As a shrewd share investor you should always be on the lookout for what are known as ‘value-plays’ which are simply quality stocks that due to some market mispricing have found themselves trading at a discount to their intrinsic value (aka the sum total of the business’s worth based on earnings, dividends, equity and debt).
However, you need to be careful not to assume that all blue-chip stocks trading at a discount to (IV) are automatically screaming buys.
If you don’t keep an eye on a stock’s underlying business, and where the profits are coming from, what you thought were buying opportunities could turn out to be accidents waiting to happen.
There’s no shortage of one-time large-cap stocks on the ASX which, regardless of their market capitalisation went on to crash and burn.
But the rot can set in if you simply assume that a former blue-chip can replicate its former glory days. You don’t want to be the last shareholder to realise that the company’s best days are now behind it due to any number of reasons.
Commonly referred to as ‘value-traps’, these are stocks that you may have bought into when they appeared to be cheap based on (low) multiples of earnings, cash flow or book value and trading below their IV.
However, if after an extended time period the stock never improves, there’s a strong likelihood that you’ve fallen into a value trap that needs to be lanced from your portfolio.
Given that value-traps seldom improve, it’s better to cut losses, and deploy funds into the market’s next best opportunity than simply ride your losses down.
There might be a future buying opportunity to enter a former value-trap that’s been bought out by private equity with plans to implement a robust turnaround strategy.
But this is a completely different proposition, and the risks of paying too much for this underlying growth story – which may not deliver – are high.
The lesson for rookie share investors is that a discount to IV or low-price earnings ratio (P/E) doesn’t always mean 'cheap'.
While some stocks trade at a significant premium to their value (IV) for good reason, the opposite can also be true.
So as a litmus test of value, the P/E ratio can be and often is highly misleading. Take for example insurers, cyclical businesses, and the materials sector, where the businesses often have high profits and consequently low-price earnings ratios at the very moment when conditions are at their best.
Sadly, investors who are drawn to shares under the psychological $1 barrier often confuse affordability with value. On the flipside, many investors consider 'blue chip' companies with a strong brand name, a high profile and a long history of good performance as perennial bellwethers when they’re clearly not.
Whether it’s poor management, deteriorating economic factors or industry-related issues, stocks that fall into value-trap zone typically struggle to retain market share in the face of new competition, generate substantial and consistent profits, and often lack new products or earnings growth.
The danger of holding onto emerging value-traps is that by the time the company’s deteriorating fortunes become obvious to the broader market, the gap between the price you bought the stock at is now a lot wider.
Given that reporting seasons can be full of surprises, it’s important to stay on the lookout for stocks with disappointing results, together with negative commentary on the outlook for a business or the competitive edge it once enjoyed.
The trick is to anticipate what damage reporting season will have on a stock’s value before any re-ratings occur. Typically, if a broker is going to downgrade a stock, it’s going to happen within a few days of the result, after the dust has settled, so pay attention.
There’s no shortage of value-traps across all industry sectors: Here are 10 to consider.
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