The consistent message from the Motley Fool is to buy good companies when they are trading cheaply. However, in buying cheap shares, investors must learn to avoid value traps.

Jim Chanos – an American hedge fund manager – recently listed the common characteristics of value traps:

  1. 1. Cyclical and/or overly dependent on one product.
  2. 2. Hindsight drives perceived value.
  3. 3. Marquis management and/or famous investors.
  4. 4. Appears cheap using management metrics.
  5. 5. Accounting issues.

Mr Chanos then described current value traps.  He warns against investing in commodity companies which are dependent on demand from a single country. He further warns against any investment which is dependent upon a continuation of China’s current investment boom.

Even though Mr Chanos talked about Brazilian iron ore producer Vale S.A. (NYSE: VALE), he may as well be describing Fortescue Metals Group Ltd. (ASX: FMG).

Fortescue’s Bull Story

Fortescue’s bull story is familiar to many. It touts itself as Australia’s New Force in Iron Ore. It produces a single commodity, iron ore, and sells everything to China.

China’s apparent insatiable demand is predicted by Rio Tinto Ltd. (ASX: RIO) and BHP Billiton Ltd. (ASX:BHP) to continue for at least 10 years. This demand will ensure that current high pricing of iron ore is maintained.

If Fortescue’s planned expansion is successful, the current 55 MTpa of output will reach 155 MTpa, with a further 100MTpa planned for the future.  This is fully supported by FMG’s resource inventory of 11 billion tonnes.

If all goes well, Fortescue will be rolling in billions of cash flow every year. The planned capital expenditure of $8 billion will be repaid with one year of cash flow.

The Bear Story

Over the last 10 years, Fortescue took $1.3 billion of shareholders’ money and turned this into a book value of $2.4b, which is about 6.3% per annum compounding.  This underwhelming return has been achieved with substantial amount of debts. $4.9b of debt currently sits on the balance sheet.

Cyclical High

The current price of iron ore at $160/ton is more than 5 times the average price achieved over the last 30 years. The scary thing is that both the price and the demand for FMG’s iron ore supply are dependent on continued investment growth within China. This investment growth is fuelled by easy credit within China, supported by banks controlled by the government. It is highly doubtful that such excesses can be maintained.

Rapid Past Growth Extrapolated

Fortescue’s past growth has been impressive. The problem is that this growth has been fuelled by tremendous tailwinds from China, and nothing much else. Investors are projecting this into the future. No actual investment graph I have seen grows to the sky without falling back at some point.

Star-studded Registry and Celebrity Founder

There are some well known shareholders, namely Leucadia, Hunan Valin, and Russian billionaire Victor Rashnikov’s Magnitogorsk Iron & Steel Works.

The first problem is that Leucadia has a lucrative royalty deal unlike normal shareholders. The second problem is the Chinese and the Russian investments are likely to be more concerned with ensuring supply to their mills rather than based on any real investment merits in FMG.

Management Metrics

Fortescue’s management seldom mentions its relative high cost of production, and the rising costs of its capital expenditure. With all major mining companies, including BHP and RIO, pouring billions into capital expenditure works, costs will go up.

The average mining worker’s wages is now twice the average wage. For Fortescue, costs are paid in Australian dollars, but its ore is paid in US Dollars, not the best combination in the foreseeable future.

Neville Power, Fortescue’s CEO, recently said the company could still be profitable even if iron ore prices plunge to $70 a ton from the average of $169 obtained last year. He does not say what happens if prices go to $32/ton, the 30 year historical average.

Accounting

$3.2 billion sits on the balance sheet as capitalised exploration expenditure. If some of this had been written off as expenses, tax payable of $90 million this year would have been reduced. The problem is that the income statement and the balance sheet would have to take a hit.

The 2011 cash flow has been boosted by at least $200m, because typically, Fortescue has $1 of receivables for every $2 of payable, and both items have doubled. The royalty to Leucadia is classified as an investing outflow, rather than an actual operating cash outflow.

The Foolish Bottom Line

Fortescue appears to tick every single characteristic of a value trap. As an investment, this is too difficult. We believe that there are much safer ways to make a profit from China’s continuing growth. We will elaborate in future articles.

If you are looking for specific stock ideas, look no further than The Motley Fool’s Top Stock For 2011-12. Click here now to request this special report, whilst it’s still free and available.

Peter Phan has no interest in the stock mentioned. The Motley Fool has a disclosure policy.This article authorised by Bruce Jackson.

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