Value Investing and the Value Trap

The value investing strategy hinges on finding the stocks of fundamentally sound companies which are trading at a discount to their true or intrinsic worth. That situation can transpire for all sorts of reasons. A stock (business) can be unpopular with investors because it’s temporarily out of fashion, is going against a general market trend or it’s off the market’s radar. But they’re not the only reasons why a stock can be cheaper than it really should be: stocks can be undervalued for other and more worrying reasons.

The fundamentals

To determine if a stock is undervalued or not, value investors analyze a company’s financial fundamentals. They’ll scrutinise a range of ratios including – but not limited to – Earnings Per Share, PEG, P/E Ratio, Dividend Yield and Payout Ratio, Book Value, Price / Book, Price / Sales Ratio and Return on Equity. No matter how meticulous the analysis, sometimes some of these ratios can be misleading, one of the main culprits being Earnings Per share (EPS). EPS is widely considered to be one of the more important ratios because it shows how much of the company’s profit is apportioned to each share. But the fact is that when EPS figure increases it doesn’t always follow that the profit increasing accordingly. Although two companies may have very similar EPS, one of them may need substantially more shareholder’s capital to generate the same EPS. Out of the two, the most appealing option for the value investor would be the business requiring less capital.

The Margin of Safety

Serious value investors don’t take shortcuts. To help them decide whether a stock is undervalued or not, the investor will want to analyze as many of a company’s fundamentals as is possible and practical – i.e. they’ll turn over as many stones as they can find. When that quantitative analysis identifies an apparently undervalued stock, the next consideration is ‘undervalued yes, but by how much?’ Because capital preservation is a key issue for value investors, they like stocks which provide a high Margin of Safety (MoS). The MoS is the difference between the stock’s current (depressed) price and its true market price – the greater the difference, the higher the MoS. And the higher the MoS, the better insulated the investor’s capital against any errors made in their calculations or indeed any post-purchase and substantial market volatility.

The Emperor’s Clothes

But even when some of the ratios appear favorable, a cheap stock may not be quite as cheap as it seems and in reality may deserve to be cheap, or even cheaper than it already is. Problems may exist which the company’s financial statements are not able or 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 the competition increasing, or getting smarter? 
· Is the business model flawed? 
· Is the business carrying too much debt? 
· Are doubtful or unconventional accounting procedures being applied? 
· Is there a whiff of scandal, corruption or are there are any corporate governance problems? 
· Are earnings-estimates revised more frequently than they ought to be? 
· Has the company grown purely through acquisitions?

The moral is:

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

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