Value Investing and the value trap

The value investing strategy depends on finding shares of fundamentally sound companies that are trading at a discount to their real or intrinsic value. That situation can occur for all sorts of reasons. A stock (business) may be unpopular with investors because it is temporarily out of style, goes against a general market trend, or is off the market’s radar. But these are not the only reasons why a stock may be cheaper than it really should be: Stocks may be undervalued for other, more troubling reasons.

the basics

To determine whether or not a stock is undervalued, value investors look at a company’s financial fundamentals. They will examine a variety of ratios including, but not limited to, earnings per share, PEG, P/E ratio, dividend yield and payout ratio, book value, price/book value, price/sales ratio, and return on equity. No matter how meticulous the analysis, sometimes some of these ratios can be misleading, with one of the main culprits being earnings per share (EPS). EPS is widely considered one of the most important ratios because it shows how much of a company’s earnings is distributed to each share. But the fact is that when the EPS figure increases, it doesn’t always follow that earnings increase accordingly. Although two companies may have very similar EPS, one company may need substantially more share capital to generate the same EPS. Of the two, the more attractive option for the value investor would be the business that requires less capital.

safety margin

Serious value investors don’t take shortcuts. To help them decide whether or not a stock is undervalued, an investor will want to look at as many fundamentals of a company as possible and practical, that is, he will look for as many rocks as he can find. When that quantitative analysis identifies a stock that appears to be undervalued, the next consideration is ‘undervalued yes, but by how much?’ Because preservation of capital is a key issue for value investors, they like stocks that provide a high Margin of Safety (MoS). The MoS is the difference between the current (depressed) price of the stock and its actual market price; the larger the difference, the higher the MoS. And the higher the MoS, the better protected the investor’s capital against any error in his calculations or, indeed, any substantial post-purchase market volatility.

the emperor’s clothes

But even when some of the ratios look favorable, a cheap stock may not be as cheap as it seems and may actually deserve to be cheap, or even cheaper than it already is. There may be issues that the company’s financial statements cannot or are not designed to calculate or disclose, some of which include:

Are the company’s products out of date?
· Is the sector in decline?
· Is the management team up to the job?
· Is competition increasing or getting smarter?
· Is the business model flawed?
· Does the company have too many debts?
· Are questionable or unconventional accounting procedures being applied?
· Is there a whiff of scandal, corruption or corporate governance issues?
· Are earnings estimates revised more often than they should?
Has the company grown solely through acquisitions?

Morality is:

Although the metrics can be attractive, some undervalued stocks fully deserve their low rating. Depending on the quantitative analysis alone, it may only provide a few clues as to why a stock is as cheap as it is. There is absolutely no question that unpopular stocks can be good investments: the art is to invest only in those that are best placed to recover from their troubles.