding stores!

Finally, management's candor leaves a lot to be desired. On the last quarterly report, the following statement was printed: "The Company believes that it has adequate financial resources to meet its contractual obligations." Just 1.5 months later, the company filed for creditor protection!

Furthermore, the company blamed its deteriorating conditions on external factors: "The unusually cold spring weather and the resulting decrease in customer traffic were the most important factors responsible for the decrease in sales in Q1 versus the comparable period the previous year." This is a clear sign that management doesn't get it.

Some, but not all, unpopular stocks make for great investments. The key to value investing is discerning between which companies can recover from their recent turmoil and which cannot. Hart appears to be a perfect illustrative example of the latter.

Disclosure: No position

This article was written by Saj Karsan of Barel Karsan. If you enjoyed this article, please consider subscribing to the feed.

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