Investors are often unwise when it comes to stock picking
For example, assuming a stock has a P/E of four and a P/B of 0.2, then it looks quite attractive at first glance – since it is particularly undervalued. Investors often put such low-rated titles in their portfolio and then hope for price increases. After all, such undervalued titles should be able to increase in price. But caution is advised. It is not uncommon for investors to experience shipwreck with such value stocks. The market often knows why it values such companies so low. Losses can threaten.
Some of the low-rated, i.e. cheap stocks – which later turn out to be so-called value traps – were investor traps that destroy value and were therefore not real value stocks. Sailing around them is a certain art, similar to how ship captains, with the support of their crew, manage to avoid icebergs in the sea that are not visible on the surface. In shipping, certain auxiliary instruments and the experience of the captain and the crew can be used in this case. There are also options for avoiding value traps, which will be explained in more detail below.
How can investors avoid value traps?
To avoid value traps, investors can, for example, first examine the competitive situation of the undervalued public company. A September 2016 paper by Perkins Investment Management – a subsidiary of Janus Capital Group Inc. – entitled “Beware: Value Traps Lurking: What to Look for and How to Navigate Potential Pitfalls” refers to this.
After that, future risks for the company should be analyzed with the help of the 5 competitive forces model once developed by US marketing pope Michael E. Porter. If the competitive situation is bad and the situation could even get worse, then the drop in prices, which often ensures favorable valuations, may well be justified.
In addition, the balance sheet situation of the company to be analyzed also plays a major role in the paper. For example, if the debt is too high and equity too small, future losses may no longer be shouldered. But the ability to pay, ie cash holdings and debt management, should also be kept in mind as part of the analysis.
Furthermore, the evaluation of the company could be seen in comparison to the overall market, the industry and its own history, and attention should also be paid to the management and its quality, if necessary.
In summary, according to Perkins Investment Management, the risks of falling into a value trap can be reduced if the company has good balance sheets, consistently strong free cash flow, earnings stability and a good competitive position.
Note catalytic converters and special situations
With a view to avoiding value traps in undervalued stocks, specialist groups often focus on so-called catalysts. Catalysts are conditions that act as “ignition aids”, e.g. for an improved profit situation. An example of such a catalyst for cyclical stocks would be the general economy picking up speed. Many cyclicals tend to be attached to the economy and may be able to significantly improve their profit situation in the event of a strong economic upswing. Rising profit prospects should then tend to help the share prices of the cyclicals and act as “igniters” for a rally. For commodity producing companies, a rise in the price of the respective commodity would also be a possible catalyst for a stock rally. A copper producer, for example, whose share price has dropped massively as a result of a copper price drop and may therefore be valued favorably, should be able to benefit from a sustained increase in copper prices.
In the case of rather defensive stock companies – eg companies from the non-cyclical consumer sector – there is now and then a real undervaluation, because the shares are either swept down by a general market panic or special situations are putting pressure on the prices. A possible special situation would be, for example, a hygiene scandal at a food company that puts pressure on profits in the short term but has no long-term negative effects. As experience has shown that market participants tend to exaggerate bad news, the group’s share price could be so depressed by the scandal that the company now turns out to be a bargain for a longer-term investment.
Value approach à la Benjamin Graham
Another tool for avoiding losses at the overall portfolio level is Benjamin Graham’s very special value approach. Graham (1894-1976) – world-renowned value investor and foster father of Warren Buffett – also recommends a healthy company balance sheet when it comes to selection from real bargain stocks. Shortly before his death, Graham pointed out in an interview with the medical journal “Medical Economics” in 1976 that the equity of public companies should be at least 50 percent of the balance sheet total.
According to Graham, when hunting for real stock bargains, there is another number to look at: the P/E ratio. According to Graham, the P/E should be at most 7. Not higher. According to Graham, a portfolio of at least 30 stock companies with a P/E ratio of no more than 7 and an equity ratio of over 50 percent then represents the minimum.
Graham also gives certain rules in the interview, such as how to deal with losing stocks in the portfolio, how long the investment horizon of the stocks is usually and what specific P/E ratio an investor should focus on.
According to Graham, an average return of 15 percent pa or higher can be achieved in the long term with the help of the two easy-to-use key figures P/E and equity ratio and just a few additional rules. With an expected average annual return of around nine percent for the US stock market for blue chips, Graham’s bargain stock portfolio would outperform the market as a whole by a significant margin. Cheaply valued and solidly financed public companies would thus be a good choice to outperform the broader market over the long term. The few rules that are included ensure, so to speak, that “burst pipes” don’t permanently haunt the portfolio.
Conclusion
So investors shouldn’t make the mistake of rushing into cheaply valued stocks that, for example, have very low P/E or P/B ratios. In addition to a mere fixation on a low rating, quality should also be used in order not to fall into the famous value trap. A healthy financing structure in the company’s balance sheet could serve as an important quality benchmark. In addition, a good competitive position and good management quality should help to reduce the risk of a value trap. If there are certain catalysts that could increase the profit situation, profitability, etc., then a stock rally should probably be possible in the near future.
Editorial office finanzen.net
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