Value Stocks Vs Value Traps
Value investors examine thousands of stocks to find bargains, also known as value stocks, which they believe are undervalued by the market. However, at the same time, there are value traps, which attract value buyers due to their cheap valuations; however its stock price never recovers.
Value investing is a strategy of identifying stocks that trade for less than their intrinsic value. Value investors would scour thousands of stocks to find bargains, also known as value stocks, which they believe are undervalued by the market. The standard approach is to compare the market price of a stock with its fundamentals, using valuation ratios such as the price-to-earnings (P/E) ratio, or the price-to-book (P/B) ratio.
Consider an example to illustrate the use of the P/E ratio to identify value stocks. The P/E ratio of a stock is calculated by dividing market price of the share by its trailing 12 months’ earnings per share. As on 22 January 2016, the average P/E ratio of the NIFTY stocks was around 20. It means that the average NIFTY stock was trading at around 20 times its earnings per share. At the same time, the share price for Punjab National Bank (PNB), for example, was Rs92.55 with a trailing 12-month earnings per share of Rs12.34. Therefore, the P/E ratio for the PNB scrip was 7.5 (92.55/12.34 =7.5). The PNB stock seems cheap as it is trading at just 7.5 times its earnings per share. In fact, we can extend this reasoning and claim that since a typical NIFTY stock trades at 20 times its earnings per share, the market price of the PNB stock should have been around Rs246 (20×12.34 =246). Therefore, the PNB stock appears to be quite a bargain at Rs 92.55.
The concept of value investing is not only logically appealing, but it is also supported by the works of leading academic researchers such as Eugene Fama, a Nobel laureate in economics. The lure of beating the market by finding cheap stocks is so compelling that value investing has transformed into a modern-era gold rush, endorsed by an army of investors and experts. It doesn’t hurt that some of the most successful investors of our times, from Warren Buffett to Rakesh Jhunjhunwala, consider value investing as their key to success. Computing valuation ratios for a large number of stocks may be tedious for most retail investors. To put it in perspective, there are more than 5,500 stocks listed on the BSE alone.
Sometimes when a company’s share is trading at very low P/E values, it is doing so for a good reason — because its business holds little promise for the future. Such stocks, also known as value traps, would attract value buyers due to their cheap valuations; however the stock prices never recover, and may even fall in the future. Identifying value traps is tricky, even for some of the smartest investors. In 2012, faced with intense competition, the shares of British retail giant Tesco began to slide. Sensing very attractive valuations, Warren Buffett-led Berkshire Hathaway invested heavily in Tesco, eventually becoming its third largest shareholder. However, Tesco’s share price did not recover, and Berkshire Hathaway was forced to liquidate its stake in Tesco at a loss of $444 million. Fortunately, a careful analysis can reveal red flags that indicate a potential value trap. Even if a company’s valuation seems very low, investors should avoid its stock if the company has unsustainably high level of debt, extremely low margins, excessive competition, or when the industry itself is in a steady decline.
Another common mistake is comparing valuation ratios of stocks belonging to different industries. The P/E ratios can vary considerably across different industries. Currently, the average P/E ratio for FMCG stocks is around 41, whereas the same for banking stocks is around 19. This means that ITC, with its current P/E ratio of 25.5, is undervalued relative to its peers in the FMCG industry, whereas IndusInd Bank, with a P/E ratio of 23.3, is overvalued relative to other banking stocks.
Investors must also recognize a basic flaw in the valuation ratios; while the price of the stock changes constantly in response to new developments; the fundamentals such as earnings are only updated quarterly. For example, on 28 May 2015 Nestle India stock traded at Rs7,099. At the time, as per the most recent quarterly results declared for March 2015, the trailing 12-months earnings per share for Nestle India was Rs132, leading to a P/E ratio of 53.7 (7099/132=53.7). While the P/E ratio of 53.7 is healthy, it is not unusually high for the FMCG industry. On 31 May 2015, a criminal complaint was filed against Nestle India for having high levels of lead in its flagship product, Maggi noodles. The Food Safety and Standards Authority of India (FSSAI) banned Maggi noodles, terming them “unsafe and hazardous for human consumption”. Within 10 days, the stock price of Nestle India fell from Rs7,099 to Rs5,504 per share, and the P/E ratio fell from 53.7 to 41.6 (5,504/132 = 41.6). Did this mean that the Nestle India stock had suddenly become cheap? The ban on Maggi noodles was damaging for Nestle India’s stock price, but it was also detrimental for its future earnings prospects. However, while the price (numerator) had immediately fallen in response to the news, the trailing 12-month earnings per share (denominator) remained the same until Nestle India reported its next quarterly results on 30 July 2015. In the quarter ending June 2015, Nestle India reported a loss of Rs64 crore, its first quarterly loss in past 15 years. With this reduction in its earnings, the P/E ratio increased to 68.22 on 30 July 2015, and the stock price of Nestle India no longer looked undervalued relative to its earnings.
7 Factors to Consider Whether Your Investment is a Value Trap
1. Earnings and Cash Flow
If a stock’s price is very cheap compared to past earnings this is a warning sign. Past earnings have little effect on the future price of an investment. The markets are looking forward to discount future cash flows. If an investment has fallen to the point where it is absurdly cheap compared to past earnings, that is a clue something is deeply wrong.
2. Business Plan
Beware of a business plan that is not understandable or is unprofitable. If a company is unable to make profits or has a plan that is complicated and hard to explain – avoid it.
Bypass companies whose business plan has been outdated by new technologies. If a product or service is outdated it doesn’t really matter how many other good attributes the company has; it will most likely fail. Technological obsolescence is a common misfortune of many business plans.
Poor management can sink almost any company. If management is selling stock, giving guidance that is untrustworthy, or cutting the dividend; beware. These would be signs of a possible value trap.
Look for management that owns their company’s stock; insider buying is a positive sign. Quality management will give trustworthy guidance and demonstrate they have the knowledge to successfully guide the company.
Producing complicated or fraudulent company accounting reports often means there is additional hidden problems. Any hint of fraud should eliminate an investment from consideration for purchase. This usually results in further declines in the stock or bond price.
Real value investments will have transparent financial reports and credibility with investors. Quality companies with sound management will demonstrate openness and honesty with their successes and failures.
5. Balance Sheet / Debt
The balance sheet may be more important than the income statement for sorting out value traps. High debt can cause problems with liquidity and solvency that can sink an otherwise good business plan. A highly leveraged company has less leeway for making mistakes or overcoming obstacles.
A strong balance sheet is the foundation of a quality company and provides a margin of safety. When a company faces adverse conditions a conservative capital structure gives them the financial flexibility to meet the challenges.
6. Strategic Advantages
A company that lacks strategic advantages to overcome tough competition or heavy regulations can lose their ability to compete. In today’s cutthroat global markets a company must have sustainable competitive advantages. Before purchasing a cheap stock be sure the company has competitive advantages that will provide the cash flow and growth needed to raise the price of the stock.
Does the company have the ability to stay ahead because they are a market leader, have economies of scale, pricing power, differentiation of product, cost benefits, or have powerful brands. Without one or more competitive advantages the company may not be able to thrive.
7. Look Forward Instead of Backwards
A stock may look cheap when compared to its past earnings. But the market values companies on future earnings and growth of those earnings. What a company has earned in the past will have little to do with its value today.
Most financial sites quote P/E ratios based on past earnings. Looking forward means estimating future earnings and cash flows; then comparing those metrics, not past metrics, to the current price.