- Investment strategies
- Why invest in the stock market?
- Buy and hold or technical analysis? Why you need an investment plan
- Value investing and short selling in volatile markets
- Using technical analysis to support value investing
- Investing in the unexpected
- Franking credits, explained
- What is dividend stripping and is it a sensible strategy?
- Investing in quality IPOs
- How to invest in stocks that benefit from a moving Australian dollar
- Reasons to avoid bonds when interest rates are low
- How value investors use Skaffold
- Quality, growth and value = a winning strategy
- Know your investor type and boost your performance
- Technical + fundamental analysis = better buy and sell decisions
- Fundamental investing
- Value investing and the price earnings ratio
- Intrinsic valuation models and methodology
- Value investments or value traps?
- How to find value stocks in a bull market
- Find value investments in expanding markets
- Why capital raisings struggle to add investment value
- How to value an insurance company
- Top stocks
- 5 qualities of top stocks
- How to find stocks with a competitive advantage
- Why return on equity is the best measure of business performance
- Using cash flow to find value investments
- Finding high quality dividend stocks
- Debt is not always a dirty word
- Why Skaffold share investment software makes sense
- Using economic factors to uncover the best investment options
- How do experts find top stocks to invest in?
- Investing in global stocks
- How to invest in international shares on global stock markets
- Benefits of investing in international shares
Value investments or value traps?
Quality stocks trading at a discount to intrinsic value should be good investments, but how do you know if they are ‘value traps’?
As an astute share investor you should always be on the hunt for great ‘value-plays’ or quality stocks trading at a discount to their intrinsic value. But if you don’t keep an eye on a stock’s underlying business, and where the profits are coming from, what you thought was a buying opportunity could turn out to be an accident waiting to happen.
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 at a bright green positive safety margin. 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 dealt with before it gets any worse.
Price earnings ratio is not the only indicator
The lesson for new or misinformed share investors is that a big safety margin or low price earnings ratio (P/E) doesn’t always mean 'cheap'. And while some stocks trade at a significant premium to their value for good reason, the opposite can also be true.
So as a litmus test of value, the price earnings 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. Similarly, many investors consider 'blue chip' companies with a strong brand name, high profile and a long history of good performance as perennial bellwethers when they’re not.
Due to any number of factors, whether it’s poor management, deteriorating economic factors or industry-related issues, stocks that become value-traps are frequently unable to survive in the face of new competition or generate substantial and consistent profits, and often lack new products or earnings growth.
The danger of holding onto an emerging value-trap 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 and its value is getting wider.
Value changes with changing results
Reporting seasons can be full of surprises, so be 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.
Many investors will be surprised to see the discount to value they thought some companies were trading at look totally different by year’s end.
So while one sector might look attractive when compared with current earnings, weakness in commodity prices and other macro headwinds pose major risks in buying these stocks going forward.
Examples of quality insurers that have suffered from deteriorating business performance and value include: Insurance Australia Group (IAG) and QBE Insurance.
QBE Insurance (QBE)
In 2007 QBE reported earnings per share of $2.26, and by December 2012 it had fallen to $0.73. Over that same period profit has declined by more than $100 million, while debt has increased to over 25 per cent of the company’s total equity. From a peak of $31.78 in 2007, QBE’s underlying value has fallen by around 60 per cent.
Skaffold Line chart plots QBE’s intrinsic value and share price (at 12 July 2013).
Insurance Australia Group (IAG)
In the case of IAG, the company’s return on equity (a strong measure of profitability), went from over 20 per cent between 2004 and 2006 to less than half that by mid 2012. But despite declining earnings, the company continued to pay a dividend. When cash dried up the company took on debt and in 2008 ROE fell to 0.14 per cent. Unsurprisingly, over the same period the company’s share price virtually halved.
Skaffold Line chart plots IAG’s intrinsic value and share price (at 12 July 2013).
Finding emerging value traps
Let’s take a look at companies that have traded at a discount, and where future valuations are forecast to decline.
Diversified services company Monadelphous Group (MND) looks like an attractive buy. But while its intrinsic value has increased 45 per cent per annum over the past nine years, it is forecast to decrease just over 12 per cent over the next two years. So while MNDs 30 per cent discount to value looks compelling, you should be concerned that this may indeed widen based on deteriorating conditions for the sector.
Skaffold Line chart plots MND’s intrinsic value and share price (at 12 July 2013).
Then there’s taxicab payment operator, Cabcharge (CAB) which – due to the erosion of its virtual monopoly status – is forecast to see its intrinsic value (up 13.5 per cent per annum over the last nine years) decrease by around 10 per cent per annum over the next two years. Given these dynamics, the current circa 40 per cent gap between price and value is concerning.
Skaffold Line chart plots CAB’s intrinsic value and share price (at 12 July 2013).
It would have been inconceivable five years ago to suggest that retail darling JB Hi-Fi (JBH) could be a value trap in waiting, but recent developments are concerning.
Skaffold Line chart plots JBH’s intrinsic value and share price (at 12 July 2013).
Monadelphous, Cabcharge and JB Hi-Fi have a few things in common when you see them in Skaffold. First, their Skaffold Line charts are bright green – they’re all historically strong businesses, and right now are trading at positive safety margins.
On the negative side, looking at their Skaffold Verdict we can see that the future change in value forecast is negative.
Evaluate Future Value for a look ahead
Future Value, also known as FV or Forecast change in Value, is the forecast percentage of annual growth (or decline) in value for a company. Change in Future Value estimates will change as Skaffold's future intrinsic value estimates change.
A business may have a great track record, and in many cases the future looks just as promising. However businesses are dynamic. Economic environments impact business models, consumer sentiment changes and businesses that fail to adapt can be left behind.