The greatest curse momentum investors/traders in the market face apart from liquidity is ‘the ability to pick stocks. Picking the right stocks for your portfolio is not as straightforward as it is said. Many investors mimic growth strategists and completely forget about their financial plans and risk appetite. Such investors follow the principles of value investing and look at the fundamentals of business before investing in them.
Is it the correct way?
Or what is the correct way to pick stocks?
The aim is to milk returns from your portfolio and not set a trend by investing in one. Therefore, the idea is to identify undervalued stocks that can generate good returns over a longer period of time.
We are aiming longer period of time because the short term only helps build capital but the long term is the only way to grow your portfolio and become rich!
Yea, literary!
All successful investors look at the value of the business.
But are all value investors successful?
A big, definite, gigantic NO!
Then, what separates successful value investors from the not so successful ones?
One of the key characteristics is the ability to come to an understanding that whether the undervalued stock is a good bet or not.
Precisely is it just a trap?
A value trap!
So, what is a value trap?
How do you know the investment you have zeroed in is a value trap?
In today’s blog article let’s understand the importance of Value Investing and ways to avoid Value traps.
Here we go…
Let’s understand Value Investing,
Value investing is a strategy which involves picking stocks that are trading at less than their book value or intrinsic value. In simpler terms, it is about investing in underestimated or underrated stocks in the markets. This forms in the bracket of fundamental analysis, and when fundamental analysis sets in it is expected investors to have a long-term approach. This is exactly the way value investors tend to work.
Based on the intrinsic value, stocks can be categorized as:
Overvalued stocks – or stocks that are selling above their intrinsic value
Undervalued stocks – or stocks that are selling below their intrinsic value
By analysing the financial records of the company which includes revenue, cash flow, profits, etc. with the non-financial parameters like the competition, brand image, target market, etc. one can conclude on the intrinsic value of the stock.
The Price-to-earnings ratio, the price-to-book ratio, free cash flow, etc are some of the most popular ratios used in this context.
However, some investors go a way out, think out of the box and use various \other metrics to calculate the intrinsic value to get a clear picture of the value of the company before investing. Now, that we understand value investing and intrinsic value, let’s look at what a value trap is and how you can identify a value trap stock.
What is a Value Trap?
When you are looking for undervalued stocks, you can come across stocks that are cheaply priced since they have been trading below par for an extended time.
Such stocks seem to fit the space of a perfect bargain!
They are way inexpensive compared to the valuation multiples or industry peers. But sometimes it happens that they fail to perform as per expectations and cause losses. These stocks are without any doubt ‘valuable’, but since they have a higher probability of incurring a loss, we say such stocks are value trap stocks!
So how do you stay away from such stocks?
How do you Identify such Value Trap stocks?
From the point of view of an Investor, it is important to remember that buying a stock simply because its price has fallen considerably can lead you into a value trap.
Here are some signs which help you identify a value trap:
1. Under-performing in its Sector
Note that never ever analyse a stock as a standalone asset. Comparative analysis is fruitful.
If the company is at the top of its operating cycle but still showing lower growth as compared to its peers in the sector, then it calls for additional investigation. Look for reasons behind the lack of performance.
2. Aim for the Management
No company has made linear or exponential progress. Every organization follows a cycle of ups and downs. Usually, a sliding stock price would mean some rigorous changes in the management’s pay structures displaying a responsible and alert management team.
However, if the company’s earnings have declined but the pay structures haven’t adapted, then such companies are less likely to weather economic storms and can be value traps in the long run.
3. Declining Market Share
Market Share is another important aspect of identifying value traps. The market share of a company is an indicator of how it is faring against its competitors. If the company is constantly losing its market share, then there is a huge possibility of it being a value trap.
Usually, an increasing market share is accompanied by a rising share price and vice versa.
4. Inefficient Capital Allocation
This requires some amount of understanding of the company and the industry. An important aspect of a value trap is that the company has good free cash flow but is failing to allocate the capital efficiently to boost business. Hence, if you merely look at the free cash flow numbers and compare it with the company’s peers, then you might fall into the ‘trap’.
Ensure that you determine the efficiency of capital allocation too.
You can look at the Return on Equity (ROE) ratio to assess if the company is utilizing the shareholder equity optimally. Also, the Return on Assets (ROA) ratio can tell you more about how the company is managing its overall assets.
5. ‘Over-promising’ and ‘Under-delivering’
Another classic sign of a value trap. A company’s management always declares long-term and short-term goals based on a plan. However, when the operational results are out, some companies fail to improve at a majority of these goals.
This indicates a gap between the management and operations that is never good for business. Hence, look for companies that ‘under-promise and ‘over-deliver and not the other way round.
6. Debts
More debt in the company’s books can be alarming. While most companies use financial leverage or debts for working capital requirements, leases, etc., they should be able to sustain it too.
If a company has more financial leverage than a multiple-year turnaround, then it can be the scariest value trap. The simplest way of identifying this is by looking at the debt ratio of the company. This is total liabilities divided by the total assets of the company.
A quick look at the D/E ratio can tell you how deep the company is standing in debts as opposed to the equity capital.
If you are an Investor who goes an extra mile to understand the business of the organization/company does spend time getting a clearer picture about the valuation as well.
Getting the stocks right based on the valuations itself is not enough, since you have come this far just have a quick check of the above parameters and make sure you don’t fall into a value trap!
Happy Investing!
Until next time…
