Friday, May 6, 2011

Paramés on value traps

In an interview my friend David was kind enough to pass along, the response of Francisco García Paramés to a couple of questions serves as a good reminder of the importance of business quality.

How do you identify value traps?

After being in business for 20 years, I have learnt that value traps are companies with low-quality businesses. We used to buy average businesses at five times free cash flow (FCF); now we only buy high quality businesses at 10-12 times free cash flow.

A company with a return on capital of 12 per cent, which enjoys a good position in the market but is unable to raise prices because of competition, could be an example of a value trap.

Then how do you avoid such value traps — companies that may not grow in revenues or profits?

We have had our share of value traps over the years. But lately, in the last two to three years, we have moved to high-quality businesses with high return on capital employed, and very high strength of balance sheet. We have moved away from average companies that are only undervalued.

In the case of high-quality businesses, even if they don’t grow, they tend not to be value traps. That is because they generate so much free cash flow that the value of the stock grows over time.